Expenses or Payments Not Deductible Under Section 40A

Section 40A of the Income Tax Act, 1961 specifies certain expenses or payments that cannot be deducted while computing taxable income under the head “Profits and Gains of Business or Profession” (PGBP). These provisions aim to prevent tax evasion, ensure compliance, and promote transparency in business transactions.

Below is a detailed breakdown of the key disallowances under Section 40A, along with conditions, exceptions, and practical implications.

1. Overview of Section 40A

Section 40A overrides other deduction provisions (Sections 30 to 38) and disallows certain expenses if they:

• Are excessive or unreasonable(Section 40A(2)).
• Are made in cash exceeding ₹10,000 per day(Section 40A(3)).
• Involve unapproved gratuity funds(Section 40A(7)).
• Are contributions to non-statutory welfare funds(Section 40A(9)).

2. Key Disallowances Under Section 40A

A.  Excessive Payments to Specified Persons [Section 40A(2)]

• Applicability: Payments to related partiesdeemed unreasonable by the Assessing Officer (AO).
• Specified Persons Include:
  • Relativesof the assessee (e.g., spouse, siblings, lineal descendants).
  • Directors, partners, or membersof a company/firm/AOP/HUF.
  • Entities with substantial interest(holding ≥20% shares or profits).
• Disallowance Rule:
  • The excessportion (beyond fair market value) is not deductible.
  • Example: A company pays ₹5 lakhas consultancy fees to a director’s relative, but the market rate is ₹3 lakh. The ₹2 lakh excess is disallowed.

B.  Cash Payments Exceeding ₹10,000 per Day [Section 40A(3)]

• Rule: Any single cash payment > ₹10,000(or ₹35,000 for transport operators) is fully disallowed.
• Exceptions (Rule 6DD):
  • Payments in rural areas with no banking facilities.
  • Business exigencies(e.g., urgent purchases).
  • Payments to government entities(e.g., taxes, fees).
• Example: A business buys raw materials for ₹12,000 in cash→ entire ₹12,000 is disallowed.

C.  Cash Repayment of Earlier Deducted Expenses [Section 40A(3A)]

• If an expense was claimed earlier (on accrual basis)but later repaid in cash > ₹10,000, the amount is added back to income.
• Example:
  • Year 1: A firm records ₹50,000(credit) and claims a deduction.
  • Year 2: It repays ₹25,000 in cash→ ₹25,000 is taxable in Year 2.

D.  Provisions for Unapproved Gratuity Funds [Section 40A(7)]

• Only actual paymentsto approved gratuity funds are deductible.
• Disallowed:
  • Provisionsfor future gratuity (not paid).
  • Payments to unapproved funds.
• Example: A company sets aside ₹5 lakhfor gratuity but does not pay → ₹5 lakh is disallowed.

E.  Contributions to Unapproved Welfare Funds [Section 40A(9)]

• Disallowed: Payments to unapproved employee welfare funds, societies, or trusts.
• Allowed: Only if specifically permitted under Section 36(1)(e.g., PF, ESI).
• Example: A company donates ₹1 lakhto an unregistered welfare trust → ₹1 lakh is disallowed.

3. Summary of Key Disallowances

4. Compliance Tips to Avoid Disallowances

1. Avoid Large Cash Transactions: Use digital paymentsfor amounts > ₹10,000.
2. Maintain Fair Pricing: Ensure payments to related parties are at market rates.
3. Deposit Gratuity in Approved Funds: Use recognized gratuity trusts.
4. Keep Documentation: Retain invoices, agreements, and payment proofs.
5. Review Contracts: Ensure TDS compliancewhere applicable.

5. Impact of Non-Compliance

• Increased Taxable Income: Disallowed expenses inflate profits, raising tax liability.
• Penalties: Possible scrutiny & penaltiesfor unreasonable payments or TDS defaults.

Example Calculation

• Disallowed Cash Payment: ₹15,000 → Taxable income increases by ₹15,000.
• Tax Rate 30%: Additional ₹4,500 tax liability.

Conclusion

Section 40A ensures only legitimate business expenses are deductible. Key takeaways:

• Avoid excessive paymentsto related parties.
• Limit cash transactionsto ₹10,000 per day.
• Use approved fundsfor employee benefits.
• Maintain recordsto justify deductions.