Section 40A of Income Tax Act, 1961: Expenses or payments mot deductible in certain circumstances
Because section 40A(1) expressly states that the provisions of section 40A shall apply notwithstanding anything to the contrary contained in any other provisions of the Act, the provisions covered by the various subsections of section 40A have precedence over the provisions of any other section. Therefore, if any of the sub-sections of section 40A apply, any expense or allowance, even one that is expressly permitted under any other provisions under the head business or profession, will not be deductible.
1. Expenses or payments not deductible where such payments are made to relatives.[Section 40(2)]
When the assessee makes any expenditures for which payment has been made or will be made to specific individuals (i.e., relatives or close friends of the assessee), and the assessing officer believes that such expenditures are excessive or unreasonable in light of the fair market value of the goods, services, or facilities for which the payment is made or the legitimate needs of the assessee's business or profession or the benefit derived from such expenditures, as much of the expense as is so deemed by him to be excessive or unreasonable shall not be allowed as a deduction, regardless of the reason for which the payment is made, the legitimate needs of the assessee's business or profession, or the benefit derived or accruing to him therefrom.
Three requirements must be met in order for an amount to be disallowed under this Section:
a. the payment is made in relation to any expense;
b. the payment for such expenses has been made to or will be made to a specific person;
c. Given the following considerations, the payment for the expense is deemed excessive or unreasonable:
(i) the items, services, or facilities' fair market value; or
(ii) the actual business requirements of the assessee's enterprise or line of work; or
(iii) the advantage that the payee will receive as a result of the payment.
If the aforementioned requirements are met, the Assessing Officer may refuse to approve the expenditure to the extent that, in his opinion and in accordance with the aforementioned objective standards, it is excessive or unreasonable.
However, if a specified domestic transaction referred to in section 92BA is carried out at an arm's length price as defined in section 92F, no disallowance will be made because the expenditure is excessive or unreasonable in light of the fair market value not less than 20% of such business or profession's profits.
2. Disallowance of 100% of Expenditure if payment is made by any mode other than Account Payee Cheque or Draft [Section 40A(3)(a)]
No deduction shall be made for any expense incurred by the assessee for which the total of payments made to a person in a day, other than by account payee bank draft or account payee cheque, or through the use of an electronic clearing system through a bank account, exceeds Rs. 10,000.
3. Exceptions provided in Rule-6DD, under which expenditure, even exceeding Rs.10,000 / Rs. 35,000 shall be Allowed as Deduction,
In addition, there are some exceptions listed in rule 6DD that allow deductions for expenses up to and including Rs. 10,000 / Rs. 35,000, even if the payment or the total of payments made to a person in a day are not made by an account payee check or draft.
These exceptions are:
1. When a payment is made to
(i) the Reserve Bank of India, a banking company,
(ii) the State Bank of India, a subsidiary bank,
(iii) a co-operative bank, a land mortgage bank,
(iv) a primary agricultural credit society, or a primary credit society,
(v) the life Insurance corporation of india
2. where a payment is made to the government and is required to be made in legal tender by the government's rules;
3. where the payment is made by—
(i) a book adjustment from one account in a bank to another account in that bank or any other bank;
(ii) mail or telegraphic transfers made through a bank;a bank;
(iii) mail or telegraphic transfers made through a bank;
(iv) the use of an electronic clearing system through a bank account;
(v) a bill of exchange that is payable only to a bank;
4. if the payment is made by way of adjustment against the sum of any liability incurred by the payee for any goods supplied or services rendered by the assessee to such payee;
5. where the payment is made for the purchase for —
(i) To the cultivator, grower, or producer of such items, produce, or products:
(ii) agricultural or forest products; animal husbandry products (including livestock, meat, hides, and skins); dairy or poultry products;
(iii) fish or fish products; fish; or
(iv) horticultural or apicultural products;
6. if the producer of the goods is compensated for the sale of goods produced or processed in a cottage industry without the use of machinery;
7. If the payment is made in a village or town that, as of the date of the payment, is not served by any banks, it may be made to any person who ordinarily resides in that village or town or who is engaged in any type of business, profession, or occupation there.
8. when an employee of the assessee or the heir of any such employee receives a payment on or in connection with their retirement, retrenchment, resignation, discharge, or death on account of gratuity, retrenchment compensation, or another similar terminal benefit, and the total amount of such payments to the employee or his heir does not exceed $50,000;
9. when an assessee pays his employee salary after deducting income tax from that salary in accordance with section 192 of the Act, and when that employee—
(i) is temporarily assigned for a period of time of at least fifteen days to a location other than his regular place of duty or to a ship; and
(ii) does not maintain any account in any bank at such place or ship;
10. the payment was required to be made on a day when banks were closed due to a strike or a holiday;
11. where a person pays an agent acting on his or her behalf who is required to make a cash payment for goods or services;
12. where a licensed dealer or money changer makes the payment in exchange for buying foreign currency or traveler's checks in the regular course of business.
4. Disallowance in respect of Provision for Gratuity[Section 40A(7)]
Gratuity is a liability that typically develops based on how long an employee of the assessee has worked there. Typically, the liability would grow every year. However, it has been stipulated under section 40A(7) that deduction on account of provision for gratuity shall be allowed only in the following circumstances due to practical difficulties in computing the deduction allowable on an accrual basis:—
a. either when a provision has been made for payment of a sum by way of any contribution towards an approved gratuity fund, or
b. when the amount of gratuity has actually become payable during the previous year to the employees (provided deduction has not been claimed under clause (b) below).
5. Disallowance in respect of Contributions to Non-statutory Funds[Section 40A(9)]
Only the amount paid by the assessee as an employer into an approved gratuity fund, recognized provident fund, or an approved superannuation fund (for the purposes and to the extent required by law) shall be allowed as a deduction, according to the provisions of various sections. Regarding any amount paid to establish or form a fund, trust, society, etc. for an unapproved or unrecognized purpose, no deduction shall be made.