Understanding Income Tax Section 40A: Disallowances and Business Deductions

 Section 40A of the Income Tax Act, 1961 is a crucial provision for all business taxpayers in India. This section specifies conditions under which certain types of business expenses will not be allowed as deductions when computing taxable income.

Key Objectives of Section 40A

• Prevent tax evasion by discouraging cash payments and untraceable transactions
• Ensure transparency, compliance, and documentation in business expenses
• Encourage digital and banking transactions for better traceability​

Major Provisions Under Section 40A

Disallowance of Cash Payments (Section 40A(3))

Any payment for an expense exceeding ₹10,000 per day, per person, made in cash (i.e., not through banking channels) is disallowed as a business deduction. For transporters, the limit is ₹35,000 per day. Only digital modes or account-payee cheques/drafts are permitted above this amount. The law includes specific exceptions (like payments in remote areas or to certain institutions) defined in Rule 6DD.​

Disallowance for Related Party Transactions (Section 40A(2))

Payments to relatives or entities with substantial interest in the business (related parties) are disallowed to the extent they are considered excessive or unreasonable in relation to the fair market value. The Assessing Officer has authority to scrutinize such transactions and disallow excess payments to prevent profit shifting.​

Disallowance for Non-Compliance with TDS (Section 40(a))

• Payments to Non-Residents (Section 40(a)(i)): Payments (such as interest, royalty, fees, commissions) to non-residents are disallowed if TDS is not deducted or deposited as per law.
• Payments to Residents (Section 40(a)(ia)): Expenses like contract payments, professional fees, and commissions to residents are disallowed if TDS is not deducted or not paid within the due date. If TDS is deducted later or late paid, the deduction is allowed in the year of payment.​

Disallowance for Payment to Unapproved Gratuity Funds

Payments contributed to an unapproved gratuity fund will not be allowed as a deduction under this section.​

Why Is Section 40A Important?

• Increases accountability and reduces the scope for unaccounted or inflated expenses
• Protects revenue by enforcing strict compliance with TDS and cash payment norms
• Promotes a formal, bank-based business culture in India​

Practical Examples

1. Cash Payment to Vendor
• A business pays ₹25,000 in cash to a vendor on a single day. This expenditure will be fully disallowed in tax calculations, except for specified exceptions.
2. Excessive Payment to Related Party
• If a proprietor pays ₹2,00,000 to a close relative for services that normally cost only ₹1,00,000, only ₹1,00,000 will be allowed as a deduction. The rest is disallowed.
3. Non-deduction of TDS
• Suppose TDS is not deducted on a consultant’s fee of ₹1,00,000. The entire expense is added back to taxable income, increasing the tax burden.

Penalties and Consequences

Non-compliance with Section 40A can result in:

• Complete disallowance of the business expense
• Increase in taxable income and higher tax liability
• Possible penalties and interest for non-compliance​

How to Remain Compliant?

• Always make payments above ₹10,000 through traceable banking channels
• Deduct and deposit TDS on time as per relevant provisions
• Ensure that payments to related parties are at arm’s length and properly documented

 

Section 40A is a critical section that ensures only genuine, fair, and transparent business expenses are eligible for tax deduction, contributing to greater compliance and integrity in Indian taxation.