Inadmissible Deductions [Section 40] :

By dividing the assessees into distinct groups, this section places absolute restraint on the deductibility of certain expenses as follows:

(i) Section 40(a) – In the case of any assessee, the following expenses are not deductible:

(1) Any interest (not being interest on loan issued for public subscription before the 1st day of April, 1938), royalty, fees for technical services or other sum chargeable under this Act, which is payable, –

(a) outside India;

(b) in India to a non-resident, not being a company or to a foreign company, on which tax is deductible at source under Chapter XVIIB and such tax has not been deducted or, after deduction, has not been paid on or before the due date of filing of return specified under section 139(1). It is also provided that where in respect of any such sum, where tax has been deducted in any subsequent year, or has been deducted in the previous year but paid after the due date of filing of return under section 139(1) , such sum shall be allowed as a deduction in computing the income of the previous year in which such tax has been paid.

Clarification regarding disallowance of „other sum chargeable‟ under section 40(a)(i) [Circular No. 3/2015, dated 12-02-2015] If there has been a failure in deduction or in payment of tax deducted in respect of any interest, royalty, fees for technical services or other sum chargeable under the Act either payable in India to non-corporate non-resident or a foreign company or payable outside India, then, disallowance of the related expenditure/ payment is attracted under section 40(a)(i) while computing income chargeable under the head “Profits and gains of business or profession”. The interpretation of the term ‘other sum chargeable‘ in section 195 has been clarified in this circular i.e. whether this term refers to the whole sum being remitted or only the portion representing the sum chargeable to income-tax under the Act. In its Instruction No. 2/2014, dated 26.02.2014, the CBDT has clarified that the Assessing Officer shall determine the appropriate portion of the sum chargeable to tax as mentioned in section 195(1), to ascertain the tax liability on which the deductor shall be deemed to be an assessee in default under section 201, in cases where no application is filed by the deductor for determining the sum so chargeable under section 195(2). In this circular, the CBDT has, in exercise of its powers under section 119, clarified tha t for the purpose of making disallowance of ‘other sum chargeable‘ under section 40(a)(i), the appropriate portion of the sum which is chargeable to tax shall form the basis of disallowance. Further, the appropriate portion shall be the same as determined by the Assessing Officer having jurisdiction for the purpose of section 195(1). Also, where the determination of ‘other sum chargeable‘ has been made under sub-section (2), (3) or (7) of section 195 of the Act, such a determination will form the basis for disallowance, if any, under section 40(a)(i).

(2) Section 40(a)(ia) provides that 30% of any sum payable to a resident, on which tax is deductible at source under Chapter XVII-B, shall be disallowed if –

(i) such tax has not been deducted; or

(ii) such tax, after deduction, has not been paid on or before the due date specified in section 139(1).

If in respect of such sum, tax has been deducted in any subsequent year or has been deducted during the previous year but paid after the due date specified in section 139(1), 30% of such sum shall be allowed as deduction in computing the income of the previous year in which such tax has been paid.

If, for instance, tax on royalty paid to Mr. A, a resident, has been deducted during the previous year 2015-16, the same has to be paid by 31st July/30th September 2016, as the case may be. Otherwise, 30% of royalty paid would be disallowed in computing the income for A.Y.2016-17. If in respect of such royalty, tax deducted during the P.Y.2015-16 has been paid after 31st July/30th September, 2016, 30% of such royalty would be allowed as deduction in the year of payment.

Illustration
Delta Ltd. credited the following amounts to the account of resident payees in the month of March, 2016 without deduction of tax at source. What would be the consequence of nondeduction of tax at source by Delta Ltd. on these amounts during the financial year 2015 -16, assuming that the resident payees in all the cases mentioned below, have not paid the tax, if any, which was required to be deducted by Delta Ltd.?

	Particulars	Amount in Rs
(1)	Salary to its employees (credited and paid in March, 2016)	12,00,000
(2)	Directors‘ remuneration (credited in March, 2016 and paid in April, 2016)	28,000

Would your answer change if Delta Ltd. has deducted tax on directors‘ remuneration in April, 2016 at the time of payment and remitted the same in July, 2016?

Solution
With effect from A.Y.2015-16, non-deduction of tax at source on any sum payable to a on which tax is deductible at source as per the provisions of Chapter XVII -B would attract disallowance under section 40(a)(ia). Therefore, non-deduction of tax at source on any sum paid by way of salary on which tax is deductible under section 192 would attract disallowance @30% under section 40(a)(ia). Whereas in case of salary, tax has to be deducted under section 192 at the time of payment, in case of directors‘ remuneration, tax has to be deducted at the time of credit of such sum to the account of the payee or at the time of payment, whichever is earlier. Therefore, in both the cases i.e., salary and directors‘ remuneration, tax is deductible in the P.Y.2015-16, since salary was paid in that year and directors‘ remuneration was credited in that year. Therefore, the amount to be disallowed under section 40(a)(ia) while computing business income for A.Y.2016-17 is as follows –

	Particulars	Amount paid in Rs	Disallowance u/s 40(a)(ia) @ 30%
(1)	Salary [tax is deductible under section 192]	12,00,000	3,60,000
(2)	Directors‘ remuneration [tax is deductible under section 194J without any threshold limit]	28,000	8,400
	Disallowance under section 40(a)(ia		3,68,400

If the tax is deducted on directors‘ remuneration in the next year i.e., P.Y.201 6-17 at the time of payment and remitted to the Government, the amount of ` 8,400 would be allowed as deduction while computing the business income of A.Y.2017-18. Section 201 provides that the payer (including the principal officer of the company) who fails to deduct the whole or any part of the tax on the amount credited or payment made to a resi dent payee shall not be deemed to be an assessee-in-default in respect of such tax if such resident payee –

(i) has furnished his return of income under section 139;

(ii) has taken into account such sum for computing income in such return of income; and

(iii) has paid the tax due on the income declared by him in such return of income, and the payer furnishes a certificate to this effect from an accountant in such form as may be prescribed.

The date of deduction and payment of taxes by the payer shall be deemed to be the date on which return of income has been furnished by the resident payee.

Consequently, in cases where such person responsible for deducting tax is not deemed to be an assessee-in-default on account of payment of taxes by the resident payee, it shall be deemed that the payer has deducted and paid the tax on such sum on the date of furnishing return of income by the resident payee.

Since the date of furnishing the return of income by the resident payee is taken to be the date on which the payer has deducted tax at source and paid the same, 30% of such expenditure/payment in respect of which the payer has failed to deduct tax at source shall be disallowed under section 40(a)(ia) in the year in which the said expenditure is incurred. However, 30% of such expenditure will be allowed as deduction in the subsequent year in which the return of income is furnished by the resident payee, since tax is deemed to have been deducted and paid by the payer in that year.

Disallowance of any sum paid to a resident at any time during the previous year without deduction of tax under section 40(a)(ia) [Circular No.10/2013, dated 16.12.2013] There have been conflicting interpretations by judicial authorities regarding the applicability of provisions of section 40(a)(ia), with regard to the amount not deductible in computing the income chargeable under the head ‘Profits and gains of business or profession‘. Some court rulings have held that the provisions of disallowance under section 40(a)(ia) apply only to the amount which remained payable at the end of the relevant financial year and would not be invoked to disallow the amount which had actually been paid during the previous year without deduction of tax at source. Departmental View: The CBDT‘s view is that the provisions of section 40(a)(ia) would cover not only the amounts which are payable as on 31st March of a previous year but also amounts which are payable at any time during the year. The statutory provisions are amply clear and in the context of section 40(a)(ia), the term “payable” would include “amounts which are paid during the previous year”. The Circular has further clarified that where any High Court decides an issue contrary to the above “Departmental View”, the “Departmental View” shall not be operative in the area falling in the jurisdiction of the relevant High Court.

(3) any sum paid on account of tax or cess levied on profits on the basis of or in proportion to the profits and gains of any business or profession;

(a) Any sum paid outside India (on account of any rate or tax levied) which is eligible for tax relief under section 90 or deduction from the income-tax payable under section 91 is not allowable and is deemed to have never been allowable as a deduction under section 40(a).

(b) However, the tax payers will continue to be eligible for tax credit in respect of income-tax paid in a foreign country in accordance with the provisions of section 90 or section 91, as the case may be.

(c) Any sum paid outside India (on account of any rate or tax levied) and eligible for relief under section 90A will not be allowed as a deduction.

(4) any sum paid on account of wealth tax.

For the purpose of this disallowance the expression ‘wealth -tax‘ means the wealth-tax chargeable under Wealth-tax Act, 1957, or any tax of similar nature or character chargeable under any law in any country outside India or any tax chargeable under such law with reference to the value of the assets of, or the capital employed in a business or profession carried on by the assessee, whether or not the debts of business or profession are allowed as a deduction in computing the amount with reference to which such tax is charged, but does not include any tax chargeable with reference to the value of any particular asset of the business or profession.

(5) (i) any amount paid by way of royalty, licence fee, service fee, privilege fee, service charge, etc., which is levied exclusively on, or

(ii) any amount appropriated, directly or indirectly, from a State Government undertaking, by the State Government (SG)

A State Government undertaking includes –

(6) any sum which is chargeable under the head ‘Salaries‘ if it is payable outside India or to a non-resident and if the tax has not been paid thereon nor deducted therefrom under Chapter XVII-B.

(7) any contribution to a provident fund or the fund established for the benefit of employees of the assessee, unless the assessee has made effective arrangements to make sure that tax shall be deducted at source from any payments made from the fund which are chargeable to tax under the head ‘Salaries‘.

(8) Tax paid on perquisites on behalf of employees is not deductible- In case of an employee, deriving income in the nature of perquisites (other than monetary payments), the amount of tax on such income paid by his employer is exempt from tax in the hands of that employee. Correspondingly, such payment is not allowed as deduction from the income of the employer. Thus, the payment of tax on perquisites by an employer on behalf of employee will be exempt from tax in the hands of employee but will not be allowable as deduction in the hands of the employer.

(ii) Section 40(b) – In the case of any firm assessable as such or a limited liability partnership (LLP) the following amounts shall not be deducted in computing the income from business of any firm/LLP:

(1) Any salary, bonus, commission, remuneration by whatever name called, to any partner who is not a working partner. (In the following discussion, the term ‘remuneration‘ is applied to denote payments in the nature of salary, bonus, commission);

(2) Any remuneration paid to the working partner or interest to any partner which is not authorised by or which is inconsistent with the terms of the partnership deed;

(3) It is possible that the current partnership deed may authorise payments of remuneration to any working partner or interest to any partner for a period which is prior to the date of the current partnership deed. The approval by the current partnership deed might have been necessitated due to the fact that such payment was not authorised by or was inconsistent with the earlier partnership deed. Such payments of remuneration or interest will also be disallowed. However, it should be noted that the current partnership deed cannot authorise any payment which relates to a period prior to the date of earlier partnership deed.

Next, by virtue of a further restriction contained in sub-clause (iii) of section 40(b), such remuneration paid to the working partners will be allowed as deduction to the firm from the date of such partnership deed and not for any period prior thereto. Consequently, if, for instance, a firm incorporates the clause relating to payment of remuneration to the working partners, by executing an appropriate deed, say, on July 1, but effective from April 1, the firm would get deduction for the remuneration paid to its working partners from July 1 and onwards, but not for the period from April 1 to June 30. In other words, it will not be possible to give retrospective effect to oral agreements entered into vis a vis such remuneration prior to putting the same in a written partnership deed.

(4) Any interest payment authorised by the partnership deed falling after the date of such deed to the extent such interest exceeds 12% simple interest p.a.

(5) Any remuneration paid to a partner, authorised by a partnership deed and falling after the date of the deed in excess of the following limits:

On the first Rs 3 lakh of book profit or in case of loss, the limit would be the higher of Rs 1,50,000 or 90% of book profit and on the balance of book profit, the limit would be 60%.

Illustration
A firm has paid Rs 7,50,000 as remuneration to its partners for the P.Y.2015-16, in accordance with its partnership deed, and it has a book profit of Rs 10 lakh. What is the remuneration allowable as deduction?

Solution
The allowable remuneration calculated as per the limits specified in section 40(b)(v) would be –

Particulars	Rs
On first Rs 3 lakh of book profit [Rs 3,00,000 × 90%]	2,70,000
On balance Rs 7 lakh of book profit [Rs 7,00,000 × 60%]	4,20,000
	6,90,000

The excess amount of Rs 60,000 (i.e., Rs 7,50,000 – Rs 6,90,000) would be disallowed as per section 40(b)(v).

There are four Explanations to section 40(b):

Explanation 1 provides that where an individual is a partner in a firm in a representative capacity:

(i) interest paid by the firm to such individual otherwise than as partner in a representative capacity shall not be taken into account for the purposes of this clause.

(ii) interest paid by the firm to such individual as partner in a representative capacity and interest paid by the firm to the person so represented shall be taken into account for the purposes of this clause.

Explanation 2 provides that where an individual is a partner in a firm otherwise than in a  representative capacity, interest paid to him by the firm shall not be taken into account if he receives the same on behalf of or for the benefit of any other person.

Explanation 3 defines the term “book profit”. It means the net profit as shown in the profit and loss account for the relevant previous year computed in accordance with the provisions for computing income from profits and gains.

The above amount should be increased by the remuneration paid or payable to all the partners of the firm if the same has been deducted while computing the net profit.

Explanation 4 defines a working partner. Accordingly, it means an individual who is actively engaged in conducting the affairs of the business or profession of the firm of which he is a partner

(iii) Section 40(ba) – Association of persons or body of individuals : Any payment of interest, salary, commission, bonus or remuneration made by an association of persons or body of individuals to its members will also not be allowed as a deduction in computing the income of the association or body.

There are three Explanations to section 40(ba):

Explanation 1 – Where interest is paid by an AOP or BOI to a member who has paid interest to the AOP/BOI, the amount of interest to be disallowed under clause (ba) shall be limited to the net amount of interest paid by AOP/BOI to the partner.

Explanation 2 – Where an individual is a member in an AOP/BOI on behalf of another person, interest paid by AOP/BOI shall not be taken into account for the purposes of clause (ba). But, interest paid to or received from each person in his representative capacity shall be taken into account.

Explanation 3 – Where an individual is a member in his individual capacity, interest paid to him in his representative capacity shall not be taken into account.