Income tax Section 40A(3) disallows payment above Rs. 10000/- (₹35,000 for transporters) from being allowed as expenses.
This is done in the Interest of transparency & reducing tax evasion.
While the limit is rigorous, rule 6DD provides certain exceptions for practical difficulties & business needs.
In this article, we examine major provisions exceptions & judicial decisions which deal with the application of Section 40A(3).
Key Highlights of Section 40A(3)
Basic Applicability
Payment more than Rs, 10,000/- in day to single party other than through account payee cheque or bank draft, or electronic modes is not allowed as deductible expenses. For transporters, the limit is increased to Rs. 35,000/-
Section 40A(3A) Application
If any expense was incurred & claimed as a deduction in the previous year which was paid in cash more than Rs.10,000/- then such payment is considered as taxable income u/s. 40A(3A).
Objectives
To control tax evasion, to ensure transactions are observable by the tax authorities. To promote digital and non-cash payment modes.
Amendments to Section 40A(3)
1. Threshold Reduction: Cash payments above ₹20,000 were not allowed. The 2009 amendment reduced the threshold to ₹10,000.
2. Specific Modes: Introduced electronic clearing systems (ECS) and specified electronic modes as permissible alternatives.
3. Expanded Scope: Included transactions involving stock-in-trade and raw materials under its purview
Exceptions under Rule 6DD
Considering that cash transactions could not be completely eliminated in some cases, Rule 6DD provides exceptions to Section 40A(3)
1. Government Payments: Taxes customs duty, railway tickets, and others when paid in legal tender.
2. Payments to Financial Institutions: Payment to RBI, cooperative banks, agricultural credit societies, or LIC.
3. Forex Transactions: Purchases of traveller's cheques or foreign currencies from an authorized dealer.
4. Employee Benefits: Retrenchment compensation, gratuity, or terminal benefits up to ₹50,000.
5. Remote Locations: Salaries are paid in cash to employees stationed in remote areas where banking facilities are not available.
6. Specific Purchases: Includes rural or farm purchases, slaughtering animals, and cottage industry.
7. Non-Banking Regions: Payments made in villages or towns that do not have a bank
Payment for Purchase of Stock-in-Trade Covered by Section 40A(3)
1. Inclusion of Stock-in-Trade Payments:
Payment in Respect of Stock-in-trade Payments for acquiring stock-in-trade fall under Section 40A(3) as such expenditures form an essential part of business activity and have a direct effect on profitability computation under Section 28.
2. Exceptions Under Rule 6DD:
The cash transactions are exempt under certain conditions prescribed under Rule 6DD, such as-
a) Payments in localities where no banking facility exists.
b) Payments on agricultural or horticultural produce to the cultivators.
3. Effect on Compliance:
Failure to obey with Section 40A(3) means that all cash payment from business expense is disallowed leading to an increase in taxable income.
Supreme Court's Decision: Attar Singh Gurmukh Singh v. ITO (1991)
This case related to the Section 40A(3) to cash payments by the assessee towards purchasing stock-in-trade. The assessee was a trader who had made payments above the prescribed limit under the section mainly for stock-in-trade. Payments were not even through prescribed banking channels such as account payee cheques/drafts. The ITO disallowed the expenses under Section 40A(3), which prohibits cash payments other than those allowed under Rule 6DD beyond the specified limit. The assessee argued against the disallowance, leading to a legal battle that ultimately reached the Supreme Court.
Submissions by the Assessee
1. Stock in trade purchases were not expenditure within the purview of Section 40A(3) as urged by the assessee.
2. These payments were genuine business transactions, and the assessee argued that these should not attract disallowance as they were essential for business operations.
3. The payments were forced by business conditions, for example delivery had to be done urgently or the parties had no banking facilities in regions.
Analysis by the Assessing Officer
1. The AO contended that the payments were more than the threshold limit prescribed under Section 40A(3).
2. The payments were made not through account payee cheques or drafts, which are contrary to the statutory provision.
3. The AO found no exceptional circumstances under Rule 6DD to warrant cash payments and entirely disallowed the expenses.
Analysis by the Commissioner of Income Tax
1. The CIT affirmed the order of the AO, which held that Section 40A(3) applies to all business expenditure, including stock-in-trade.
2. The CIT emphasized that the rule was passed to have traceability and check the unaccounted cash transaction.
3. The assessee could not present any authentic proof for the cash payments made under Rule 6DD exemptions.
Tribunal's View
1. The Tribunal held for Revenue that stock-in-trade purchases constitute 'expenditure' on the definition according to commercial accounting practices.
2. It stressed that actual business transactions do not automatically fall under Section 40A(3) exemption unless they fall in Rule 6DD criteria.
3. The Tribunal found no evidence to suggest that the payments were made under unavoidable circumstances.
Supreme Court Judgment
1. Meaning of 'Expenditure': Supreme Court, inter alia held that under Section 40A(3) the word 'expenditure' has wide amplitude and thus includes all outgoings incurred wholly and exclusively for purposes of business, including stock-in-trade.
2. Relevancy to Stock-in-Trade: Payments for stock-in-trade are covered u/s 40A(3). Since these payments directly figure in arriving gross profit u/s 28 of the Act, their consideration becomes an essential part of the business.
3. Genuineness Not Material: It clarified that the genuineness of the payment is not over-riding requirement of following the prescribed modes of payment under the statute.
4.Exceptions under Rule 6DD: Relief is available only if the assessee can show that the payments were made in circumstances falling within the ambit of Rule 6DD, such as the absence of banking facilities or payments for agricultural produce.
5. Legislative Intent: The judgment highlighted the legislative intent of Section 40A(3): to curb tax evasion and ensure transparency in business transactions.
Key Takeaways
1. Definition of the Expenditure: Stock in trade purchases are treated as expenditure under Section 40A(3) and the same would be disallowed if the amount paid in cash exceeds the prescribed limit.
2. Mandatory Banking Channels: The payment in excess of ₹10,000 (₹35,000 for transporters) should be made through account payee cheques, drafts, or electronic modes to claim deductions.
3. Limited Exemptions: Relief under Rule 6DD is available only under limited circumstances, such as non availability of banking facilities or to the cultivators.
4. No Automatic Relief for Genuineness: Even legitimate deals are not exempted from rejection if they do not have a statutory basis or otherwise qualify for Rule 6DD.
5. Purpose of Compliance: The judgment highlights the value of procedural compliance to prevent section 40A(3) rejections. This landmark judgment reiterates the purpose of Section 40A(3), that is, to increase the transparency in dealing and reduce cash dealings. The judgment ensures that taxation of business transactions will improve with such compliance.
v No Disallowance U/S 40A(3) When No Deduction of Expenditure is Claimed
I. Applicable of Section 40A(3):
This section will apply only when the cash payment is claimed as a deduction for the purpose of computing taxable income.
I. Expenditure in Balance Sheet:
If the expenditure is capitalized (for instance, as closing stock) or is appearing in the balance sheet and not in the Profit and Loss Account, then Section 40A(3) will not apply.
II. No Deduction, No Disallowance:
If the assessee doesn't claim the expenditure as deduction there is no problem of disallowance U/S 40A(3).
III. Verification by Assessing Officer :
It is the AO's responsibility to verify whether the expenditure has been claimed as a deduction before invoking Section 40A(3).
IV. Undertaking to Avoid Future Claims:
Committing to not claim this expenditure in future years will assist the taxpayer in avoiding the repercussions of disallowance.
Case Analysis: CIT v. Motilal Khatri (2008) 218 CTR (Raj) 602
Facts of the Case
The assessee incurred case payment more than specified under Section 40A(3) of the Income Tax Act.
These expenses related to the assets acquisitions or purchases of items appearing in the assessee's balance sheet rather than claimed as deductions in the P & L.
The AO disallowed the payments under Section 40A(3), arguing that cash payments exceeded permissible limits.
Submission by the Assessee
1. The assessee said that the amount spent in cash was not deductible from the taxable income.
2. The payments made for the closing stock or capital asset in the balance sheet.
3. Since no deduction was claimed, the rules in Section 40A(3) regarding the disallowance of deductions for cash payments did not apply..
Analysis by the Assessing Officer
- The AO treated the cash payments as a violation of Section 40A(3) which prohibits payments more than a certain limit except for a prescribed banking mode.
- AO had disallowed the amounts as being treated as forming part of the deduction allowable business expenditure.
Analysis by the CIT
- If expenses are recorded in the Profit and Loss Account this section 40A(3) applicable
- Payments are recorded as assets on balance sheet instead of being claimed as expenses in P&L statement.
Tribunal's Decision
- The Tribunal agreed with the findings of the CIT(A).
- Section 40A(3) is relied upon only when the expense is claimed as a deduction.
- Payments that are reflected as assets or closing stock in the balance sheet are outside the purview of this section.
Judgment by the Rajasthan High Court
- The court gave a nod to the determination of CIT(A) and Tribunal.
- Section 40A (3) is only relevant where a claim for expenditure incurred is made in the computation of taxable income.
- In this case, because the payments were not accepted as deductions there was no point in invoking Section 40A(3) for any disallowance.
Key Takeaways
Scope of Section 40A(3):
- The above section applies only to cash payments considered for deduction in the computation of income.
- When the expenditure is capitalized- for example, as a component of closing stock or assets-it cannot attract Section 40A(3).
Shown in Balance Sheet: Payments reflected in the balance sheet rather than in the Profit and Loss Account are not disallowed by Section 40A(3).
Judicial Decision: It decides that the applicability of Section 40A(3) is restricted to only the claimed deductions and not for capitalizing it.
AO's Verification: The AO must verify the expenditure's nature and ascertain whether it has been claimed as deduction before invoking Section 40A(3)
Case: Vikrant Happy Homes (P) Ltd. v. Dy. CIT 2022 TaxPub(DT) 4024 (Pune-Trib)
Facts of the Case
- The assessee engaged in land dealing and development made cash payments for land purchases that exceeded the limit set by Section 40A(3) of the Income Tax Act.
- The AO disallowed these cash payments citing violation of the mandated payment method.
- The Commissioner of Income tax supported the AO's decision to disallow the payments.
Submission by the Assessee
1. Nature of Payment: The assessee claimed that these lands were part of the company's closing stock.
2. Non-Deductible Nature: Cash payment were not eligible for any deductions in Profit & Loss Account u/s. 40A(3) which specific disallowance of deductions for cash payment did not apply.
3. Genuineness of Transactions: The cash payments were legitimate and the sellers admitted to receiving them. These were made on business compulsions so that deals could be sealed in time and competitors should not intervene.
Analysis by the Assessing Officer: Decision of Assessing office on Section 40A(3) which state that any cash payment more than Rs.10,000 to person in a day is not allowed as deductible expenses and this judgment was based on Section 40A(3) without in view of if payments were linked to deductible business expense or closing stock
Observations by the Commissioner of Income Tax
- CIT(Appeal) has agreed with interpretation of officer & affirmed disallowance.
- The focus was still on the default of the payment mode under Section 40A(3).
Tribunal's Decision
1. Section 40A(3)'s Applications
- Above would apply only if the expenditure is claimed as deduction at the time of calculating taxable income.
- As the assessee did not claim the cash payments as a deduction Section 40A(3) could not be applied.
2. Genuineness of Transactions
- The Tribunal accepted that the transactions were genuine, as the sellers accepted having received the cash payments.
- The payments were made due to business compulsions, which further established the genuineness of these transactions.
3. Final Judgment
- The Tribunal's decision in the assessee favor holding that disallowance under Section 40A(3) was unnecessary when no deduction was claimed for the expenditure in question.
Key Take away
1. Scope of Section 40A(3): Applies only when cash payments exceeding the prescribed threshold are claimed as deductions. Does not apply to transactions forming part of the closing stock.
2. Genuineness Matters: If the genuineness of the cash payments is established and acknowledged by the recipient, disallowance may not hold if no deduction is claimed.
3. Business Exigencies Considered: Justifiable business necessities, like closing deals in time to prevent competition, will be valid reasons for cash payment.
4. Judicial Precedence: This case supports the proposition that Section 40A(3) cannot be invoked where the expenditure does not constitute a part of the deductible income.
5. Burden of Proof: It is the assessee's responsibility to prove transactions and its accounting management to avoid disallowance.
Conclusion
Section 40A(3) is an important tool for increasing financial transparency and preventing tax evasion. Though it strictly prohibits cash payments, the exceptions under Rule 6DD provide for genuine and unavoidable situations. Businesses should be aware of these provisions by using traceable payment methods, maintaining proper documentation, and being aware of applicable exceptions. The judicial interpretations that are changing over time provide a framework for balancing tax compliance with business exigencies
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