Introduction

The Income Tax Act, 1961, aims to ensure that taxpayers claim only legitimate business expenses while computing their taxable income. To achieve this, Section 40 specifies certain expenses that are not allowed as deductions when calculating income under the head “Profits and Gains of Business or Profession.” Understanding these disallowed expenses helps businesses avoid errors in tax compliance and minimizes the risk of penalties.

This blog explores the types of expenses disallowed under Section 40, supported by examples, case laws, and practical explanations.

---

Overview of Section 40

Section 40 disallows specific expenses from being deducted while computing taxable income. These disallowances apply to business income and aim to regulate deductions to ensure transparency and accountability.

---

Types of Expenses Disallowed Under Section 40

Section Clause	Disallowed Expenses
Section 40(a)(i)	Payments to non-residents or foreign companies without appropriate TDS (Tax Deducted at Source) compliance.
Section 40(a)(ia)	Payments to residents without TDS deduction or delayed TDS deposit.
Section 40A(2)	Excessive payments to related parties (beyond reasonable limits).
Section 40(b)	Payments to partners of a firm, such as remuneration and interest exceeding prescribed limits.
Section 40(c)	Excessive payments to directors and other employees in companies.
Section 40(a)(iii)	Payments to employees outside India without tax deduction under Section 192.

---

Detailed Explanation of Each Clause

1. Section 40(a)(i): Payments to Non-Residents Without TDS

Payments such as royalties, fees for technical services, or other sums chargeable to tax in India made to non-residents or foreign companies are disallowed if TDS is not deducted or deposited.

Example:

• A business pays ₹5,00,000 as royalty to a foreign consultant without deducting TDS. This expense will be disallowed under Section 40(a)(i).

Compliance Tip: Deduct and deposit TDS as per applicable rates to claim this deduction.

---

2. Section 40(a)(ia): Payments to Residents Without TDS

Payments to residents such as interest, commission, brokerage, rent, or professional fees are disallowed if TDS is not deducted or deposited within the due date.

Example:

• A company pays ₹2,00,000 as commission to a resident agent without deducting TDS. This expense will be disallowed under Section 40(a)(ia).

---

3. Section 40A(2): Excessive Payments to Related Parties

Expenses paid to related parties, including relatives, directors, or entities controlled by the taxpayer, exceeding the fair market value are disallowed.

Example:

• A business pays ₹10,00,000 as rent to a director for a property with a fair rental value of ₹5,00,000. The excess ₹5,00,000 will be disallowed under Section 40A(2).

Case Reference:

• In CIT v. Edward Keventer Pvt. Ltd. (1972) 86 ITR 370 (SC), the Supreme Court ruled that payments must align with fair market values to qualify as deductions.

---

4. Section 40(b): Payments to Partners

Payments to partners in a partnership firm, such as salary, bonus, commission, or interest, exceeding prescribed limits are disallowed.

Nature of Payment	Prescribed Limit
Interest on Partner’s Capital	Maximum 12% per annum.
Remuneration to Partners	Subject to limits specified under Section 40(b)(v) based on book profits.

Example:

• A firm pays ₹10,00,000 as salary to partners, exceeding the limit of ₹7,50,000 as per Section 40(b)(v). The excess ₹2,50,000 will be disallowed.

---

5. Section 40(c): Excessive Payments to Directors and Employees

Excessive or unreasonable payments made to directors and employees of companies are disallowed.

Example:

• A company pays ₹50,00,000 as salary to a director when the fair market salary for the role is ₹30,00,000. The excess ₹20,00,000 will be disallowed.

---

6. Section 40(a)(iii): Payments to Employees Outside India Without TDS

Salary or remuneration paid to employees working outside India is disallowed if tax is not deducted under Section 192.

Example:

• A company pays ₹8,00,000 as salary to an employee working in the USA without deducting TDS. This amount will be disallowed under Section 40(a)(iii).

---

Case Laws Supporting Section 40

1. CIT v. East India Hotels Ltd. (1994) 209 ITR 854 (SC)
   • Highlighted the importance of deducting TDS for foreign payments to claim deductions.
2. CIT v. HMM Ltd. (1995) 216 ITR 401 (SC)
   • Explained that excessive payments to related parties must be justified with reasonable valuation.
3. CIT v. Punjab Stainless Steel Industries (2014) 364 ITR 144 (SC)
   • Clarified that failure to deduct TDS results in disallowance under Section 40(a)(ia).

---

FAQs

1. What is the purpose of Section 40?
Section 40 ensures taxpayers claim only legitimate expenses as deductions and comply with TDS provisions.

2. Can excessive payments to relatives be allowed as deductions?
No, excessive payments to relatives or related parties are disallowed under Section 40A(2).

3. What happens if TDS is deducted but deposited late?
If TDS is deposited after the due date but before filing the return, the expense is allowed in the same financial year.

4. Are salary payments to employees always allowed as deductions?
Salary payments are allowed only if they are reasonable and comply with TDS rules.

5. Are payments to non-residents always disallowed?
Payments to non-residents are disallowed only if TDS is not deducted or deposited.

---

Conclusion

Section 40 plays a vital role in regulating business expenses by disallowing certain payments to ensure transparency and compliance. By adhering to TDS requirements and ensuring payments align with fair market values, businesses can avoid disallowances and penalties. Proper documentation and professional advice can further help maintain tax compliance.

Additional Resources

Learn more about Tax Provisions on the official Income Tax India website.

Want to consult a professional? Contact us: 09463224996

For more information and related blogs, click here.