Disallowance of Expenses u/s 40(a) (ia) of the Income-tax Act

S.R. Wadhwa, Advocate Former Chairman,
Income-tax Settlement Commission

The Provision

The Finance Act (No.2) Act, 2004 has inserted sub-clause (ia) to clause (a) of section 40 of the Income-tax Act w.e.f. 01/04/2005.  It lays down the condition of deposit of tax deducted at source of allowability of certain expenses paid or payable to a resident while computing the total income of the assessee from business or profession.  They are:-

  1. Interest covered by sections 193, 194A;
  2. Commission or brokerage covered by section 194H
  3. Fees for professional or technical services covered by section 194J
  4. Payment to a contractor or sub-contractor covered by section 194C.  

Other payments requiring deduction of tax at source such as salary (s.192) and rent (s. 194-I) made to residents are not covered by this prohibitory provision. 

2. As certain important issues of interpretation arise and tax disputes in a big way as started coming up from the AY 2005-06 and onwards, it is necessary to study this provision in great depth.  The said sub-clause (ia) is, therefore, reproduced below:-

“S.40  Notwithstanding anything to the contrary in sections 30 to 38, the following amounts shall not be deducted in computing the income chargeable under the head “Profits and gains of business or profession”-

          (a)      in the case of any assessee
                   (i)      ………………
(ia) any interest, commission or brokerage, fees for professional services or fees for technical services payable to a resident, or amounts payable to a contractor or sub-contractor, being resident, for carrying out any work (including supply of labour for carrying out any work), on which tax is deductible at source under Chapter XVII-B and such tax has not been deducted or, after deduction has not been paid during the previous year, or in the subsequent year before the expiry of the time prescribed under sub-section (1) of section 200.
          Provided that where in respect of any such sum tax has been deducted in any subsequent year or, has been deducted in the previous year but paid in any subsequent year after the expiry of the time prescribed under sub-section (1) of section 200, such sum shall be allowed as a deduction in computing the income of the previous year in which such tax has been paid”.
 
3. Provision similar to sub-clause (ia) already exists in sub-clause (i) of clause (a) to section 40 where under interest, royalty, fees for technical services and other sums payable to non-residents are not allowed deduction in computing the income of an assessee if he has not deducted or after deduction has not paid the same on any of these items of expenditure.  Besides, the salary payable outside India or to a non-resident is, like wise, not allowable as deduction because of section 40(a) (iii) if tax deducted is not paid or is not deducted at source.

4. Proviso to sub-clause (ia) permits deduction of the expense if tax is deducted there from in any subsequent year or is deducted in the relevant previous year but is paid in any subsequent year after the expiry of the time prescribed under sub-section (1) of section 200.   Under section 200(1) read with Rule – 30 of the Income-tax Rules, the tax is to be paid within 7 days of the end of the month in which it is deducted.  If the amount liable to tax deduction is credited to the account of the payee on the last date of the accounting year of the assessee, the tax deducted thereon can be paid within two months of that date.  Since the accounting year in most cases is the financial year, such amount in respect of which payment of tax deducted, is made up to 31st May of the next year, will be allowed deduction in computing the income of the deductor-assessee even though actually paid in the next year.   Thus, the criterion for allowance is not the accrual or payment of the expense but the deposit of TDS on such expense within previous year or the time permitted by law.

5. Another criterion is that the “tax is deductible at source” from the expense.   Thus for example, expense on account of interest will not be deductible on the payee furnishing a declaration as prescribed in section 197A (1A) to the effect that no tax is deductible as his estimated total income of the year will be nil. Thus in such a case, the rigours of section 40(a) (ia) will not be applicable.

Objective of the Provision

6. The provision is intended to ensure better compliance of TDS provisions and to curb bogus or non-genuine payments largely in respect of wide spread hawala entry racket and other similar rackets prevalent in many parts of the country.  It supplements several existing weapons in the armory of the Income Tax Department for enforcement of TDS provisions, namely; interest u/s 201(1A), penalty u/s 271C, prosecution u/s 276B etc.  Being a penal provision that disallows bonafide expense in computing the total income, it needs to be interpreted strictly keeping in view the underlying objective.

Important Issues

7.  Several important issues arise in the implementation of this provision.  They are:-

  1. Legal validity – whether the principle of double jeopardy applicable
  2. Single transaction – no tax can be deducted subsequently
  3. Delay in the payment of tax deducted at source
  4. Deduction of payment of lower tax
  5. Tax paid voluntarily or collected involuntarily, without deduction from the payee
  6. How to obtain credit for excess payment of tax not deducted from the payee
  7. Tax not deducted at source but is paid by the payee in his assessment
  8. Tax on usance interest – whether deductible
  9. Disharmony between provision to section 40(a) (ia) and section 199

(i) Legal validity – whether principle of double jeopardy applicable

8.  Article 20(2) of the Indian Constitution lays down the principle against double jeopardy and states that no person shall be prosecuted for the same offence more than once.   The question that arises is if sub-clause (ia) of section 40(a) violates the principle against double jeopardy by disallowing bonafide business expenditure on which tax is not deducted and thereby increasing taxable income in addition to penalizing the assessee for the same offence by charging interest, levying penalty and initiating criminal prosecution.

9. In the context of the levy of penalty as also starting criminal prosecution for the same offence of non-deduction/non payment of tax, the Courts have held in the past that the rule of double jeopardy is applicable to criminal cases and cannot be applied to penalty and prosecution for the same offence of non-deduction in income tax cases.  [CIT v. Ram Chandra Singh (1976) 104 ITR 77 (Patna)].  Besides, penalty and prosecution are separate proceedings and the question of double jeopardy will not arise.  [PNB Finance and Industries v. ITO 157 ITR 385 (Del) and Sequoia Construction Co. Ltd. v ITO 158 ITR 496 (Del)]. 

Since disallowance of expenditure and levy of penalty/prosecution are different proceedings, it could be argued that the principle against double jeopardy will not be applicable and expense could be disallowed in computing the business expense in addition to other consequences for non deduction/payment of tax.

(ii) Single transaction - No tax can be deducted subsequently Application of the maxim “Lex Non Cogit Ad Impossibilia”
10.     If tax is deducted and paid in a subsequent year, the business expenditure can be reduced from total income in that year.  But tax can be deducted if there is another transaction between the assessee and the same payee or some amount should remain outstanding to enable deduction.  What happens if there was only one transaction and the payment was made in full without deduction of tax?  Could not the assessee rely on the well-known maxim of Lex Non Cogit Ad Impossibilia, which means that the law does not compel a person to do that what he can not possibly perform?   This principle has been well recognized by the Courts of law [For example, see Escorts Ltd. v. CIT 257 ITR 468, 476 (Del)].  The maxim may help in bonafide cases of non-deduction e.g. subsequent change of law or Court judgement or Board’s clarification making a payment taxable from some earlier date.

(iii) Delay in payment of tax deducted at source

11. There may be some delays in payment of tax deducted at source beyond the period prescribed in sub-section (1) of section 200 read with Rule-30 of the Income-tax Rules.  Will the assessee lose the benefit of deduction of the prescribed expenditure in the computation of his income?  It appears, he will not lose the benefit.  The expression in sub-clause (ia) to the effect that “after deduction, has not been paid during the previous year,” implies that even if, after deduction, there is delay in payment, the expense will be deducted in computing the total income if the tax deducted is paid within the previous year.     

(iv)  Deduction and payment of lower tax than required

12. Situations may also arise where the deduction of tax and its payment is lower than what was required under the law.  The issue would be; (i) if the full amount will be allowed as deduction: or (ii) it will only be proportionate to the tax deducted at source: or (iii) no deduction at all will be allowed. 

13.  While there is no direct decision on the subject, there are judgements, in the area of short deduction of tax, which show that the issue has to be judged on the basis of the facts and circumstances of each case.  If there was bonafide dispute about the liability for tax deduction or about the rate of tax deduction, it may be possible to claim deduction of the expenses in the computation of income even where the deduction was at a lower rate than what was held ultimately in tax litigation.    Although sub-section (1) and (1A) of section 201 was amended by Finance Act, 2001 with effect from 01.04.1962 to deem the assessee a defaulter and make him liable to pay interest if there is short deduction yet the nature of responsibility cast on the deductor is to form an honest and bonafide opinion as to the deduction of tax from salaries as was held in the case of Gwalior Rayon Silk Co. Ltd. v. CIT ((1983) 140 ITR 832 (MP).  Besides u/s 191(2), the deductee is liable to pay tax on his income and this liability is not extinguished in case of short deduction of tax.  

(v)  Tax paid voluntarily or collected involuntarily without deduction from the payee

14.  Another situation would be where the tax was not deducted at source but was paid voluntarily or collected by the Income-tax authorities from the assessee through coercive methods prescribed in section 201.  The way sub-clause (ia) to section 40(a) is worded, a view can be taken that the assessee will not be entitled to the deduction of the expenditure where tax was not deducted by him but was voluntarily paid by him or involuntarily collected from him.   The main sub-clause (ia) as well as the proviso thereto makes deduction from the payee an essential condition for allowing expenditure as business deduction in the hands of the assessee.  However, in a similar provision contained in sub-clause (i) of section 40(a) in respect of payments to non-residents and foreign companies, the Rajasthan High Court, in Addl. CIT v. Farasal Ltd. (1987) 163 ITR 364-371-2 (Raj), interpreted the word “paid” in that sub-clause to include involuntary payment of tax collected by the Revenue.  In doing so, it took into account the fact that the object of section 40(a) (i) is to protect the interest of Revenue by ensuring that in respect of the amount chargeable under the Act and payable outside India, the tax is paid by the non-resident or deducted in cases where the non-resident does not have any agent in India from whom the tax can be recovered.  From this point of view, it is immaterial whether the Revenue has received payment of the tax due either voluntarily or by initiation of recovery proceedings against him.  Following the ratio of the said judgement of the Rajasthan High Court, the voluntary or involuntary payments of tax should be covered in the word “paid” used in section 40(a) (ia) also.  Deduction of expenditure should be allowed to the assessee in case of involuntary payments.   The word “paid” would also take in voluntary payments made by the assessee without deduction from the payee.

(vi) Credit for payment of tax not deducted at source

15.  Where the tax is paid by or is recovered from the assessee without having been deducted from the payee, the latter cannot get the credit for the deduction of tax at source because no such deduction was effected from the payment made to him.  The assessee also cannot issue him the certificate of tax deduction.  On the other hand the payee has paid the tax due in his assessment.  Who will then get the credit for such payment and in what manner is the question that is likely to arise in several cases.  While it is desirable by the Board to issue an instruction on the subject, the assessee paying the tax without deducting the same could claim the refund or seek adjustment against any tax demand outstanding against him or getting the refund if no demand is outstanding by relying on the ratio of Board’s Circular No. 285 dated 21.10.1980 reported at 130 ITR 01 (St).  In that Circular, the Board considered the issue of excess payment of the amount not actually deducted or deductible at source and held that it can be refunded “to the person responsible for making such payment”.  The assessee may have to show that the payee has paid the tax in his assessment and there has thus been no loss of revenue.

(vii) Tax not deducted at source paid by the payee in his assessment

16. Very often, issue that is arising is  as to whether the deduction for the expenses would be admissible to the assessee where no tax was deducted at source but the payee has in his assessment paid the tax? If so, in which year such deduction would be liable. 

17. Deduction of tax at source is only one of the modes of recovery and is “without prejudice to any other mode of recovery” (s. 202).  The charge of income tax u/s 4(1) of the Act is on the payee and this is also specifically provided in section 190(2) of the act, which states that the tax deduction provisions will not “prejudice the charge of tax on such income under the provision of sub-section (1) of section 4”.  Besides, section 191 requires the payee to make that payment of the tax that is not deducted at source.  Finance Act 2003 has inserted an Explanation in section 191 which treats the assessee to be in default for the purposes of the  proviso to sub-section (1) of section 201 only to the extent of non-deduction of tax that “has not been paid by the assessee/payee direct”.    

18. Gujarat High Court in CIT v. Rishikesh Apartments Co-Operative Society Ltd. (2002) 253 ITR 310 (Guj) held that “it would not be proper on the Board of the Revenue to levy any interest u/s 201 (1A)” where the payee has paid the tax directly at the time when it had become due.  Similar view has been taken by several other High Courts notably the Kerala High Court in the case Kannan Diwan Hill Produce Co. Ltd. v. CIT (1986) 161 ITR 477 (Ker) and Madhya Pradesh High Court in CIT v. Life Insurance Corporation of India (1987) 166 ITR 191 (MP).  Apart from the non-levy of interest, the deductor will not be liable for penalty u/s 221 since he will not be an assessee in default where the tax has been paid by the payee directly.

19. In such a situation, could the deduction of expense u/s 40(a) (1a) be denied?   One view is that section 40(a) (1a) stands on a different footing.    The pre-requisite for the allowability of expenditure is the deduction of tax at source and the deposit of the same with the Central Government before the expiry of time prescribed under sub-section (1) of section 200 on which “tax is deductible at source under Chapter XVII-B and such tax has not been deducted or after deduction has not been paid ……………..”.   One has to look at the words used in the enactment and if they are clear and unambiguous, there is no scope in any intendment.  According to this view, deduction of the expenses should not be allowed even if the payee made the payment of the entire tax in his assessment.  

20. The other view proceeds on the basis that the denial of the deduction could lead to an absurd result and would also not be in consonance with the objective of this provision, namely to ensure the collection and recovery of tax.  The tax on the same income cannot be collected twice.  If the payee has made the payment in his assessment and the assessee is not to be treated as in default and no interest/penalty is leviable in view of Explanation to section 191, it would be unreasonable to deny deduction of the expense to the assessee.  It will also be absurd to require him to pay the tax in order to claim the deduction and since it would have been paid in excess and no certificate of deduction could be given to refund the excess payment to him.  It, therefore, appears to be fair and reasonable, though against the plain language of section 40(a) (ia) to allow the deduction for the expenses in the year in which the payment has been made by the payee direct.  Of course, it will be for the assessee to lead evidence to the satisfaction of the Assessing Officer that the payment of tax has been made directly and in the year in which it has been made.

  1. The second view appears preferable.

(viii)  Tax on usance interest – whether deductible

22.  Usance interest is very common in both, national and international purchases made on deferred payment basis.  Gujarat High Court in CIT v. Vijay Shipbreaking Corporation (2003) 261 ITR 113 (Guj) has held that usance charges represent usance interest charged by the bank/non-resident to be regarded as interest within the meaning of section 2(28A) and if the payer in India did not deduct income tax at source, he could not claim deduction of the expenditure on account of interest/usance charges and the entire amount thereof would be liable to be disallowed u/s 40(a)(ia) of the Act.  Similar view was taken by Madras High Court in CIT v.   C.C.C. Holidays (2003) 260 ITR 433 (Mad).

23. Though detailed, the judgement of the Gujarat High Court in Vijay      Shipbreaking seems to require re-consideration.   It hinges on the question as to whether usance interest arises from debt referred to in section 2(28A) which defines the word “interest”.   The High Court has referred to the Jurisprudence by Roscoe Pound Part III page 176.7where it is stated that “Debt arises from the unwillingness or inability to pay cash down. When the purchase price becomes payable against delivery and the engagement to pay it at a later date or by installments”. In this case there was no unwillingness to pay against delivery. With letters of credit as stipulated by the seller having been raised, and the two agreements as dictated by the seller having been signed on the dotted line, there could be no question of the party unwilling to pay a debt having been incurred. The Interpretation placed by the High Court would imply that where a sale takes place a debt is incurred which seems far-fetched. A debt can be said to have been incurred when there is failure to pay and that gives rise to an actionable claim.

24. Besides the Oxford Dictionary defines the word  ‘usance’ to mean ‘time given for payment of foreign exchange” So if the foreign seller gives, let us say, 180 days to the purchaser for payment, the so called interest charged for 180 days will not make the purchase price a debt.  It is in the nature of finance charges similar to the cost of material and manufacturing costs while making goods for sale.  Entry in the books of account and categorizing the payment as interest will also not be decisive as was held by the Supreme Court in Kedarnath Jute Manufacturing Co. v. CIT 82 ITR 363 (SC).  Besides, the Madras High Court in the case of CIT v. India Pistons (2006) 282 ITR 632(Mad) held that the payment of purchase price in installments for supply of goods to a non-resident and the interest on unpaid installment was not the same thing as loan and no tax was deductible at source.  It, therefore, appears that the last word on the nature of usance interest has not been said though the preponderance of judicial opinion is that tax is deductible at source on such interest.

(ix) Disharmony between provision to section 40(a) (ia) and section 199

25. Section 199 prescribes that the credit for the tax deducted at source will be allowable to the payee in the year in which the income liable to deduction is assessed to tax.  Normally, income is assessed on accrual basis.  The payee may not get the benefit of the deduction of tax at source if it is deducted by the assessee in a year subsequent to the year in which it is assessable in the payee’s hands.  Principles of equity and justice will require that such credit should be allowed in the assessment year relevant to the previous year in which the payment is made.

26. To sum up, the above discussion would show that there are several issues that arise in implementing the provision. Basically, in the zeal of the Revenue to add yet another weapon in its armoury to strengthen the enforcement of TDS provisions it has lost sight of the implications of the basic concept that the TDS is merely one of the methods of collection and recovery of tax; the charge of tax on the income continues to be on the deductee because of charging section 4 of the Act. The provision was justified in the case of deductees being non-residents and the Revenue not being able to reach them for levy and collection of tax. Its extension to residents is the root cause of various anomalies and absurdities as pointed out above. But we have no option but to help its enforcement in as best a manner as possible.

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