Inadmissible Expenses and Disallowances in Business Income

Understand Inadmissible Expenses and Disallowances

Key rules to remember

Business income after disallowances

Business income = Book profit + Disallowed expenses + Unpaid pay-to-claim items of this year − Earlier-year items paid this year

Start from profit after the expenses were debited. Add back only what was debited. Do not add back an item that was never debited.

Cash payment rule

Single payment, or total to one person in one day, above ₹10,000 in cash or non-prescribed mode → 100% of that expenditure disallowed

The limit is ₹35,000 for payments to a transporter for plying, hiring or leasing goods carriages. Account payee cheque or draft, bank electronic clearing and prescribed electronic modes are fine. Test per person per day, not per bill. The rule hits an item only to the extent it is claimed as expenditure. An amount fully disallowed under this rule is not disallowed again for TDS default.

TDS default on resident payee

Disallowance = 30% × expenditure, for specified payments to residents on which tax was deductible but not deducted, or deducted but not deposited by the due date for filing return

This covers only specified payments on which TDS is required, such as interest, commission, fees, rent and contractor payments. If tax is deducted and deposited by the return due date, nothing is disallowed. If tax is deducted in a later year, or deducted in the year but deposited after the return due date, the 30% disallowed is allowed in the year the tax is deposited.

TDS default on non-resident payee

Disallowance = 100% × expenditure, if the sum is chargeable to tax in India and tax deductible was not deducted, or was deducted but not paid on or before the due date for filing return

This covers interest, royalty, fees for technical services and other sums payable to a non-resident, only where the sum is chargeable to tax in India and TDS applies. If the sum is not chargeable to tax in India, this disallowance does not apply. If tax is deducted in a later year, or deducted in the year but paid after the return due date, the amount is allowed in the year the tax is paid.

Payments to related persons

Disallowance = Amount paid − Reasonable amount having regard to fair market value, legitimate business need and benefit derived

Applies where the payee is a specified related person, such as a relative of the proprietor or a director of the company. Only the excess is disallowed.

Allowed on payment basis (due-date group)

Allowed in the year it relates to if paid on or before the due date for filing the return; otherwise allowed in the year of actual payment. Items: taxes, duties, cess, fees; employer contribution to provident, superannuation, gratuity and similar funds; bonus or commission to employees, only where it would not otherwise be payable as profit or dividend; interest on loans from banks and public financial institutions

Employer contributions to funds follow the same rule as taxes, bonus and bank loan interest: they are allowed if paid by the return due date. Bonus or commission is covered by this rule only where it is payable to employees and would not otherwise be payable as profit or dividend. Employees' contributions are a separate rule and need payment by the due date under the relevant law. Mere provision or accrual gives no deduction. Interest converted into a new loan or borrowing is not payment.

Allowed only on actual payment (separate from the due-date group)

Leave encashment: allowed only in the year of actual payment. Sums due to micro and small enterprises: if unpaid beyond the section 15 MSMED Act time limit (15 days where there is no written agreement, or the agreed period, never more than 45 days), allowed only in the year of actual payment

Paying these items by the return due date does not make them allowable in the earlier year. Add them back in the year debited and allow them in the year paid. Micro and small enterprise dues paid within the time limit are not caught by this rule.

Never allowed

Income tax and similar taxes on profits, provisions (other than ascertained liabilities), personal expenses, capital expenditure

Check these first. They are disallowed regardless of how paid.

How to solve Inadmissible Expenses and Disallowances questions

1. 1Write the starting figure: net profit as per the profit and loss account, after all the debits the question mentions.
2. 2List each expense the question gives. Mark whether it is a business expense at all. Capital, personal, income tax and general provisions are added back at once.
3. 3For each remaining payment, test cash: was the payment above ₹10,000 to one person in one day by cash or a non-permitted mode? Add up same-day payments to the same person. Use ₹35,000 for goods transporters. If the item is fully disallowed here, do not disallow it again for TDS default.
4. 4For items not already disallowed, test TDS: was tax deductible on this payment? Was it deducted and deposited by the return due date? If the payee is a resident and the payment is a specified one on which TDS is required, and tax was not deducted, or was deducted but not deposited by the return due date, disallow 30%. If the payee is a non-resident, the sum is chargeable to tax in India and tax was deductible but not deducted, or was deducted but not paid by the return due date, disallow 100%. If the tax is deducted later, or deposited after the due date, the amount disallowed is allowed in the year of deposit.
5. 5Test related persons: if the payee is a specified related person, compare the payment with fair market value and disallow only the excess.
6. 6Test pay-to-claim items. For taxes, fund contributions, bonus or commission to employees (only where it would not otherwise be payable as profit or dividend) and bank loan interest, add back those unpaid by the return due date. For leave encashment, add back whatever is unpaid. For micro and small enterprise dues unpaid beyond the section 15 MSMED Act time limit (15 days, or the agreed period up to 45 days), add back whatever is unpaid at year end; the return due date does not help. Then deduct amounts of earlier years that were paid in this year.
7. 7Add all add-backs and deduct the earlier-year payments from the book profit. Show a short table of item, reason and amount.
8. 8State the final business income. Mention any assumption, such as TDS being applicable, in one line.

Quickest way: Four-question scan for disallowances

Common mistakes in Inadmissible Expenses and Disallowances

• Disallowing 100% of a resident payment for TDS default

  Students mix up the resident and non-resident rules, or recall the older rate pattern.

  Fix: Resident payee: 30%. Non-resident payee: 100%. Write the payee's status next to the item before computing.

• Testing the cash limit bill by bill instead of per person per day

  Students read each payment separately and see it is below ₹10,000.

  Fix: Add all cash payments to the same person on the same day. If the total is above ₹10,000, the whole amount is disallowed, not just the excess.

• Disallowing only the excess over ₹10,000 in cash

  Students treat the limit like an exemption limit.

  Fix: The limit is a trigger. Once crossed, the entire expenditure is disallowed.

• Forgetting to allow earlier-year dues that are paid this year

  Students focus on add-backs and treat the adjustment as one-sided.

  Fix: Always check for amounts disallowed earlier for non-payment and paid now. Deduct them in the year of payment.

• Adding back an expense that was never debited to the profit and loss account

  Students add back every item in the list without checking whether profit already reflects it.

  Fix: Add back only debited items. If the question says an amount is paid out of capital or not recorded, check how it was treated before adjusting.

• Treating a mere provision or conversion of interest into a new loan as payment

  Students assume that any journal entry counts as payment.

  Fix: Payment means actual discharge of the liability. Provisions, adjustments and conversion of unpaid interest into a loan do not qualify.

Worked examples