Direct and Indirect Taxation · Profits and Gains of Business or Profession

Expenses Not Deductible and Disallowances in Business Income

Updated 10 October 2026 · Fact-checked

Disallowances are business expenses that the Income-tax Act, 2025 refuses or restricts even if you have booked them. Key ones are section 36 (excess payments to specified persons, cash payments above ₹10,000) and section 37 (items allowed only when actually paid). Add back the disallowed part to book profit.

Understand Expenses Not Deductible and Disallowances

A business expense is first allowed under the general rules. Then the Act removes or limits certain items. These are disallowances. They exist to stop tax leakage: inflated payments to relatives, untraceable cash payments, and claiming a deduction for taxes or contributions you never pay.

In the exam you start from the profit in the books. Every expense already debited there is added back if the Act disallows it, fully or partly. Items that the Act allows only on payment are added back when unpaid, and allowed later when paid.

Three groups matter most. First, excess or unreasonable payments to specified persons (section 36(2) and (3)). Second, cash payments above the limit (section 36(4) to (6)). Third, sums allowed only on actual payment (section 37). Section 36(9) also bars marked to market loss and other expected loss, except as allowable under section 32(1)(h).

Section 37 applies irrespective of your method of accounting. So even if you follow the mercantile system and have provided for the liability, the deduction comes only in the tax year of payment. The one relaxation is payment on or before the due date of filing the return under section 263(1), which brings the deduction into the year the liability was incurred.

Key rules to remember

Specified person payments (section 36(2)): Disallowed = Expenditure − reasonable amount (by fair market value, business needs, benefit derived); Applies to payments to a specified person: relative of an individual; director or relative for a company; partner or relative for a firm; member or relative for an AOP or HUF; and persons with substantial interest.
Substantial interest (section 36(3)(b)): Company: beneficial owner of shares carrying ≥ 20% voting power. Others: beneficially entitled to ≥ 20% of profits.; Test is at any time during the tax year. Shares with a fixed rate of dividend do not count.
Cash payment limit (section 36(4)): Payments in a day to one person > ₹10,000 not via specified banking or online mode → entire such expenditure disallowed; Limit is ₹35,000 for plying, hiring or leasing of goods carriages (section 36(6)). The test is per day, per person, aggregated.
Earlier-year liability paid in cash (section 36(5)): Payment in a day to a person > ₹10,000 (₹35,000 for goods carriages) not via specified mode, for a liability already deducted earlier → deemed business income of the payment year; Do not disallow again; it is taxed as income in the year of payment.
Actual payment items (section 37(2)): Allowed only in the tax year paid: taxes, duties, cess, fees; employer contributions to PF, superannuation, gratuity or welfare funds; leave encashment; interest to specified financial entities; railway dues; MSME payments beyond section 15 time limit; Section 37(3): items other than the MSME payment, if paid by the section 263(1) return due date, are allowed in the year incurred.
Gambling and winnings (section 94(4)): Income from lotteries, games, gambling, betting: no deduction for related expenditure; Exception: owner of horses maintained for running in races, for owning and maintaining them (section 94(5)).

How to solve Expenses Not Deductible and Disallowances questions

Use the same sequence for any disallowance question. Start from book profit and treat each expense separately.

1List every expense debited in the profit and loss account with its amount, payee and date and mode of payment.
2Tag each item to a rule: specified person, cash payment, actual-payment item, expected loss, or no issue.
3For specified persons, identify the payee under the table in section 36(3) and compare the payment with a reasonable amount. Disallow only the excess.
4For cash payments, aggregate payments per person per day. Check the limit (₹10,000, or ₹35,000 for goods carriages) and the mode. Disallow the whole expenditure in the breach.
5For actual-payment items, check payment date against the end of the tax year and the section 263(1) due date. Add back if unpaid by then.
6Check earlier-year provisions paid this year: allow if not already allowed, and apply section 36(5) if paid in cash above the limit.
7Write an add-back schedule with the section against each line, then total it and adjust the profit.

Quickest way: Add-back table method

When to use it: Use for the computation questions where many expenses are listed and time is short.

Draw three columns: item, amount debited, amount to add back.
Go down the list once and write the add-back only. Leave allowed items blank.
Ask two quick questions per item: Was it paid? Was it paid in cash above the limit?
Add the third column and add it to net profit.
Show the section number against each add-back for step marks.

Common mistakes in Expenses Not Deductible and Disallowances

Disallowing only the excess over ₹10,000 in a cash payment.
Students confuse the rule with a threshold-excess rule.
Fix: Under section 36(4), once the day's payment to a person exceeds ₹10,000 without specified mode, the whole expenditure by way of such payments is disallowed.
Testing each bill separately for the cash limit.
Each bill looks small.
Fix: Aggregate all payments made in a day to the same person. Different days are tested separately.
Adding back unpaid taxes or PF contribution even though paid before the return due date.
Students look only at the 31 March position.
Fix: Under section 37(3), payment on or before the due date under section 263(1) allows the deduction in the year incurred. The MSME payment under section 37(2)(g) is excluded from this relief.
Allowing the actual-payment item again when paid later, after it was already allowed.
Students treat payment year as always allowable.
Fix: Section 37(5): if already allowed in the year the liability was incurred, it is not allowed again.
Disallowing the full payment to a relative.
Students assume related-party payments are barred.
Fix: Only the part the Assessing Officer considers excessive or unreasonable is disallowed under section 36(2).
Using ₹10,000 for transport hire in all cases.
Students forget the special limit.
Fix: Use ₹35,000 only for plying, hiring or leasing of goods carriages.

Worked examples

Example 1

Sharma Traders (a firm) debited ₹48,000 to purchases of packing material, paid in cash on one day to one supplier. Separately, it paid ₹30,000 cash to a goods transporter on one day for hiring a goods carriage. Compute the disallowance.

Show the solution

Packing material: payment in a day to one person is ₹48,000, above ₹10,000, and not via specified mode.
Section 36(4) applies, so the whole ₹48,000 is disallowed.
Goods carriage hire: the limit is ₹35,000 under section 36(6).
₹30,000 does not exceed ₹35,000, so no disallowance.
Total disallowance = ₹48,000.

Answer: ₹48,000 is added back to the firm's profit; the ₹30,000 transport payment is allowed.

Example 2

For tax year 2026-27, Mehta Industries Ltd debited: (a) ₹2,40,000 employer PF contribution for March, of which ₹40,000 was paid after the section 263(1) due date and ₹2,00,000 was paid before it; (b) ₹1,50,000 paid to a director's brother for services, where a reasonable value is ₹1,00,000, paid by bank transfer; (c) ₹60,000 interest on a loan from a scheduled bank, unpaid at year end and paid after the return due date. Compute the add-back.

Show the solution

(a) Section 37(2)(b) applies. The ₹2,00,000 paid by the return due date is allowed under section 37(3). The ₹40,000 paid later is added back.
(b) A director's relative is a specified person for a company under section 36(3). Excess = ₹1,50,000 − ₹1,00,000 = ₹50,000, disallowed under section 36(2). Bank payment so section 36(4) is not attracted.
(c) Interest to a scheduled bank is under section 37(2)(e). It was paid after the return due date, so ₹60,000 is added back and is allowed in the year paid.
Total add-back = ₹40,000 + ₹50,000 + ₹60,000 = ₹1,50,000.

Answer: Add back ₹1,50,000 in tax year 2026-27; ₹40,000 and ₹60,000 are allowed in the year of actual payment.

Exam tips

Write the section number against each add-back; step marks depend on the rule being named.
Read the mode of payment in every line. A bank transfer removes the cash disallowance.
Check the payee against section 36(3) before applying the specified person rule, and disallow only the excess.
For unpaid items, note the date of payment against the section 263(1) due date; the question often hides it in a footnote.
In MCQs, watch for the ₹35,000 goods carriage limit and the 20% substantial interest test.

Practice questions from Profits and Gains of Business or Profession

Expenses Not Deductible and Disallowances in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Expenses Not Deductible and Disallowances: frequently asked questions

What is the cash payment limit for business expenses?

Under section 36(4), payments or aggregate payments made in a day to one person above ₹10,000, not made through specified banking or online mode, are disallowed. The limit is ₹35,000 for plying, hiring or leasing of goods carriages.

Which expenses are allowed only on actual payment?

Section 37(2) lists taxes, duties, cess and fees, employer contributions to PF and similar funds, leave encashment, interest to specified financial entities, railway dues and certain MSME payments. They are deductible only in the tax year of payment, subject to the section 37(3) relief.

Who is a specified person?

It depends on the assessee. For a company it means a director or his relative, and for a firm a partner or his relative. It also includes persons with substantial interest, meaning at least 20% of voting power or profits.

Can I claim expenses against lottery or betting winnings?

No. Section 94(4) bars any deduction for expenditure related to such winnings. The only exception is for owners of race horses for owning and maintaining them, under section 94(5).