Tax Laws and Practice · Computation of Total Income and Tax Liability of various Entities

Deductions Allowed on Actual Payment Basis under Income-tax Act, 2025

Updated 11 October 2026 · Fact-checked

Under section 37 of the Income-tax Act, 2025, certain business expenses, such as taxes, employer fund contributions, leave pay and bank interest, are deductible only in the tax year you actually pay them. Payment on or before the due date of return for the liability year lets you claim it in that year.

Understand Deductions Allowed on Actual Payment Basis

Most businesses keep books on the mercantile (accrual) system. An expense is booked when it becomes due, not when cash leaves. Section 37 overrides this for a list of items. For these items, the deduction depends on payment, not on accrual.

The section applies to sums that are otherwise allowable as a deduction. It does not create a new deduction. It only fixes the timing. It applies irrespective of any contrary provision, the accounting method you follow, and the year in which the liability arose.

The items are listed in section 37(2): tax, duty, cess, surcharge or fee under any law in force; employer contribution to a provident, superannuation, gratuity or employee welfare fund; leave encashment payable to employees; any sum referred to in section 32(a); interest on loans from specified financial entities; amounts payable to Indian Railways for use of railway assets; and amounts owed to a micro or small enterprise beyond the time limit in section 15 of the MSMED Act, 2006.

There is a relief. For all items except the micro or small enterprise item, a payment made after the end of the tax year but on or before the due date of filing the return under section 263(1) for that year is allowed in the year the liability was incurred. So you can claim in the liability year if you pay by the return due date.

There are guard rails. Converting interest into a loan, advance, debenture or other instrument that defers payment is not actual payment. A deduction already allowed in the liability year is not allowed again on payment. Employee contributions you collect are dealt with separately: section 37 does not apply to them, and section 29(1)(e) allows them if credited to the employee's fund account on or before the due date of filing the return under section 263(1) for that tax year.

Key rules to remember

Core rule: Deduction year = tax year of actual payment (items in section 37(2)); Applies irrespective of the accounting method and the year the liability was incurred.
Relief for late payment: Paid after year-end but on or before due date under section 263(1) → allowed in the liability year; Does not apply to the micro or small enterprise item in section 37(2)(g).
Micro or small enterprise payments: Allowed only when paid, if owed beyond the section 15 MSMED Act time limit; Payment after year-end, even before the return due date, does not bring it back to the earlier year.
Interest converted into loan or debenture: Conversion of interest into a deferred-payment instrument ≠ actual payment; Under section 37(4); the deduction waits for real payment.
No double deduction: Already allowed in the liability year → not allowed again on payment; Section 37(5).
Employee contribution: Section 37 does not apply; allowed under section 29(1)(e) if credited to the employee's fund account on or before the due date under section 263(1); Applies to contributions received from employees under section 2(49)(o).
Specified financial entities: Public financial institution, State Financial Corporation, State Industrial Investment Corporation, notified NBFC class, scheduled bank, co-operative bank (other than PACS and primary co-operative agricultural and rural development bank); Section 37(7). Interest to others is not covered by clause (e).

How to solve Deductions Allowed on Actual Payment Basis questions

Use this sequence for any question on actual payment deductions.

1List each expense in the question and confirm it is otherwise deductible under the Act.
2Check whether it falls in section 37(2). If not, normal accrual rules apply under the method of accounting.
3For interest, check the lender is a specified financial entity as defined in section 37(7), and that payment follows the agreement terms.
4Note the date of actual payment of each sum. Treat conversion of interest into a loan or debenture as non-payment.
5Compare the payment date with the end of the liability year and with the due date of return under section 263(1) for that year.
6If paid by the return due date, allow it in the liability year. If later, allow it in the year of payment. Apply the stricter rule to micro or small enterprise dues.
7For employee contributions, apply section 29(1)(e) instead of section 37.
8Check no amount is deducted twice, and state your conclusion clearly.

Quickest way: Three-question check

When to use it: When you have a list of expenses and a few minutes per item.

Is the item in section 37(2)? If no, deduct on accrual.
Was it paid in the liability year? If yes, allow it in that year.
If not, was it paid by the section 263(1) due date? If yes, allow in the liability year (except the micro or small enterprise item). If no, allow in the year of payment.

Common mistakes in Deductions Allowed on Actual Payment Basis

Allowing accrued tax, duty or fee because the books are on mercantile basis.
Students assume the accounting method decides timing.
Fix: Remember section 37(1)(b): the method of accounting is irrelevant for listed items. Only payment counts.
Applying the return-due-date relief to dues owed to micro or small enterprises.
The relief sub-section covers most clauses, so students assume it covers all.
Fix: Section 37(3) excludes clause (g). Such dues are allowed only in the year of actual payment.
Treating conversion of unpaid interest into a debenture or loan as payment.
A book entry looks like settlement.
Fix: Section 37(4) says it is not deemed paid. Allow it only when the new instrument is actually paid.
Allowing interest paid to any lender under clause (e).
Students forget the lender test.
Fix: Check the lender against the section 37(7) list of specified financial entities before applying the rule.
Applying section 37 to employee contributions collected from staff.
Both deal with fund contributions, so they get mixed up.
Fix: Section 37(6) excludes them. Use section 29(1)(e): credit to the employee's fund account on or before the return due date.
Claiming the deduction again in the payment year after claiming it in the liability year.
Students see a payment and reflexively deduct it.
Fix: Section 37(5) bars a second deduction. Track where each sum was already allowed.

Worked examples

Example 1

For the tax year 2026-27, Mehta Traders Pvt. Ltd. (books on mercantile basis) debited ₹4,00,000 as employer contribution to a recognised provident fund. It paid ₹3,00,000 on 20 March 2027 and ₹1,00,000 after the year-end but before the due date of filing the return under section 263(1). Discuss the deduction for 2026-27.

Show the solution

Employer contribution to a provident fund is listed in section 37(2)(b). So it is allowed only on actual payment, whatever the accounting method.
₹3,00,000 was paid within the tax year 2026-27. It is allowed in 2026-27.
₹1,00,000 was paid after the year-end but on or before the due date under section 263(1). Section 37(3) allows it in the year the liability was incurred, 2026-27.
Total deduction in 2026-27 = ₹3,00,000 + ₹1,00,000 = ₹4,00,000, subject to the section 29(1)(a) conditions on recognised funds.

Answer: The full ₹4,00,000 is deductible in 2026-27, as ₹3,00,000 was paid in the year and ₹1,00,000 was paid before the return due date.

Example 2

Sharma Industries Ltd. accrued ₹6,00,000 interest on a term loan from a scheduled bank in 2026-27 and ₹2,00,000 on a loan from a private individual. Nothing was paid in the year. On 10 June 2027 (before the return due date) it paid ₹4,00,000 to the bank. The remaining ₹2,00,000 bank interest was converted into a debenture on 15 July 2027. Compute the deduction allowed for 2026-27 on these interest items.

Show the solution

Interest on the bank loan falls under section 37(2)(e), as a scheduled bank is a specified financial entity under section 37(7). Payment is needed.
₹4,00,000 was paid before the return due date. By section 37(3), it is allowed in 2026-27.
The remaining ₹2,00,000 was converted into a debenture. Under section 37(4) this is not actual payment, so it is not allowed in 2026-27 on this basis. It becomes deductible only when actually paid.
Interest of ₹2,00,000 to a private individual is not covered by section 37(2)(e), because the lender is not a specified financial entity. It follows normal accrual rules under the method of accounting, so it is allowable on accrual in 2026-27 if otherwise deductible.
Deduction for 2026-27 = ₹4,00,000 (bank) + ₹2,00,000 (individual) = ₹6,00,000.

Answer: ₹6,00,000 is allowed for 2026-27. The ₹2,00,000 converted into a debenture is allowed later, in the year it is actually paid.

Exam tips

Write the provision first: name section 37, state it is a timing rule, and then apply it. ICSI answers reward provision, analysis, conclusion.
Always compare the payment date with two dates: year-end and the due date under section 263(1). Write both dates in your answer.
Mention exceptions explicitly: micro or small enterprise dues, interest conversion and employee contributions. These are common question hooks.
Show each item separately with its allowed year, then total. This earns step marks even if one item is wrong.
Cite the Income-tax Act, 2025 section numbers, not the 1961 Act, for the June 2027 session.

Practice questions from Computation of Total Income and Tax Liability of various Entities

Deductions Allowed on Actual Payment Basis in other exams

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

CS ProfessionalDeductions Allowed on Actual Payment Basis

Deductions Allowed on Actual Payment Basis: frequently asked questions

What does section 37 of the Income-tax Act, 2025 say?

It says that listed sums payable, which are otherwise deductible, are allowed only in the tax year in which they are actually paid. This applies despite your accounting method or the year the liability arose. Section 37(3) gives relief for payment by the return due date.

Can I claim a deduction in the liability year if I pay after year-end?

Yes, for most listed items. If you pay on or before the due date of filing the return under section 263(1) for that tax year, the deduction is allowed in the liability year. This relief does not cover dues to micro or small enterprises.

Is interest on a loan from a private person covered by actual payment rules?

No. Section 37(2)(e) covers interest on loans from specified financial entities such as scheduled banks, public financial institutions and certain co-operative banks. Interest to other lenders follows the normal accounting method.

How are employee contributions treated?

Section 37 does not apply to sums received from employees as contribution to funds. Section 29(1)(e) allows them if they are credited to the employee's account in the relevant fund on or before the due date of filing the return under section 263(1) for that tax year.