Expenses and Payments Not Deductible in Business Income

Understand Expenses and Payments Not Deductible

Key rules to remember

Excessive payment to specified person (section 36(2))

Disallowance = amount the Assessing Officer considers excessive or unreasonable

Judged against fair market value, legitimate business needs and benefit derived. Only the excess is disallowed, not the whole payment.

Specified person for a company (section 36(3))

Company: any director or his relative; also a person with substantial interest, or a business in which such persons have substantial interest

For an individual it is a relative; for a firm, a partner or his relative; for an AOP, a member or his relative; for an HUF, a member or his relative.

Substantial interest (section 36(3)(b))

Company: beneficial owner of shares carrying ≥ 20% voting power at any time in the tax year. Other cases: beneficially entitled to ≥ 20% of profits

Shares with a fixed rate of dividend do not count. The test is at any time during the tax year.

Cash payment limit (section 36(4))

Payment or aggregate of payments in a day to one person > ₹10,000 and not by specified banking or online mode → expenditure disallowed

The whole expenditure paid this way is disallowed, not just the excess. The test is per person per day.

Limit for goods carriages (section 36(6))

₹10,000 is read as ₹35,000 for plying, hiring or leasing of goods carriages

Applies to sub-sections (4) and (5).

Later cash payment of earlier deducted liability (section 36(5))

Payment in a later year > ₹10,000 in a day, not by specified mode → deemed income of that later year

Applies where the liability was deducted in an earlier tax year. The amount is taxed as business income when paid.

Marked to market or expected loss (section 36(9))

No deduction, except as allowable under section 32(1)(h)

Covers expected losses. Only actual losses are generally deductible.

Head office expenditure of non-resident (section 60)

Limit = 5% of adjusted total income; if adjusted total income is a loss, 5% of average adjusted total income

Average is the mean over the three preceding tax years in which the assessee was assessable; two years if only two, one year if only one. Allowed only for expenditure attributable to the Indian business.

Income from other sources (section 94)

Not deductible: personal expenses; interest or salary payable outside India without tax paid or deducted; all expenses against winnings from lotteries, games and gambling

Owners of horses kept for racing are excepted for their horse owning and maintenance activity.

How to solve Expenses and Payments Not Deductible questions

1. 1List every expense from the question with its amount, and note whether profit has already been reduced by it.
2. 2Check who was paid. If the payee is a director, partner, member, relative or a person with 20% or more substantial interest, test section 36(2) for excess against market value.
3. 3Check how and when payment was made. Add up payments to each person for each day. If one person got more than ₹10,000 in a day (₹35,000 for goods carriages) without banking or online mode, disallow the whole expense.
4. 4Check the nature of the item. Expected losses and marked to market losses are disallowed under section 36(9). Personal expenses are disallowed in other sources under section 94.
5. 5For a non-resident, compute adjusted total income and apply the 5% cap on head office expenditure under section 60.
6. 6Add back each disallowed amount to book profit. Do not add back items that are already allowable.
7. 7State the conclusion clearly: the provision, your analysis, the disallowed amount and the final business income.

Quickest way: Three-question scan for each expense

Common mistakes in Expenses and Payments Not Deductible

• Disallowing only the excess over ₹10,000 for a cash payment.

  Students confuse the cash rule with the excessive payment rule, where only the excess goes.

  Fix: Under section 36(4) the whole expenditure paid in that way is disallowed once the daily limit is crossed.

• Testing the cash limit per payment instead of per person per day.

  The question lists payments separately, so each looks small.

  Fix: Add all payments to the same person in a day. The law speaks of payment or aggregate of payments made in a day to a person.

• Using ₹10,000 for truck hire and leasing of goods carriages.

  Students forget the special limit in section 36(6).

  Fix: For plying, hiring or leasing of goods carriages, use ₹35,000.

• Treating a payment to any relative as disallowed.

  Students think related party means automatic disallowance.

  Fix: Only the part that the Assessing Officer finds excessive or unreasonable, judged on market value, business needs and benefit, is disallowed.

• Applying the 5% cap to the wrong base in the head office rule.

  Students use total income as shown, without removing the adjustments listed in the definition.

  Fix: Use adjusted total income as defined in section 60(3). If it is a loss, use average adjusted total income of the preceding years.

• Allowing a provision for expected loss because it is prudent accounting.

  Books follow prudence, so students assume tax follows the books.

  Fix: Section 36(9) denies marked to market and other expected losses, except as allowed by section 32(1)(h).

Worked examples