Advanced Direct Tax Laws and Practice · Computation of Total Income, Tax Liability and Filing of Returns of various Entities excluding Companies

Deductions Allowed on Actual Payment Basis under Section 37

Updated 11 October 2026 · Fact-checked

Under section 37 of the Income-tax Act, 2025, listed business sums such as taxes, employer fund contributions, leave pay, interest to specified lenders and delayed MSME dues are deductible only when actually paid, whatever your accounting method. Most (not MSME dues) are also allowed for the year of liability if paid by the return due date.

Understand Deductions Allowed on Actual Payment Basis

Normally a business deducts an expense in the year it accrues if it follows the mercantile system. You record the expense, book the liability and claim the deduction, even if you have not paid.

Section 37 changes this for a fixed list of sums. For these, the deduction is allowed only in the tax year in which the sum is actually paid. This holds despite any contrary provision in the Act, despite the method of accounting you follow, and despite the year in which the liability arose.

The listed sums in section 37(2) are: tax, duty, cess, surcharge or fee levied under any law in force; employer contributions to a provident, superannuation, gratuity or employee welfare fund; amount payable in lieu of leave at the credit of an employee; any sum referred to in section 32(a); interest on loans, advances or borrowings from specified financial entities as per the loan terms; amount payable to the Indian Railways for use of railway assets; and amount payable to a micro or small enterprise beyond the time limit in section 15 of the MSMED Act, 2006.

There is a relief. If the sum is paid after the end of the year of liability but on or before the due date of filing the return under section 263(1) for that year, the deduction is allowed in the year of liability. This relief does not apply to the MSME clause (g). For MSME dues paid late, the deduction comes only in the year of actual payment.

Two guardrails apply. Converting interest into a loan, advance, debenture or other instrument that defers payment is not payment. And a sum already deducted in the year of liability cannot be deducted again when paid later.

Key rules to remember

Core rule: Sum in section 37(2) → deduction in the tax year of actual payment; Applies irrespective of the accounting method, any contrary provision in the Act, or the year the liability arose.
Grace rule: Paid after year-end but on or before due date under section 263(1) → deduction in the year of liability; Applies to all listed sums except the MSME clause (g).
MSME rule: Amount payable to a micro or small enterprise beyond the section 15 MSMED Act time limit → deduction only when paid; No grace period up to the return due date for this item.
Interest conversion: Interest converted into loan, advance, debenture or other deferring instrument ≠ actually paid; Applies to interest on borrowings from specified financial entities.
No double deduction: Deduction already allowed in year of liability → not allowed again on payment; Section 37(5).
Specified financial entities: Public financial institution, State Financial Corporation, State Industrial Investment Corporation, notified class of NBFCs, scheduled bank, co-operative bank (other than a primary agricultural credit society or primary co-operative agricultural and rural development bank); Interest to other lenders is outside clause (e).
Employee contribution: Section 37 does not apply to employee contributions covered by section 2(49)(o); Section 29(1)(e) allows deduction if credited to the employee's fund account on or before the return due date under section 263(1).

How to solve Deductions Allowed on Actual Payment Basis questions

Use this sequence for any question on payment-basis deductions.

1List each expense in the question and check whether it falls within section 37(2). If it does not, apply the normal accrual rules.
2Confirm the facts of the lender or payee. For interest, check that the lender is a specified financial entity.
3Find the tax year of liability and the date of actual payment.
4If paid within the year, allow the deduction in that year.
5If paid after year-end, check whether payment was on or before the due date for filing the return under section 263(1). If yes, allow it in the year of liability. Exclude the MSME clause from this relief.
6For MSME dues, check whether the payment was beyond the time limit in section 15 of the MSMED Act. If so, allow the deduction only in the year of actual payment.
7Check for converted interest and for deduction already claimed earlier. Then state the amount deductible in each year and conclude.

Quickest way: Three-question filter

When to use it: Use when the question lists many expenses with payment dates and you must decide year-wise deductibility fast.

Is the item on the section 37(2) list? If not, stop and apply accrual.
Was it paid in the year, or by the return due date? If yes, deduct in the year of liability. The exception is MSME clause (g) dues.
If unpaid by then, defer the deduction to the year of actual payment, unless converted interest, which is never treated as paid.

Common mistakes in Deductions Allowed on Actual Payment Basis

Deducting a listed expense on accrual because the books follow the mercantile system.
Students assume the accounting method decides timing.
Fix: Section 37(1)(b) overrides the method of accounting. Listed sums need actual payment.
Applying the due-date grace to MSME dues.
The grace rule is remembered for all items in the list.
Fix: Section 37(3) excludes clause (g). MSME dues paid late are deducted only in the year of payment.
Treating conversion of unpaid interest into a loan or debenture as payment.
A book entry looks like a settlement.
Fix: Under section 37(4) such conversion is not actual payment. Deduct only when cash interest is paid.
Applying clause (e) to interest paid to any lender, such as a private person.
Students remember only that interest is on the list.
Fix: Check the lender is a specified financial entity under section 37(7).
Claiming the deduction a second time on payment after it was allowed in the year of liability.
Students forget the payment year also has a rule.
Fix: Section 37(5) bars a second deduction. Allow it once only.
Applying section 37 to employee contributions to provident or similar funds.
Both employer and employee contributions relate to funds.
Fix: Section 37(6) excludes employee contributions under section 2(49)(o). Section 29(1)(e) governs them: credit to the employee's account by the return due date under section 263(1).

Worked examples

Example 1

Sharma Traders follows the mercantile system. For the tax year, it has accrued a cess of ₹80,000 and employer provident fund contribution of ₹1,20,000. It pays ₹50,000 of the cess within the year and the balance ₹30,000 after the year-end but before the due date of filing the return under section 263(1). It pays the full provident fund contribution only after that due date. Compute the deduction for the year.

Show the solution

Both cess and employer provident fund contribution are listed in section 37(2).
Cess paid within the year: ₹50,000 is allowed.
Cess of ₹30,000 is paid after year-end but on or before the return due date. Section 37(3) allows it in the year of liability.
Total cess deduction for the year is ₹50,000 + ₹30,000 = ₹80,000.
Provident fund contribution of ₹1,20,000 is paid after the due date. It is not allowed in this year. It is allowed in the year of actual payment.
Deduction for the year = ₹80,000.

Answer: The deduction for the year is ₹80,000 (cess). The ₹1,20,000 provident fund contribution is deductible in the year it is actually paid.

Example 2

Mehta Industries owes ₹6,00,000 to a small enterprise supplier beyond the time limit in section 15 of the MSMED Act, 2006, at the end of the tax year. It pays the amount before the due date of filing the return under section 263(1). Is the deduction allowed in that year?

Show the solution

The amount payable to a micro or small enterprise beyond the section 15 limit is in section 37(2)(g).
Section 37(1) allows the deduction only in the year of actual payment.
Section 37(3) gives the return due date relief for all listed sums except clause (g).
So the payment before the return due date does not move the deduction back to the year of liability.
The deduction is allowed in the tax year in which the ₹6,00,000 is actually paid, which is the next year.

Answer: No. The ₹6,00,000 is deductible in the year of actual payment, not in the year of liability.

Exam tips

Write the section 37(1) rule first, then apply it to each item in a table-like list using bullets, since the question usually mixes listed and unlisted expenses.
Always state whether payment fell in the year, before the return due date, or after. This decides the answer.
Remember the three traps: MSME has no grace, converted interest is not paid, and the lender must be a specified financial entity.
Keep employee contributions separate from employer contributions, and cite section 29(1)(e) for the former.
Close with a one-line conclusion giving the deductible figure for each year.

Practice questions from Computation of Total Income, Tax Liability and Filing of Returns of various Entities excluding Companies

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 ExecutiveDeductions Allowed on Actual Payment Basis

Deductions Allowed on Actual Payment Basis: frequently asked questions

What is the actual payment basis of deduction?

It means certain listed expenses are deductible only in the tax year in which they are paid, not when they accrue. This applies even if you follow the mercantile system of accounting. The list is in section 37(2) of the Income-tax Act, 2025.

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

Yes, for most listed sums. If you pay on or before the due date of filing the return under section 263(1), the deduction is allowed in the year the liability was incurred. This relief does not apply to MSME dues under clause (g).

Is interest to any lender covered by section 37?

No. Clause (e) covers interest on loans, advances or borrowings from specified financial entities, such as scheduled banks, public financial institutions and co-operative banks, as defined in section 37(7). Interest to other lenders follows the normal rules.

What happens if unpaid interest is converted into a loan?

It is not treated as actually paid. Section 37(4) says conversion of interest into a loan, advance, debenture or any other instrument that defers payment is not payment. You get the deduction only when you pay it.