Section 40 of the Income Tax Act: Disallowance of Certain Business Expenses

Section 40 of the Income-tax Act, 1961 is an important provision which specifies expenses which are not deductible while calculating the taxable income under the head “Income from Business or Profession”. It provides restrictions on claiming certain deductions which helps prevent tax evasion. In this article, we will explore in detail the expenses that are not eligible for deduction under the Income Tax Act.

Key Provisions of Section 40

The following are the expenses that are not allowed as deductions from business income under Section 40 of the Income-tax Act, 1961:

1. Section 40(a)(i):

If any interest, royalty, fees for technical services, or any other sum is payable to a person outside India or to a non-resident residing in India (excluding a company or a foreign company), on which tax is required to be deducted at source, and such tax has not been deducted or, if deducted, has not been paid to the government on or before the due date of filing the return.

Note:  If the tax has been deducted on account of any amount in the following year or has been paid to the government after the income tax return is filed, then such amount will be eligible as a deduction for the year when it has been deducted or paid to the government.

2. Section 40(a)(ia): 

If any amount paid or credited to a resident on which TDS was supposed to be deducted but TDS has not been deducted or TDS has been deducted but not paid to the government on or before the due date of return filing then 30% of such sum shall not be allowed as deduction.

Note:  If tax has been withheld on any amount in the following year or has been remitted to the government after the submission of the income tax return, then 30% of that amount will be permitted as a deduction in the year it was withheld or paid to the government.

3. Section 40(a)(ib):

If any sum is paid or payable to a non-resident for a specified service on which equalisation levy is deductible, and such levy has not been deducted or has been deducted but not paid to the government on or before the due date of return filing, then such sum paid for the specified services shall not be allowed as deduction. 

Note: If the equalisation levy has been deducted in a subsequent year or paid after the due date of the return filing, then the expense shall be allowed as a deduction in the previous year in which the levy has been paid.

4.  Section 40(a)(iib):

If any royalty, fees, service charge, etc. is exclusively collected by State Government from State Government Underatking then such expense is not allowed to such State Government Underatking.

5. Section 40(a)(iii):

If any salary payable outside India or to a non-resident in India and if TDS is not deducted or TDS deducted but not paid to the government upto the due date of TDS payment then such salary paid shall not be allowed as deduction.

Note: If TDS is deposited late even by one day, then the salary shall not be allowed as deduction.

6. Section 40(a)(v):

If an employer provides a non-monetary perquisite to an employee, the tax on such perquisite is the responsibility of the employee. However, if the employer chooses to pay the tax on behalf of the employee, that tax is not allowed as a deduction, as it is exempt in the hands of the employee under Section 10(10CC).

7. Section 40(b)(i):

Any salary, bonus, commission or remuneration paid by the firm to any partner who is not a working partner shall not be allowed as a deduction from the firm’s taxable income. To be a working partner, the partner has to be actively engaged in conducting the affairs of the business or profession of the firm.

8. Section 40(b)(ii):

Any payment of salary, bonus, commission orremuneration paid by the firm to any of its partners which is not authorised by the partnership deed will not be allowed as a deduction.

9. Section 40(b)(iii):

The partnership deed can only authorize payments of remuneration or interest to partners for the period after the date of the current partnership deed. If the payment relates to a time before the partnership deed was signed, it cannot be authorized, even if the current deed mentions it. Additionally, such payments will only be allowed as deductions from the date of the new partnership deed, not for any earlier period. In simple terms, remuneration and interest must relate to the period after the partnership deed is signed and cannot be made retrospective.

10. Section 40(b)(iv):

Similar to the salary or remuneration, the interest payment should also be authorised by the partnership deed, additionally as per this section, the interest payment should not exceed 12% per annum. Interest paid to any partner in excess of 12% simple interest p.a. will not be allowed as deduction even if it is authorised by the partnership deed.

11. Section 40(b)(v):

Also specifies the maximum salary and capital interest paid to a partner. Any remuneration paid to a working partner, authorised by a partnership deed and falling after the date of the deed in excess of the following limits will not be allowed as deduction:

Example: Kumar & sons, a partnership firm consisting of two partners, reports a net profit of`15,00,000 before deduction of the following items.

1. Salary of  40,000 each per month payable to two working partners.
2. Interest on capital at 15% per annum. The amount of capital eligible for interest is 5,00,000.

Solution : 

The maximum allowable working partners’ salary for the A.Y. 2025-26 in this case would be:

Tax deduction for any sum paid to partners

Currently there is no provision deducting TDS on salary, remuneration, interest, bonus, or commission to partners by the partnership Firm. A new section 194T has been introduced w.e.f 1st April 2025 stating partnership firms to deduct tax at source (TDS) @10% on any sum paid to partners. No deduction is required if the sum or aggregate of such sum does not exceed Rs.20,000 during the financial year.

Hence, any payment to partners requires multiple compliances such as TDS on salary, remuneration, interest, bonus, or commission, its authorisation by partnership deed, salary or remuneration should not increase the limits and interest not exceed 12% per annum.

12. Section 40(ba):

Any payment of interest, salary, commission, bonus or remuneration made by an association of persons or body of individuals to its members will not be allowed as a deduction from the taxable income of the association or body.

Conclusion

Understanding Section 40 of the Income Tax Act, 1961 is crucial for businesses as it directly impacts their tax liabilities. This section lays down clear guidelines on which business expenses are not allowed as deductions when calculating taxable income. Failure to comply with these provisions may result in the disallowance of various deductions, thereby increasing the overall tax liability. Moreover, businesses that are not aware of these restrictions might inadvertently violate tax laws, which could lead to penalties or non-compliance issues.