Section 40A(3) of Income Tax Act: Examples, Exceptions, Amendment Applicability

With the advent of digital banking, India is slowly but steadily becoming a cashless economy, where major transactions are done through authorised banking channels or electronically. Not only are digital transactions faster and more convenient, they save money for individuals and businesses and reduce the circulation of black money. 

If you are a business owner and still make transactions in cash, you might end up not getting deductions of certain expenses. What are those deductions, you must be asking? The trouble is that you might not get tax deductions for the expenses that you incur in cash.

Section 40A(3) of the Income Tax Act is one of the many measures taken by the Indian Government to restrict cash payments. It discourages individuals and businesses from making transactions through cash above a certain limit. 

Now, let's review the provisions, applicability, and exceptions under Section 40A(3) and learn how it works.

Section 40A(3) of the Income Tax Act

Section 40A(3) is an additional amendment introduced to Section 40A in 2009 that restricts payment or receipts in cash beyond a certain threshold. The section disallows tax deductions on expenses above Rs. 10,000 made in cash in a single day to a single person. This daily limit applies to any mode of transaction other than bank draft, account payee cheque, electronic payment system and prescribed electronic modes. 

You read it correctly. If as a business owner, you make a business payment to any person in a single day in excess of Rs. 10,000, then the said expense will not be allowed as a deduction to you while computing your taxable income. 

The ceiling under Section 40A(3) is increased to Rs. 35,000 where the cash payment is made to transporters to hire, lease or ply goods vehicles. The provisions also do not apply to commission agents for goods that they have received for commissions/consignments. This is because such expenses cannot be deducted by the commission agents. 

If you make any payment in excess of the limit of Rs. 10,000/35,000, it will be disallowed. Further, there can be a situation where you have already claimed the deduction of an expense in an earlier year on an accrual basis and during the current year you make payment for such already accrued expense, then, in that case, it will be deemed as your income and will be taxed under the head ‘profits and gains of business or profession’ [Section 40A(3A)]. Your tax liability will arise in the year previous to the one when you made such a payment. 

Amendment to Section 40A(3) of the Income Tax Act

The earlier version of Section 40A(3) of the Income Tax Act, valid from 01/04/2009, restricted an assessee who spent more than Rs.20,000 in a single day through payments made via any means other than an account payee bank draft or cheque. It disallowed such individuals from claiming deductions on such expenses. 

Furthermore, the section also stated that in the event that an individual claims tax deductions on these payments, they would be deemed to be the person's business profits for the previous year. 

An amendment was made to the provisions of Section 40A(3), decreasing the cash limit for business transactions from Rs.20,000 to Rs.10,000 in a single day. The same limit was applicable for deeming a payment as profits from business/profession. Furthermore, the use of the electronic clearing system was added to the specified mode of payments. 

Exceptions to Section 40A(3) under Rule 6DD 

There can be practical scenarios where cash payment is not always possible, so the government has introduced certain scenarios where the said provision will not be applicable. The above disallowance does not occur when a taxpayer makes payments in certain situations. These circumstances and cases are described by Rule 6DD which was added via Notification No. SO2431(E) on 10/10/2008. The following is a list of exceptions to Section 40A(3) of the Income Tax Act:

• Payments to the Government
  Disallowances are not made when you make payments to the Union Government or any state government via legal tender. This exception applies to payments like sales tax, GST, customs, excise duty, freight charges, railway bookings, etc. 
• Payments to RBI, Banks and Other Credit Institutions
  You can make payments in non-specific modes (cash or bearer cheques) above the Rs.10,000 limit to the Reserve Bank of India, State Bank of India and any banking company. Furthermore, you can also pay in cash to any cooperative bank, primary credit society, land mortgage bank, primary agricultural credit society or LIC. 
• Payments Made to an Authorised Dealer
  Exceptions under Rule 6DD also apply to authorised dealers and money changers, people authorised by law to offer forex services. This exception only applies to the purchase of travellers' cheques and foreign currencies from such dealers. 
• Payments to Low-paid Employees
  The restrictions u/s 40A (3) do not apply to employers who pay retrenchment compensation, gratuity, or any other terminal benefits to employees or their heirs. However, there are two conditions. Firstly, the sum or aggregate sum must not be over Rs.50,000. Secondly, it should be paid upon an employee's retirement, resignation, discharge, or death. 
• Payments of Salary in Remote Locations
  This exception applies to employers paying salaries to employees posted temporarily at any place other than his/her normal place of duty or on a ship for 15 days or more. The employee must not have a bank account that is accessible at such a place.
• Payments via Certain Options
  Exceptions to disallowances under Section 40A (3) of the Income Tax Act apply to payments made via the following modes:

1. Mail or telegraphic transfers from one bank to another
2. Letter of credit issued by banks
3. Bill of exchange payable to a bank
4. Book adjustment from one bank account to another

For this clause, the term ‘bank’ refers to any bank, banking company, banking society, and any bank outside India defined by the Banking Regulation Act of 1949. 

• Payments via Book Adjustment
  Disallowances are exempted for payments made via adjusting the purchaser’s liability against goods/services rendered by the seller in the past. 
• Purchase of Animal/Agricultural Produce
  Restrictions on payments under Section 40A(3) do not apply when you purchase any produce from poultry farming, animal husbandry, dairy farming, apiculture, horticulture or fisheries. However, the payment must be made to the cultivator, grower or producer of these goods. The exception does not apply to third parties selling these products.  
• Purchase of Animals by a Butcher
  The Rs.10,000 disallowance u/s 40A(3) does not apply to meat producers or butchers. Such persons must be engaged in the business of slaughtering animals to sell raw meat or animal carcasses to traders, retail outlets or meat processing factories. The person must declare his/her profession and receive certification from a veterinary doctor. 
• Purchase of Cottage Industry Produce
  Payments can be made in cash to purchase products from producers who do not use power for manufacturing or processing. 
• No Banking Service

A payment is made in a village or town, which is not served by any bank, to any person who ordinarily resides, or is carrying on any business in such village.

• Payment on retirement, retrenchment, resignation, discharge or death of employee

Payment made to an employee or his legal heir in these cases if it does not exceed Rs. 50,000.

Section 40A(3) of Income Tax Act Case Laws

Here, we will discuss several cases that illustrate the working of Section 40A(3) of the Income Tax Act with example:

Case 1: CIT Vs. K.K.S K. Leather Processor P Ltd [2008] 160 Taxman 251 (Madras)

In this case, the court allowed the cash payment as an exception where a taxpayer made payments on a bank holiday or a Sunday. Thus, there was no disallowance under the provisions of Section 40A(3) in such a situation.

Case 2: Attar Singh Gurmukh Singh Vs. ITO, 191 ITR 667 (SC)

In this case, the Hon'ble Supreme Court held that the provisions of Section 40A (3) shall be attracted when payments are made to acquire stock-in-trade/other materials for the business. Furthermore, the apex court ruled that the intention of this section was not to restrict the business activities of traders. A taxpayer can furnish information to the concerned Assessing Officer that shows that it wasn’t practical for him/her to make payments via specified modes. 

Case 3: Harshila Chordia v. ITO [2008] 298 ITR 349 (Rajasthan)

Here, the Division Bench of the Rajasthan High Court held that the exceptions listed under Rule 6DD are not exhaustive. Therefore, Section 40A (3) is not absolute and its rules need to be interpreted liberally where the taxpayer can prove the genuineness of the transaction. 

Case 4: A. Daga Royal Arts Vs. ITO [2018] 94 taxmann.com 401 (Jaipur Tribunal)

The Coordinate Bench observed that even though a new amendment of Rule 6DD (j) was passed, the apex court's judgement regarding the consideration of expediency would stand. The bench observed that Rule 6DD was not sufficiently exhaustive. Therefore, the authorities need to provide a mechanism for allowing exceptions in unavoidable circumstances.

Difference between Section 40A(3) and Section 40A(3A)

Section 40A(3) is applicable to any assessee that makes one or more payments exceeding Rs.10,000 to a person in a single day via any mode except account payee cheque, bank draft or electronic clearing system. In such a case, the expenses made are disallowed claim tax deductions. 

On the other hand, Section 40A(3A) states what happens if an expense has been booked in the previous year but its payment is made in the subsequent year. If such a payment made in a single day to a single person in a mode other than account payee cheque, bank draft or ECS exceeds Rs.10,000, the expense will be deemed as profit from business or profession. Such an income is chargeable to income tax in the subsequent year. 

To sum up, Section 40A(3) of the Income Tax Act restricts tax deductions on expenses paid via cash that exceed Rs.10,000 in a single day to a single person. The restriction or disallowance applies to payments made from sources which cannot be tracked by the income tax department. This section aims to curb tax evasion and the circulation of black money in India. 

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