While the Income Tax Act, 1961, allows businesses and professionals to claim various legitimate expenses as deductions to reduce their taxable income, not all expenses qualify for such a benefit. Section 40 of the Act lays down specific restrictions and disallowances on certain types of expenditures, even if those are incurred wholly and exclusively for business purposes. This means that despite the correct outflow of the business, certain payments cannot be deducted while computing business profits for taxation.
This blog explores the nature and types of disallowed expenses under Section 40 of the Income Tax Act, 1961.
Who Does Section 40 Apply to?
Section 40 applies to all assessees carrying on business or profession, including individuals, companies, partnership firms, LLPs, etc. However, some clauses apply only to firms or LLPs, and not to individuals or companies.
Types of Disallowed Expenses under Section 40
1. Income Tax Paid on Profits
Any amount paid as Income Tax on the profits of the business is not allowed as a deduction.
Disallowed payments include:
- Income Tax
- Interest or penalty levied for late payment or default of income tax
- Wealth Tax (now abolished)
Allowed taxes: GST, customs duty, excise duty, and local taxes (these are not income taxes and thus can be claimed).
2. Payments to Non-residents without Deducting TDS
If a business makes payments to a non-resident (such as interest, royalty, technical service fees, etc.) and fails to deduct tax at source (TDS) or fails to deposit it within the time allowed, that payment is disallowed.
However, if the TDS is deposited later, the deduction can be claimed in the year of such payment.
3. Payments to Residents without Deducting TDS
If a business fails to deduct or deposit TDS on payments made to residents (such as professional fees, rent, contractor payments), then 30% of such expenditure will be disallowed in that year. This disallowed portion becomes allowable in the year when the TDS is actually deposited.
4. Salary Paid Outside India without TDS
If a salary is paid outside India, or to a non-resident, and the TDS is not deducted as required, then the salary expense will be completely disallowed.
5. Payments to Partners (in case of Firms or LLPs)
This clause is applicable only to partnership firms and LLPs. The following expenses are disallowed unless specified conditions are met:
a. Remuneration to partners:
Remuneration (salary, bonus, commission) paid to partners is allowed as a deduction only if:
- It is paid to a working partner
- It is authorised by the partnership deed
- It does not exceed the prescribed limits under the Income Tax Rules
Prescribed limits:
- On the first ₹3 lakhs of book profit (or in case of loss): ₹1.5 lakhs or 90% of book profit, whichever is higher
- On the balance book profit: 60%
Any excess payment beyond these limits will be disallowed.
b. Interest to partners:
Interest paid to partners is allowed as a deduction only if:
- It is authorised by the partnership deed
- The rate of interest does not exceed 12% per annum
If interest exceeds 12%, the excess portion is disallowed.
6. Payments to Members in case of AOP or BOI
In the case of Association of Persons (AOP) or Body of Individuals (BOI), any payment, such as salary, commission, or bonus, made to a member of the AOP/BOI from the share of profit is disallowed. This prevents duplication, since the member will already be taxed on their share of the income.
7. Expenditure Made in Cash over the Prescribed Limit
Although technically listed under Section 40A, it works closely with Section 40 in disallowing excessive or non-transparent payments.
If you make a cash payment of more than:
- ₹10,000 in a single day to a person (₹35,000 in case of transporters),
Then the entire amount is disallowed, unless it falls under exceptions such as no banking facility in rural areas, or in cases of emergency, etc.
Disallowances under Section 40
| Nature of expense | When it is disallowed |
| Income Tax and related penalties | Always disallowed |
| Payment to Non-Resident without TDS | Disallowed until TDS is paid |
| Payment to Resident without TDS | 30% disallowed until TDS is paid |
| Salary paid outside India without TDS. | Fully disallowed |
| Remuneration to Partners (Firms/LLPs) | Disallowed if not authorised or exceeds prescribed limits |
| Interest to Partners beyond 12% | Excess interest is disallowed. |
| Payments to Members of AOP/BOI | Disallowed if paid out of profits |
| Cash payments above ₹10,000 | Disallowed unless covered under notified exceptions |
Important Notes
- Disallowance does not mean you can never claim the expense. In many cases (especially TDS defaults), you can claim the expense in a later year when the TDS is actually paid.
- Section 40 ensures that taxpayers follow tax compliance, especially TDS provisions.
- Non-compliance with Section 40 may not just disallow the expense, but it can also lead to penalties or additional tax demand from the Income Tax Department.
Conclusion
Section 40 is an important control mechanism to ensure accountability and transparency in tax filings. It encourages proper documentation, timely deduction and deposit of TDS, and restricts any attempt to reduce taxable income through improper means.
To avoid disallowance of expenses:
- Always ensure TDS compliance
- Avoid cash payments above ₹10,000
- For firms and LLPs, keep the partnership deed updated and compliant
- Do not claim income tax or penalties as expenses
- Maintain proper documentation for all business transactions
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