Section 40 of the Income Tax Act: A Guide on Disallowance of Certain Business Expenses
- PRITI SIRDESHMUKH
- Dec 4
- 7 min read
Updated: 1 day ago
Introduction
Although the Income Tax Act of 1961 permits professionals and enterprises to deduct a variety of reasonable expenses from their taxable income, not all expenses are eligible for this advantage. Even when expenses are spent solely for business purposes, they are subject to various limitations and disallowances under Section 40 of the Act. This means that some payments cannot be subtracted when calculating business profits for taxation, even if the business's outflow is correct.
Table of Contents
What is Section 40 of the Income Tax Act?
The Income Tax Act's Section 40 addresses the disallowance of specific business expenses. It establishes the guidelines for figuring out whether or not a specific item can be deducted for calculating taxable income. The section is broken up into multiple subsections, each of which addresses a particular category of spending that is not eligible for income tax deduction in various situations.
Applicability of Section 40 of the Income Tax Act
All assessees engaged in business or profession—individuals, corporations, partnership firms, LLPs, etc.—are subject to Section 40. Certain sections, however, only apply to firms or LLPs and not to people or businesses.
Sections of Section 40 of the Income Tax Act
Section 40(a)(i)
If interest, royalties, fees for technical services, or any other amount that is payable to an individual outside of India or to a non-resident living in India (apart from 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. The tax will be deductible for the year in which it was deducted or paid to the government if it was deducted on account of any amount in the subsequent year or paid to the government following the filing of the income tax return.
Section 40(a)(ia)
Under this section, 30% of any amount paid or credited to a resident that should have had TDS deducted but hasn't, or that has been deducted but hasn't been remitted to the government by the deadline for filing returns, will not be eligible for deduction. 30% of the amount that was withheld or paid to the government in the year that the income tax return was filed will be allowed as a deduction if tax was withheld on any amount in the subsequent year or remitted to the government.
Section 40(a)(ib)
Any amount paid or payable to a non-resident for a specified service on which equalisation levy is deductible will not be permitted as a deduction if the levy has not been deducted or has been deducted but not paid to the government on or before the return filing deadline. The item will be permitted as a deduction in the prior year in which the equalisation levy was paid if it was deducted in a later year or paid after the return filing deadline.
Section 40(a)(iib)
Such expenses are not permitted to such State Government Undertaking if any royalties, fees, service charges, etc. are solely collected by the State Government from State Government Undertaking.
Section 40(a)(iii)
Any remuneration that is paid to a non-resident of India or to someone who is not a resident of India and for whose TDS is either not deducted or deducted but not paid to the government by the TDS payment deadline will not be eligible for deduction. The salary will not be deducted if TDS is not deposited on time, even by one day.
Section 40(a)(v)
If an employer gives an employee a non-monetary benefit, the employee is responsible for paying the tax on that benefit. However, since the tax is exempt in the employee's hands under Section 10 (10CC), it cannot be deducted if the employer decides to pay it on the employee's behalf.
Section 40(b)(i)
The firm's taxable income cannot be reduced by any salary, bonus, commission, or other compensation given to a partner who is not a working partner. A partner must actively participate in running the company's business or profession in order to be considered a working partner.
Section 40(b)(ii)
Any salary, bonus, commission, or other compensation that the company pays to any of its partners that isn't permitted by the partnership agreement won't be deducted.
Section 40(b)(iii)
Only payments of compensation or interest to partners for the period after the date of the present partnership deed may be authorised by the partnership deed. Even if the present deed indicates it, the payment cannot be approved if it refers to a period prior to the signing of the partnership deed. Furthermore, these payments can only be deducted starting on the date of the new partnership deed; they cannot be deducted for any previous time frame. To put it simply, compensation and interest cannot be retroactive and must relate to the time frame following the signing of the partnership deed.
Section 40(b)(iv)
The interest payment must be approved by the partnership deed, just as the wage or compensation. In accordance with this provision, the interest payment cannot be more than 12% annually. Even if the partnership agreement permits it, interest paid to any partner in excess of 12% simple interest per year will not be deductible.
Section 40(b)(v)
The maximum remuneration and capital interest given to a partner are also specified in Section 40(b)(v). Any compensation permitted by a partnership deed and paid to a working partner after the deed's date that exceeds the following caps will not be deductible:
Book Profits | Quantum of Deduction |
On the first Rs. 6 lakh of book profit or when there is loss | Rs. 3,00,000 or 90% of book profit, whichever is higher |
on the balance of book profit | 60% of book profit |
Tax Deduction for Sums Paid to Partners
As of right now, the partnership firm does not deduct TDS from partners' salaries, compensation, interest, bonuses, or commissions. With effect from April 1st, 2025, a new section 194T has been created, requiring partnership firms to deduct 10% of any amount paid to partners as tax at source (TDS). If the total amount does not exceed Rs. 20,000 within the fiscal year, there is no need for a deduction. Therefore, any payment to partners must comply with a number of requirements, including TDS on salary, compensation, interest, bonuses, or commissions, approval by a partnership deed, salary or compensation that does not exceed the limitations, and interest that does not surpass 12% annually.
Section 40(b)(a)
An association of people or body of individuals will not be entitled to deduct any interest, salary, commission, bonus, or other compensation paid to its members from its taxable income.
Disallowances under Section 40: A Quick Snapshot
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 Rs. 10,000 | Disallowed unless covered under notified exceptions |
Conclusion
In conclusion, businesses must comprehend Section 40 of the Income Tax Act of 1961 since it directly affects their tax obligations. When determining taxable income, this section provides precise instructions for which business expenses are not deductible. If these rules are broken, certain deductions may be denied, which would raise the total amount of taxes owed. Additionally, companies who are unaware of these limitations may unintentionally break tax rules, which could result in fines or non-compliance problems.
Frequently Asked Questions
What is Section 40 of the Income Tax Act?
The guidelines for the disallowance of specific company expenses are outlined in Section 40 of the Income Tax Act.
What expenses may be disallowed under Section 40?
Section 40 may prohibit expenses related to paying interest, rent, compensation, bonuses, commissions, or similar payments to the taxpayer's family, non-residents, or employees who do not have taxable income.
What is the limit for disallowance of expenses under Section 40?
The type of expense and the relationship between the taxpayer and the recipient of the payment determine the maximum amount of expenses that can be disallowed under Section 40.
What are the consequences of disallowed expenses under Section 40?
The taxpayer may be subject to increased tax obligations, penalties, and interest payments as a result of disallowed spending.
How can taxpayers avoid disallowed expenses under Section 40?
By adhering to the restrictions and guidelines outlined in the provision's subsections, taxpayers can prevent spending that is prohibited by Section 40. To make sure they abide by all relevant tax laws and regulations, it is advised that taxpayers speak with a tax expert.
Can deductions be claimed if the TDS is paid late?
TDS deductions are not permitted if they are made but not paid to the government prior to the income tax return filing deadline. Nonetheless, the deduction may be claimed in the year that the TDS is paid if it is paid after the deadline.
What is the definition of “relative” under Section 40?
Section 40 defines "relative" as the taxpayer's spouse, brother, sister, or lineal ascendant or descendant.
What is book profit?
In a nutshell, book profit is the amount of money left over after the business settles all of its debts, as indicated by the profit and loss statement. To put it another way, it refers to the money that an organisation makes from the sale of goods and services during a fiscal year, subtracted from all of the costs expended during that same fiscal year.
Is it mandatory to pay remuneration for partners?
Partners in a company are not required to receive pay. If payment is made, though, it must be approved under the partnership agreement.
What is he maximum allowable working partners’ salary for the A.Y. 2025-26 if there is a loss?
The highest salary that working partners may receive in the event of a loss during the fiscal year 2025–2026 will be Rs. 3,00,000.
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