Disallowance Section 40(a)(ii) of Domestic & Foreign Taxes

Disallowance Section 40(a)(ii) of Indian / Domestic Taxes:

What is Section 40(a)(ii) & its Disallowance?

The provision you’re referring to, which deals with disallowance of expenses due to failure to deduct TDS, actually falls u/s 40(a)(ia) . It seems there might be a mix-up regarding the specific provision you’ve mentioned. Section 40(a)(ii)  actually deals with disallowance of expenses related to taxes on profits.

Specifically, it disallows the deduction of taxes levied on profits (such as income tax) from the computation of business income. The section ensures that taxes paid on business profits cannot be claimed as a deductible expense for tax purposes.

This section disallows the deduction of certain expenditures (such as payments to contractors, professionals, interest, rent, etc.) from business profits if the business fails to:

• Deduct tax at source where required, or
• Deposit the Tax Deducted at Source with the government within the specified time limit.

If TDS is not deducted or deposited as required, the entire expenditure related to that payment will be disallowed from the business’s taxable income for the year. Key Disallowances:

• Income Tax Section 40(a)(i): Applies to payments made to non-residents. If TDS isn’t deducted on these payments, they are disallowed as business expenses.
• Section 40(a)(ia): Relates to payments to residents (e.g., contractors or professionals). Failure to deduct TDS or deposit it timely results in disallowance of these payments.
• Income Tax Section 40(a)(ib): Addresses non-payment of the equalisation levy.
• Section 40(a)(ii): Disallows deduction for certain taxes paid by businesses.

Applicability of Section 40(a)(i) in certain case :

• Section 40(a) apply to individuals and HUFs, Section 40(a)(i) applies to individuals and HUFs required to deduct TDS if they are subject to a tax audit u/s 44AB. However, Section 40(a)(i) applies. Non-compliance with  Tax Deducted at Source leads to the disallowance of payments to non-residents or foreign companies.
• Tax Deducted at Source is not deducted at all on payments covered u/s 40(a)(i) : Expenses will be permanently disallowed for that year when  Tax Deducted at Source is not deducted.
• Section 40(a)(ii) of the Income Tax Act disallows the deduction of any tax paid on profits or gains of business or profession, such as income tax or fringe benefit tax, when calculating the taxable income of a business. This means that a business cannot reduce its taxable income by claiming taxes paid on its profits as an expense.
• If Tax Deducted at Source is deducted late but paid before the ITR due date, the expense is allowed as a deduction in the year the Tax Deducted at Source is paid.
• Section40(a)(i) apply to all taxpayers. Section 40(a)(i) applies to all business taxpayers obligated to deduct TDS on specific payments.
• Rectify disallowed expenses due to an error u/s 40(a)(i) : By complying with TDS provisions later, the expense can be allowed in future tax calculations.
• Section 40(a)(i) lists expenses that are not deductible while calculating taxable income when Tax Deducted at Source obligations are not fulfilled. Payments to non-residents or foreign companies without Tax Deducted at Source deduction or payment on time are disallowed u/s 40(a)(i). Section 40(a)(ia) disallows expenses made to residents (contractors, commission agents, etc.) where TDS is not deducted or paid on time.

• Income tax Section 40(a)(ii) apply to interest payments: Interest payments to both residents and non-residents are covered. Non-compliance with TDS can lead to disallowance.

Disallowance Section 40(a)(ii) of Foreign Taxes:

• In the context of taxation for non-resident assessees under the Income Tax Act, 1961, the key issue is how to treat taxes paid in foreign jurisdictions. The crux lies in the interaction between Section 5 (which defines the scope of taxable income for residents and non-residents) and Section 40(a)(ii) (which disallows deductions for “any rate or tax” paid abroad that could be claimed u/s 90 or Section 91).
• While Section 40(a)(ii) prohibits the deduction of foreign taxes in computing taxable income, relief is provided through tax treaties u/s 90 or the general relief provisions u/s 91. The judicial interpretations reinforce the principle that foreign taxes, even if not covered by a tax treaty, can still be accounted for through unilateral relief provisions, ensuring non-residents and residents receive appropriate relief from double taxation.
• This section bars any deduction for “any rates or taxes” levied on the profits of a business or profession. It implies that foreign taxes paid cannot be deducted in computing taxable income if those taxes are covered by a Double Taxation Avoidance Agreement (DTAA) u/s 90, or are eligible for credit u/s 91.
• The rationale is that since foreign taxes are applied on profits, and income tax is a charge on those profits, such taxes must not reduce the base on which Indian tax is computed.

Relief for Foreign Taxes (Section 90 and 91):

• Section 90 deals with relief provided by tax treaties (DTAAs) that India has signed with other countries. Under these treaties, relief is provided through tax credits for taxes paid abroad.
• Section 91 applies when there is no tax treaty. In such cases, the Indian tax law provides relief by granting a unilateral tax credit for foreign taxes paid.

Evolution and Interpretation:

Before the Finance Act 2006, there was ambiguity over whether income tax paid in foreign countries could be deducted in computing income under the head “Profits and gains of business or profession.” Some assessees claimed foreign taxes both as a deduction and as a tax credit. The Finance Act 2006 clarified that any sum paid outside India, and eligible for relief u/ss 90 or 91, cannot be deducted from taxable income u/s 40(a)(ii). 

Judicial Precedents in the matter of Section 40(a)(ia):

No Disallowance under Section 40(a)(ia) for Non-Deduction of TDS in the Absence of Principal-Agent Relationship:

• In the Nokia India Pvt. Ltd. Vs DCIT case (ITAT Delhi), it was ruled that disallowance under Section 40(a)(ia) was not justified when the benefit extended to distributors (HCL Infosystems Ltd. and others) was not treated as “commission” under Section 194H. This was because there was no principal-agent relationship. The AO also failed to provide reasons to classify payments as technical services under Section 194J.

Short-Deduction of TDS Doesn’t Attract Disallowance under Section 40(a)(ia):

• The ruling in A.K. Industries Vs ACIT (ITAT Kolkata) clarified that disallowance under Section 40(a)(ia) does not apply if TDS was deducted but at a lower rate. The case involved deductions under Sections 194C, 194H, 194I, and 194J, and it was concluded that this was not a situation of non-deduction, but rather short-deduction, which doesn’t trigger disallowance.

No Disallowance on Interest Payments if Deductee Furnishes Form 15G or 15H:

• In JCIT Vs Karnataka Vikas Grameena Bank (ITAT Bangalore), it was held that disallowance of interest paid should not be made under Section 40(a)(ia) if the deductees have furnished Form 15G or 15H. The failure to file these forms with the CIT was considered procedural and not grounds for disallowance.

No TDS under Section 194C on Reimbursement of Vehicle Expenses:

• In Sri. Singonahalli Chikkarevanna Gangadharaiah Vs ACIT (ITAT Bangalore), it was ruled that reimbursement of actual vehicle expenses incurred by cab owners could not be treated as payment subject to TDS under Section 194C.

Compliance with Section 194C(6) Prevents Disallowance under Section 40(a)(ia):

• The ruling in DCIT Vs Murugarajendra Oil Industry (P) Ltd. (ITAT Bangalore) held that if the assessee complied with Section 194C(6) by obtaining the contractor or sub-contractor’s PAN, disallowance under Section 40(a)(ia) would not apply. This is true even if the information was not furnished to the authorities as required under Section 194C(7).

The Bombay High Court in Lubrizol India Ltd. clarified that the term “tax” in Section 40(a)(ii) applies broadly to any taxes levied on profits or gains, not just Indian income tax.

In Smith Kline & French (India) Ltd., the Supreme Court upheld this interpretation, ruling that taxes like Surtax, which are levied on profits, also fall u/s 40(a)(ii) and are not deductible.

Issues with State Taxes (U.S. Example)in the matter of Dr. Rajiv I. Modi vs DCIT, the Ahmedabad ITAT

A complication arises with state taxes paid in countries like the U.S., where DTAAs typically only cover federal taxes, not state taxes. In Dr. Rajiv I. Modi vs DCIT, the Ahmedabad ITAT ruled that the taxpayer could still claim tax credits u/s 91 for state taxes, even though they were not covered by the Indo-U.S. treaty. This ruling was significant as it provided relief by recognizing that Section 91 applies to both federal and state taxes, offering a tax credit to avoid double taxation.

Key Issues related to Disallowed expenses Section 40(a)(ia):

• Disallowed expenses be carried forward into future years : No, disallowed expenses cannot be carried forward; they are permanently disallowed for that year. once  Tax Deducted at Source  is deducted and paid in later years, the previously disallowed expenses can be claimed in that year. The penalty is disallowance of the expense, increasing the taxpayer’s taxable income &  thus their tax liability.
• Payments disallowed u/s 40(a) be claimed as an expense in the next year if the payment was made late  Tax Deducted at Source is deducted and paid in the following year, disallowed expenses can be claimed in that year.
• Treatment of Tax Deducted at Source on payments to charitable institutions u/s 40(a): If no  Tax Deducted at Source is deducted, payments will be disallowed unless the institution is exempt from tax under the Income Tax Act.
• In the Situation where payments to contractors or suppliers are disallowed due to failure to deduct tax at source is covered u/s 40(a)(ia). This section affects payments to both residents and non-residents, with significant consequences for businesses that fail to deduct or deposit TDS on time.

Exceptions to Section 40(a)(ia):

In few case Section 40(a)(ia)provide relief from disallowance under this section:

1. If the payee has already paid tax on the income received, the payer can claim that expense later, once the TDS is paid.
2. Payments made to government agencies or certain exempt entities.
3. Non-resident payments, where the income is not taxable in India.
4. TDS deducted in the last month of the year and deposited before filing the ITR will not lead to disallowance.
5. Payments under DTAA provisions may be exempt from TDS disallowance
6. Disallowance doesn’t apply when:

• • The payee has paid tax,
  • Payee isn’t required to pay tax,
  • The payee is a non-resident whose income isn’t taxable in India,
  • Income is exempt under the Income Tax Act.
  • Section 40(a) covers payments like interest, royalty, and contractor fees, but not salaries, which are covered under separate sections.
  • Does Section 40(a) apply to the reimbursement of expenses: Reimbursement is not subject to TDS if it is a pure reimbursement of actual expenses, not income for the recipient.

Implications of Section 40(a)(ia) for Businesses- Impact of Disallowances:

Non-compliance with Tax Deducted at Source provisions can have severe financial consequences:

• Disallowance of expenses, leading to higher taxable income.
• Penalties and interest charges for not complying with  Tax Deducted at Source regulations.
• Increased Taxable Income: Disallowed expenses are added back to net profit, resulting in higher taxable income and tax liability.
• Cash Flow Issues: Businesses may face unexpected tax payments, impacting liquidity.
• Impact of Section 40(a) on advance tax calculations: Disallowances u/s 40(a) increase taxable income, affecting advance tax computation and potentially leading to interest for underpayment.

Controversy surrounding disallowances amount u/s 40(a)(ia):

The controversy surrounding Section 40(a)(ia) of the Income Tax Act relates to the treatment of disallowances when there is non-deduction or short deduction of Tax Deducted at Source (TDS). Three Key Views on the Matter:

1. 30% of the Whole Amount Should Be Disallowed: This view suggests that even if TDS is deducted on a majority of the transaction, but not on a minor part, the entire expense (30% of the whole) should be disallowed.
   • Analysis: This view seems illogical because it does not take into account the actual compliance. If an assessee has deducted and paid TDS on a significant portion of the expense but missed a small part, disallowing 30% of the entire amount seems too harsh and disproportionate to the infraction.
2. 30% of the Amount on Which TDS Was Not Deducted or Was Short-Deducted (Proportional Basis): This view supports disallowing 30% of the portion where TDS was not deducted or short deducted, rather than on the entire amount. Disallowance is calculated proportionally.
   • Analysis: This view is the most reasonable and fair, as it aligns with the principle of proportionality. If there is a failure to deduct or short deduction of TDS on a specific portion, only 30% of that portion should be disallowed. This balances the compliance requirements while not excessively punishing the taxpayer.
3. Disallowance Applies Only to Non-Deduction, Not Short Deduction: According to this view, disallowance under Section 40(a)(ia) only applies to cases where there is a complete non-deduction of TDS, and not for short deduction.
   • Analysis: This view seems illogical because Section 40(a)(ia) clearly states that disallowance applies to cases where there is a failure to deduct TDS, whether it is the whole or any part of the required deduction. Short-deduction is essentially a partial non-deduction, and therefore, disallowance should apply here as well.

The most balanced and fair approach is View 2, which advocates disallowance of 30% of the amount where TDS was not deducted or was short deducted, on a proportional basis.