Volume 5, Issue 6

24th April, 2012

Tax Alert
Disallowance of expense due to non deduction of tax at source – important decision of ITAT

The Indian tax laws provide that where tax is required to be deducted/withheld (TDS) from certain expenditure and the payer fails to do so, or after doing so, fails to deposit the TDS with the Government, the relevant expenditure is not considered as an allowable expenditure for tax purposes.  In respect of payments to Indian tax residents, section 40(a)(ia) of the Income-tax Act, 1961 (‘Act’) provides for this disallowance in respect of any interest, commission or brokerage, rent, royalty, fees for professional services or fees for technical services payable to a resident, or amounts payable to a contractor or sub-contractor, being resident, for carrying out any work (including supply of labour for carrying out any work), on which tax is deductible at source under Chapter XVII-B (emphasis provided).

In a recent case1 before the Special Bench of the Income-tax Appellate Tribunal, the question was whether the disallowance of expenditure (if TDS is not made) is attracted only where the expenditure is payable (i.e. outstanding) at the end of the year since the law uses the words ‘payable’ (as highlighted above).  This case forms the subject matter of this Tax Alert.

Relevant facts of the case:

During AY 2005-06, the tax payer incurred certain expenses on brokerage and commission of Rs. 41,18,253/-, on which TDS was not made.  Out of these expenses, the amount outstanding as on 31st March 2005 was Rs. 178,025/-. The Tax Department sought to disallow the entire expenditure of Rs. 41,18,253/-  since TDS was not made on the same.

Relevant Issue before the Tribunal:

Where TDS was required to be made on some expenditure and the tax payer fails to make TDS, whether the disallowance would only be in respect of the amount payable as on 31st March?  That is, if the expenditure is actually paid to the vendor during the year without making TDS, will such expenditure be disallowed?

Contentions of the tax payer:

  • The law defines the word ‘paid’ but it does not define the word ‘payable’.  Hence, the word ‘payable’ should be given its plain dictionary meaning and should be interpreted literally.
  • The provisions of tax deduction at source are separate and independent from section 40(a)(ia).  Hence, even though TDS is required to be made on expenditure incurred and paid during the year, this will not, by itself, result in disallowance of expenditure under section 40(a)(ia)

  • When the proposal for introducing section 40(a)(ia) was introduced in the Parliament, the words used in the proposal were ‘amount credited or paid to a contractor’.  However, when the proposal was passed by the Parliament, the words used in the section were changed to ‘amount payable to a contractor’.  The Parliament specifically replaced the words ‘credited or paid’ with the words ‘payable’.  Hence, the intention of law was to disallow only those expenses which were ‘payable’ and not the expenses that were paid or credited.
  • The Legislature knew that if any amount was already paid, TDS could not be made there from.  If disallowance is made in respect of expenses paid without making TDS, it would result in a permanent disallowance since the tax payer could not recover the TDS from the payee.  This was the reason that the Parliament changed the words ‘credited or paid’ to ‘payable’
  • Rule 30 of the Income-tax Rules, 1962 (‘Rules’) as it existed in AY 2005-06 provided the time limit for depositing the TDS after its deduction.  Where any sum was credited to the account of the payee on the date on the last day of the accounting period, the TDS could be deposited within 2 months from the date of credit.  In all other cases, the TDS was required to be deposited within 7 days of the following month.  This difference in time allowed for depositing the TDS also indicates that the terms ‘paid’ and ‘payable’ have different meanings and cannot be used interchangeably.
  • If the language of the law is ambiguous or capable of more than one meaning, the Court should adopt the interpretation which favours the tax payer, particularly where the provision relates to imposition of a penalty.  Section 40(a)(ia) is a penal provision since it provides for disallowance of expenditure if TDS is not made.
  • Hence, the disallowance should be only for Rs. 178,025/- being the amount payable at the end of the year and not for the entire expenditure of Rs. 41,18,253/-.

Contentions of the Revenue:

  • The disallowance of expenditure for failure to make TDS should also cover the expenditure actually paid off during the year.  Liability to make TDS is a continuous liability and cannot be segregated between ‘paid’ and ‘payable’ amounts.
  • The intention of law is that if the tax payer fails to make TDS on any expenditure incurred at any time during the year, the expenditure should be disallowed.
  • If disallowance is made only for expenses outstanding at the end of the year, it would mean that there would not be any disallowance for failure to make TDS if the tax payer follows cash system of accounting.
  • Rule 30 which provide the time limit for depositing the TDS is only a procedural matter and cannot override the provisions of the Act.

Tribunal’s Ruling:

There was a divergence of views between both the members of the Tribunal.  One of the members agreed with the arguments of the tax payer and the other member agreed with the arguments of the Revenue.  Hence, the matter was referred to a Special Bench which held as under:

  • The legislature was aware of the fact that there may be a case where the amount is paid and there may be a case where the amount is payable.  The Parliament consciously replaced the words ‘credited or paid’ with the word ‘payable’ while enacting section 40(a)(ia). 
  • Where the language of a section is clear, the intention of the legislature has to be gathered from the language used.
  • In cash system of accounting, the tax payer would never be able to claim any deduction for any expenses that are payable.  Hence, there would be question of disallowing the same.
  • As per Circular No.5 of 2005 issued by the CBDT, the intention behind inserting section 40(a)(ia) was to curb bogus payments by creating bogus liability
  • Section 40(a)(ia) is a legal fiction and has to be limited to the area for which it is created.
  • For all these reasons, disallowance under section 40(a)(ia) would be attracted only for those payments that are outstanding and payable at the end of the year.  If any expenditure is incurred and paid during the year without making TDS, the same cannot be disallowed, even though the tax payer would face consequences of failure to make TDS.

SKP’s comments:

For expenses where TDS is not made, the widely accepted practice adopted by the Tax Department and also by a large number of tax payers is to disallow the entire expenditure, whether or not the expenditure remains payable at the end of the year.

This judgment would be useful in cases where TDS is not made on certain expenses and the Tax Department is seeking to disallow the same during scrutiny assessment.  However, it is likely that the Tribunal’s ruling would be challenged by the Tax Department before the High Court.   Hence, reliance on this judgment could be aggressive and litigative.  This judgment should be relied upon only in cases where the tax payer has not made TDS, either inadvertently or through a difference in interpretation of law.  It is advisable that the tax payer should refrain from adopting a policy of not making TDS on expenses incurred and paid during the year.

1 M/s. Merilyn Shipping and Transports vs ACIT [ITA No. 477/Viz/2008)(Special Bench, Visakhapatnam]