Section 40A of Income Tax Act 1961: Expenses and Payments Not Deductible in Certain Circumstances
Section 40A of the Income-tax Act, 1961 contained special restrictions on deductions while computing business or professional income. It dealt mainly with excessive payments to specified related persons, payments above prescribed limits made outside permitted banking or electronic modes, gratuity provisions, contributions to employee welfare funds and marked-to-market or expected losses.
What did Section 40A of the Income Tax Act 1961 mean?
Section 40A was an overriding provision for computation of income under the head "Profits and gains of business or profession". In practical terms, an expense could satisfy a general deduction provision and still be disallowed, wholly or partly, if a specific restriction in Section 40A applied.
The section therefore operated as an anti-avoidance and payment-discipline provision. Its major rules concerned unreasonable related-party expenditure, high-value payments made otherwise than through permitted banking or electronic modes, provisions for gratuity and certain employer contributions.
Section 40A(2): Excessive or unreasonable payments to specified persons
Under Section 40A(2), where an assessee incurred expenditure involving payment to a specified person, the Assessing Officer could disallow the portion considered excessive or unreasonable. The comparison was made with reference to the fair market value of the goods, services or facilities, the legitimate needs of the business or profession, and the benefit derived by or accruing to the assessee.
Who was a specified person?
The provision covered relationships such as relatives of an individual assessee; directors, partners or members and their relatives; persons having a substantial interest in the assessee's business or profession; and specified entities or persons connected through such substantial interest.
For this purpose, "substantial interest" generally meant beneficial ownership of shares carrying at least 20 per cent of voting power where the business was carried on by a company, or beneficial entitlement to at least 20 per cent of the profits in other cases.
Section 40A(3): Payments above Rs. 10,000 outside permitted modes
Section 40A(3) restricted deduction where payment or the aggregate of payments made to a person in a day exceeded Rs. 10,000 and was made otherwise than by the permitted account-payee banking, clearing or prescribed electronic modes. Subject to the statutory exceptions, the expenditure represented by such payment was not deductible.
For payments made for plying, hiring or leasing goods carriages, the corresponding daily threshold was Rs. 35,000.
Section 40A(3A): Payment of a liability allowed in an earlier year
Section 40A(3A) dealt with a different situation. If a deduction had already been allowed for a liability in an earlier assessment and the assessee later discharged that liability through a payment exceeding the applicable limit otherwise than through the prescribed modes, the payment could be treated as business income of the subsequent year, subject to the prescribed exceptions.
| Provision | Situation | General consequence |
|---|---|---|
| Section 40A(2) | Excessive or unreasonable expenditure involving specified related persons | Excessive or unreasonable portion disallowed |
| Section 40A(3) | Current expenditure paid above the daily threshold outside permitted modes | Deduction restricted, subject to exceptions |
| Section 40A(3A) | Earlier liability deducted but later paid above the threshold outside permitted modes | Amount may be treated as business income in the later year, subject to exceptions |
| Section 40A(7) | Provision for gratuity | Generally not deductible except in specified cases |
| Section 40A(9) | Employer payment to certain funds, trusts or institutions | Deduction restricted except where specifically permitted or legally required |
| Section 40A(13) | Marked-to-market or other expected loss | Not deductible except where specifically allowed under the Act |
Rule 6DD: Exceptions to the payment restriction
The payment restriction was not absolute. Rule 6DD of the Income-tax Rules prescribed cases and circumstances in which a payment exceeding the statutory limit could be made otherwise than through the specified banking or electronic modes without attracting the disallowance. The precise exception must be checked against the rule applicable to the relevant period and facts.
Examples historically covered by the rule include specified payments to government, certain banking arrangements and other prescribed circumstances where the statutory conditions are satisfied. A taxpayer should not rely merely on business convenience; the facts should fit the applicable prescribed exception.
Section 40A(7): Provision for gratuity
Section 40A(7) generally denied deduction for a provision made for payment of gratuity to employees on retirement or termination. The restriction did not apply in the same manner to a qualifying provision for contribution to an approved gratuity fund or to gratuity that had become payable during the relevant previous year, subject to the statutory conditions.
Section 40A(9): Contributions to employee welfare funds
Section 40A(9) restricted deduction for sums paid by an employer towards setting up, forming or contributing to a fund, trust, company, association, society or other institution, except where the payment was for purposes specifically permitted by the Act or was required by another law in force.
Section 40A(13): Marked-to-market or expected loss
Section 40A(13) provided that a marked-to-market loss or other expected loss was not deductible unless it was allowable under the specific provision referred to in the Act. This prevented a deduction merely because an anticipated loss had been recognised in accounts where the tax law did not permit it.
What is the position from 1 April 2026?
For the current statutory framework, Section 36 of the Income-tax Act, 2025 is titled "Expenses or payments not deductible in certain circumstances". It carries forward the principal rules on excessive or unreasonable payments to specified persons and payments exceeding the applicable daily limits outside specified banking or online modes.
The new Act uses the expression "specified banking or online mode". The general daily threshold remains Rs. 10,000, while the amount is read as Rs. 35,000 for payments for plying, hiring or leasing goods carriages. Prescribed exceptions continue to apply.
Some subject matter formerly collected within Section 40A has been reorganised in the 2025 Act. For that reason, old subsection numbers should not simply be copied into advice or compliance documents for a tax year governed by the new Act.
Official references
Income Tax Department - Section 40A of the Income-tax Act, 1961
Income Tax Department - Income-tax Act, 2025 and transition resources
This article is a general legal and tax information resource. Applicability depends on the relevant tax year, transaction, payment mode and prescribed exceptions.