Deductions Allowed on Payment Basis

Introduction

Certain expenditures are allowed as deduction only on actual payment even if assessee follows the mercantile system of accounting. These expenditure are allowed as deduction in the year of accrual if payment thereof is made either in the tax year itself or in subsequent year on or before the due date specified for filing of return of income. However, overdue payments to micro or small enterprises are not allowed on an accrual basis even if the payment is made on or before the due date of filing of return of income.

1. Expenses deductible on payment basis

Income-tax Act allows deduction of expenditure according to the system of accounting followed by the assessee. Where assessee follows cash system of accounting, deduction should be allowed on actual payment basis. In case of mercantile system of accounting, the deduction is allowed on accrual basis. However, there are certain expenses which are allowed as deduction on payment basis, even if assessee maintains books of account on mercantile basis. These expenses shall be allowed on payment basis and it is not necessary that liability to pay them should be incurred first before making payment thereof

The list of expenses which are deductible on payment basis are as follows:

1.1. Any tax, surcharge or duty

Any sum payable by way of tax, duty, cess, surcharge or fee, by whatever name called, under any law for the time being in force, is deducted on payment basis. There are various expenditures which have been held allowable on accrual basis or have been taken out of the ambit of provisions of Section 37. These circumstances have been discussed below.

1.1.1. Sales tax deferred scheme

State Governments introduce sales tax deferred schemes wherein incentives are offered to business entities for setting up industries in backward areas. Under these schemes, entities are allowed to collect sales tax and pay it to the Govt. after a prescribed period. In such a case, the CBDT

1.1.2. Meaning of taxes, duty and fees

The term ‘tax’ should be distinguished from ‘interest’. Where interest is payable on outstanding municipal taxes, deduction thereof cannot be denied by virtue of Section 37

The ‘fees’ cannot be equated with fees for any professional charges, i.e., fees for statutory audit, etc. Thus, deduction for such fees cannot be denied under this provision

1.1.3. Meaning of any sum payable

Any sum payable means a sum for which the assessee has incurred liability in the tax year even though such sum might not have been payable within that year under the relevant law.

Advance deposit of duty constitutes actual payment

1.2. Contribution to employee’s welfare  fund

Any sum payable by employer by way of contribution to any provident fund or superannuation fund or gratuity fund or any other fund for the welfare of employees is allowed as deduction under Section 29(1)(a). If such contribution in employee’s welfare fund is allowable as deduction, it shall be allowed to be deducted only on payment basis.

Deduction for employee’s contribution to such welfare funds is governed by the provisions of Section 29(1)(e)(i). This provision deals with deduction for employer’s contribution to such welfare funds. The provision of this section shall not apply and shall be deemed never to have been applied for the purpose of deduction for employee’s contribution to such welfare funds. In other words, as per the wordings of Section 37, employer’s contribution to welfare funds shall be allowed as deduction if deposit is made by the date for furnishing return of income. Whereas, employee’s contribution shall be allowed as deduction if deposit is made by the due date specified under the relevant Act and no deduction shall be allowed if same is deposited after such date even if deposit is made by the due date of furnishing return of income.

It should be noted that the Finance Act, 2026, amended Section 29(1)(e) to allow a deduction for employee contributions if deposited on or before the due date of filing the ITR, but no corresponding amendment has been made to Section 37(6) which provided an exclusion that this provision shall not apply to sums received from employees as contributions to funds.

1.3. Bonus or commission

Deduction for bonus or commission paid or payable to the employees is deductible in accordance with Section 32(a). If such expenditure is allowable as deduction, it shall be deducted only on payment basis.

1.4. Interest on borrowings from banks or financial institutions

Any interest payable on any loan or borrowing or advance taken from following institutions shall be allowed as deduction in accordance with the terms and conditions of loan or borrowing agreement only on actual payment:

(a) Public Financial Institution

(b) State Financial Corporation

(c) State Industrial Investment Corporation

(d) Scheduled Bank

(e) Co-op. bank (other than primary agricultural credit society or a primary co-operative agricultural and rural development bank)

If interest on any loan or borrowing or advance is converted into fresh loan or borrowing or advance or debenture or any other instrument by which the liability to pay is deferred to a future date, the interest so converted shall not be deemed as actual payment. Thus, no deduction shall be allowed in respect of such interest amount. The converted interest will be eligible for deduction in the computation of income of the tax year in which such interest is ‘actually paid’. However, conversion of outstanding interest liability into share capital may tantamount to actual payment and disallowance under Section 37 is not applicable

The CBDT

In other words, nomenclature of the sum of converted interest will make no difference as the sum of converted interest whenever is actually paid will not represent repayment of the principal. The circular clarifies that the fundamental principle remains that once an amount has been determined as interest payable to the banks or financial institutions, any subsequent change of nomenclature of interest will not affect its allowability and deduction in terms of section 37 will have to be allowed on its actual payment. The Assessing Officer, however, can ask for a certificate from the assessee to be obtained from the lender bank or financial institution etc. as evidence of ‘actual payment’ of interest to banks or financial institutions.

1.5. Interest on loan from NBFC

Any sum payable by the assessee as interest on any loan or advances from any NBFC classified in the Top, Upper or Middle layer shall be allowed as deduction if it is actually paid on or before the due date of furnishing the return of income of the relevant tax year.

Also, the deduction of such interest shall be allowed, if interest is actually paid, and if it is converted into loan or borrowing or debenture or any other instrument by which the liability to pay is deferred to a future date, it will not be considered as interest actually paid for the purpose of its allowability.

1.6. Encashment of earned leave

Any sum payable by an employer in lieu of any leave at the credit of his employee (leave salary encashment) is allowed as deduction on actual payment. Where in any tax year deduction has been allowed in respect of provision for earned leave, no deduction shall be allowed in the tax year in which such sum is actually paid.

1.7. Use of Railway Assets

Any sum payable to Indian Railways for use of railway assets is allowed as deduction on actual payment.

1.8. Payment to micro or small enterprises (MSEs)

Any sum payable by the assessee to a micro or small enterprise

1.8.1. Time limit of payments to micro or small enterprises (MSEs)

Sum payable to micro or small enterprises (MSEs) is not allowed to be claimed as expenditure on accrual basis if the sum payable to the MSEs is not paid within the limitation period provided in Section 15 of the MSMED Act. Section 15 provides the following limitation period to make payments to MSEs:

(a) On or before the date as agreed upon in writing between the parties, which shall not exceed 45 days;

(b) Before the expiry of 15 days from the day of acceptance (or deemed acceptance) of goods or services by the buyer from the supplier, where there is no agreement.

For example, where goods are supplied and accepted on 01-04-2026, the due date for payment under Section 15 of the MSMED Act shall be computed as under:

If the payment is made on or before the due date specified in the third column, no disallowance shall be made under Section 37, and accordingly, the expenditure shall be allowed on an accrual basis. However, if the payment is made after the due date, the expenditure will be allowed in the year in which the payment is made.

2. Deductibility of expense where payment is made in subsequent year

All payments covered under this provision (except payments to micro or small enterprise) is allowed on an accrual basis if the payment is made on or before the due date of furnishing the return of income. If the payment is made after the due date of filing of return of income, the expenditure shall be deductible from the business income for the year in which it is actually paid and not on an accrual basis.

In the case of payments to micro or small enterprises, if the amount outstanding at the end of the year is paid in the next year but beyond the limitation period of Section 15 of the MSMED Act, the amount shall be allowed to be deducted while computing the business income in the next year on an actual payment basis, even if it is paid on or before the due date for furnishing the return of income.

For example, Mr. A receives supply of goods or services from micro or small enterprises in the tax year 2026-27 but the amount is paid in the subsequent year. How the deduction for such payment shall be allowed in the following situations?

References

CIT v. Glaxo Smithkline Consumer Healthcare Ltd. [2007] 16 SOT 134 (Chd.) (SB)

Circular No. 496, dated September 25, 1987

Circular No. 674, dated December 29, 1993

CIT v. Orient Beverages Ltd. (2001) 247 ITR 230 (Cal.)

Gorelal Dubey v. CIT [2001] 248 ITR 3 (SC)

CIT v. Shree Warana Sahakari Sakhar Karkhana Ltd. (2002) 253 ITR 226 (Bom.)

CIT v. Modipon Ltd. [2017] 87 taxmann.com 275 (SC)

CIT v. McDowell & Co Ltd (2009) 180 Taxman 514 (SC)

Garware Chemicals Ltd. v. CIT [2015] 54 taxmann.com 86 (Mum.), CIT v. Alvares & Thomas [2015] 62 taxmann.com 385 (Ahd.)

Circular No.7/2006 dated July 17, 2006

The terms “micro enterprise” and “small enterprise” are defined in clause (h) and clause (m) of Section 2 of the Micro, Small and Medium Enterprises Development Act, 2006, respectively.

This article is general information and not tax advice. Provisions change. Confirm your position with a qualified professional before acting.