Key Disallowances in Business Income as per Indian Tax Laws

Every business wants to claim the maximum possible deduction while computing taxable profits. But the Income Tax Act does not leave this entirely to an assessee’s discretion. Even after an expense qualifies under the general provisions for business deductions, three specific sections can still knock it out entirely: Section 40, Section 40A, and Section 43B. These are the special disallowances, and they override the deductions otherwise available under the general business-expense provisions, regardless of how genuine or business-related the expense actually was. For B.Com students preparing for exams or eventually filing tax returns for a client, this is one of the most exam-relevant and practically useful parts of the syllabus.

Why these three sections override everything else 🔗

The general deduction provisions allow a wide range of business expenses, from rent and repairs to bad debts and depreciation. Sections 40, 40A, and 43B act as a filter on top of these provisions. Even if an expense would otherwise qualify, it gets disallowed if it falls into one of the specific categories these sections list, most of which are linked to TDS compliance, reasonableness of related-party payments, or the timing of actual payment.

One point worth flagging for currency: the Income Tax Act, 1961 has been replaced by the Income Tax Act, 2025 for income earned from 1 April 2026 onwards, and provisions have been renumbered as part of that recodification. Most B.Com syllabi and textbooks still refer to Sections 40, 40A, and 43B as they existed under the 1961 Act, and the substance of these rules has been carried forward largely unchanged, so this article uses the familiar numbering.

Payments to non-residents without TDS: Section 40(a)(i) 🔗

If a business pays interest, royalty, fees for technical services, or any other taxable sum to a person outside India or to a non-resident, and fails to deduct tax at source on it, the entire expense is disallowed. The same disallowance applies if TDS was deducted but not deposited with the government within the prescribed time.

Say a company pays royalty of ₹5 lakh to a foreign consultant and skips the TDS deduction. That entire ₹5 lakh gets added back to taxable profit for that year. The good news is that this disallowance is not permanent. If the TDS is deposited in a later year, the expense becomes deductible in the year the tax is actually paid, though the business still faces interest and penalty for the delay.

The lighter treatment for payments to residents 🔗

Where a similar default happens on payments to a resident, such as commission, brokerage, rent, or fees for professional or technical services, the disallowance is capped at 30 percent of the expense rather than the full amount. So if a business pays ₹5 lakh in professional fees to a resident consultant without deducting TDS, only ₹1.5 lakh gets disallowed, not the full sum. This softer treatment for residents, compared to the 100 percent disallowance for non-residents, has actually been debated in cross-border tax circles as creating a disparity in outcomes despite similar defaults.

Salary, taxes, and penalties that fail the compliance test 🔗

Salary payable outside India or to a non-resident is treated strictly. If tax has not been deducted or deposited on such salary, the deduction is denied in full. What surprises many students is how unforgiving the timing rule is here: if the TDS is deposited even a single day after the due date, the entire salary payment gets disallowed for that year.

A few other everyday items also fall outside the deduction net under these special provisions:

• Income tax paid by the assessee on their own income is never a deductible business expense. It is an application of profit, not a cost of earning it.
• Fines and penalties paid for breaking a law, such as a customs penalty or a pollution-control fine, cannot be claimed as a deduction, since allowing this would effectively let the government subsidise the cost of non-compliance.

When the employer picks up the tax on a perquisite 🔗

Employers sometimes agree to pay the tax on a non-monetary perquisite given to an employee, such as free accommodation or a company car, rather than passing that tax burden onto the employee. This tax amount is exempt in the employee’s hands under Section 10(10CC), but the flip side is that the employer cannot claim this tax payment as a deductible business expense. It is treated as an application of the employer’s income rather than a genuine cost of running the business.

Curbing excess and cash: Section 40A 🔗

Section 40A works alongside Section 40 but focuses on two different risks: overpayment to related parties and untraceable cash transactions.

Unreasonable payments to relatives and related concerns 🔗

Where a business pays a relative, a director, or a related concern an amount that the Assessing Officer considers excessive or unreasonable compared to the fair market value of the goods or services, the excess portion can be disallowed. This is meant to stop businesses from artificially shifting profits to family members or associated entities through inflated invoices.

The cash payment ceiling 🔗

Any single payment exceeding ₹10,000 made in cash to one person in a day is disallowed in full (the limit is ₹35,000 for payments to transport operators for plying, hiring, or leasing goods carriages). This provision exists to push businesses toward traceable banking channels and discourage the use of unaccounted cash.

Section 43B: deductions only on actual payment 🔗

Most businesses maintain accounts on a mercantile or accrual basis, where an expense is booked the moment the liability arises, whether or not cash has actually changed hands. Section 43B carves out specific categories where this accrual comfort does not apply. These items can be deducted only in the year they are actually paid, irrespective of when the liability was incurred:

• Any tax, duty, cess, or fee payable under any law, such as GST, customs duty, or municipal property tax
• Employer’s contribution to provident fund, superannuation fund, gratuity fund, or similar employee welfare funds
• Bonus or commission paid to employees
• Interest on loans or borrowings from public financial institutions and scheduled banks
• Leave encashment paid to employees
• Payments to Indian Railways for using their assets
• Payments to micro and small enterprises beyond the 15-day or 45-day limit prescribed under the MSMED Act

There is a practical relief built into this section: if the payment is made on or before the due date for filing the income tax return under Section 139(1), the deduction can still be claimed for that year even though the actual cash outflow happened after the year ended. Miss that window, and the deduction only becomes available in the year the payment is finally made, not retrospectively.

For instance, if a company’s GST liability for FY 2025-26 remains unpaid on 31 March 2026 but is cleared before the return filing due date, the deduction is still allowed for FY 2025-26. If it is paid only in, say, October 2026, the deduction shifts entirely to FY 2026-27.

Interest and remuneration to partners: Section 40(b) 🔗

Partnership firms and LLPs often pay their partners both interest on capital and remuneration for actively running the business. Section 40(b) caps how much of this the firm can actually deduct, even where the partnership deed permits higher payments.

Conditions that must be met 🔗

Three conditions apply before any deduction is allowed:

• The payment must be authorised by the partnership deed, and only for the period after the deed permits it
• Remuneration is allowed only for a working partner actively involved in the business, not a sleeping or nominal partner
• Interest on capital is capped at 12 percent per annum; anything paid above this rate is disallowed for the excess portion

Remuneration limits based on book profit 🔗

The ceiling on deductible remuneration is tied to the firm’s book profit. As per the limits revised by the Finance (No. 2) Act, 2024, applicable from FY 2024-25 onwards, the slabs work as follows:

Consider a firm with a book profit of ₹10 lakh. On the first ₹6 lakh, the allowed amount is 90 percent, or ₹5.4 lakh. On the remaining ₹4 lakh, 60 percent is allowed, adding ₹2.4 lakh. The total deductible remuneration works out to ₹7.8 lakh. If the deed authorises the partners to draw ₹9 lakh in total, the excess ₹1.2 lakh gets disallowed in the firm’s hands, even though the partners have already received the full amount in cash.

One nuance students often miss: remuneration that gets disallowed in the firm’s hands under this section is not taxed again in the partner’s hands, since it was never really a deductible expense for the firm to begin with. Only the allowed portion is taxable as business income for the partner.

Putting it all together 🔗

The common thread across Sections 40, 40A, and 43B is compliance discipline. Section 40 punishes TDS defaults, particularly on cross-border payments. Section 40A discourages unreasonable related-party payments and untraceable cash dealings. Section 43B forces certain statutory and employee-related dues onto a cash basis rather than allowing indefinite accrual. For a B.Com student, the exam-friendly way to remember this is: TDS defaults, excessive or cash payments, and unpaid statutory dues are the three broad triggers behind almost every special disallowance in this chapter.

What do you think? If a business genuinely could not pay its GST dues on time because of a temporary cash crunch, does it seem fair that the deduction gets pushed to a later year even though the expense was clearly incurred? And should the disallowance rate for TDS defaults on payments to residents and non-residents really differ as sharply as 30 percent versus 100 percent?

References

1. https://www.incometax.gov.in/iec/foportal/help/all-topics/e-filing-services/objective-and-scope-new-act
2. https://cleartax.in/s/section-40-a-i-income-tax-act
3. https://cleartax.in/s/section-40-of-income-tax-act
4. https://www.taxmanagementindia.com/visitor/detail_manual.asp?ID=1135
5. https://www.manipalcigna.com/blog/section-43b-of-income-tax-act
6. https://taxguru.in/income-tax/enhanced-limits-partners-remuneration-section-40b-194t.html
7. https://taxadda.com/remuneration-and-interest-to-partner-section-40b/