Business expenses classification under income tax

1. Business expenses classification under the
Income Tax Act, 1961
By: Sandeep Jhunjhunwala, FCA
August 20, 2016

2. BACKGROUND
TAX DEDUCTABLE EXPENSES
SELF ASSESSMENT QUESTIONS

3. BACKGROUND
Page 3
The Income-tax Act, 1961
Basic provisions
Heads of income
Relevant provisions
Basic provisions of the Income-tax Act, 1961 (“the Act”)
Concept of ‘Previous year’ and ‘Assessment year’ (Section 3)
Income tax shall be charged on ‘total income’ in accordance and subject to
provisions of the Act (enabling provisions - Section 4)
Scope of total income - Based on Residency and Source principles (Sections 5 and
6 and 9)
Income received or deemed to be received, accrues or arises or deemed to
accrue or arise in India- Wide amplitude
Capital receipts and expenses not subject to tax unless specifically covered

4. BACKGROUND
Page 4
The Income-tax Act, 1961
Basic provisions
Heads of income
Relevant provisions
Profit and Loss (P&L) account prepared by the assessee may not be correct from the
income tax point of view, as:
– Several such expenses are charged to it may be wholly or partly inadmissible
under the IT Act
– Some admissible expenses might be omitted from it
– Some taxable incomes may not be credited to it
– Some such incomes might be credited which are either neither taxable
under the head ‘Profits and Gains of Business or Profession’ or nor taxable at
all
Hence, P&L account has to be adjusted from the income tax point of view, so that
the profit taxable under the head “Business or Profession’ is determined correctly

5. BACKGROUND
Page 5
The Income-tax Act, 1961
Basic provisions
Heads of income
Relevant provisions
Those expenses/ losses which are charged to P&L Account but are not allowed
under the IT Act, should be added to the profit, as shown by the P&L Account
prepared by the assessee
If any expense is partly disallowed, only the disallowed part of it shall be added to
the profit
If any admissible expenses are omitted from P&L Account, they should be deducted
from the above profit
If some taxable incomes are omitted from the P&L Account, they should be added
to the above profit
If some such incomes have been credited to the P&L Account which are either not
taxable under the head ‘Business or Profession’ or are not taxable at all, they
should be deducted from the above profits

6. BACKGROUND
Page 6
The Income-tax Act, 1961
Basic provisions
Heads of income
Relevant provisions Heads of Income
Salaries
Income from
House Property
Profits and Gains
from Business
and Profession
(“PGBP”)
Capital
Gains
Income from
other sources
(“IFOS”)

7. BACKGROUND
Page 7
The Income-tax Act, 1961
Basic provisions
Heads of income
Relevant provisions
Relevant provisions of the Act
dealing with business and provisions
(Section 28 to 44DB)
Income
(Scope in section 28
Deemed income (Section 41)
Tax deductible expenses
Expenses and allowance
(Section 30 to 38)
Allowed subject to compliance, payments and other
conditions
(Section 40, 40A and 43B)
Others
(Computation –Section 29 and
30)
(Definition – Section 43 and 2)

8. CONTENTS
BACKGROUND
TAX DEDUCTABLE
EXPENSES
SELF ASSESSMENT QUESTIONS

9. Page 9
Income under the head ‘IFOS’ and
‘PGBP’
To follow cash or mercantile as regularly
followed
Companies Act, 1956 / 2013: Companies
follow mercantile system of accounting
Income Computation Disclosure
Standards (ICDS): Standards applicable to
all assessees wrt income under IFOS and
PGBP (AY 2016-17 onwards)
Method of accounting
Underlying principles
Depreciation allowance
Expenses
Disallowance
TAX DEDUCTABLE EXPENSES
NATURE

10. TAX DEDUCTABLE EXPENSES
Page 10
NATURE
Section 32- Depreciation - not dependent on method of accounting, Tax depreciation
rates, Written down Value of an asset
Section 37 - Residuary Section
Sections 40, 40A – Specific disallowances
Section 43B items – Tax, duty, cess, bonus, etc – allowed only on payment basis
Preliminary expenses – 1/5th over a period of 5 years
Discount on redeemable debentures – allowed over the period of debentures
Forex fluctuations – to be adjusted to cost of asset on actual payment (Section 43A)
RELEVANE OF METHOD OF ACCOUNTING
Method of accounting
Underlying principles
Depreciation allowance
Expenses
Disallowance

11. TAX DEDUCTABLE EXPENSES
Page 11
NATURE
Method of accounting
Underlying principles
Depreciation allowance
Expenses
Disallowance
Entries in the books of accounts are not conclusive in determining the allowability or
taxability of a particular expenses or income - Kedarnath Jute Mfg. Co. Ltd vs. CIT,(1968)
82 ITR 362 (SC)
Examples:
– Income due to revaluation of assets in the books of accounts – not chargeable to
tax under the Act
– Expenses to be allowed even is the same is not entered in books of accounts
– Trading receipt will continue to be subject to tax even if the same is shown as
capital receipt in the books of accounts
RELEVANE OF METHOD OF ACCOUNTING

12. TAX DEDUCTABLE EXPENSES
Page 12
NATURE
Method of accounting
Underlying principles
Depreciation allowance
Expenses
Disallowance
Onus to prove admissibility is on the Assessee
Expenditure should relate to previous year – few exceptions in case of preliminary expenses, etc
Business should be carried on during the previous year
Benefit of expenditure may extend beyond relevant previous year
Capital expenditure allowable only if specifically allowed under any of the provisions of the Act
No allowance in respect of non-assessable business (expenses with respect to exempt is not
allowable - Section 14A)
UNDERLYING PRINCIPLES

13. Page 13
TAX DEDUCTABLE EXPENSES
- Depreciation allowable
- Actual expenses allowable subject to
provisions of the IT Act
- Interest and municipal taxes also
allowable
- Standard deduction of expenses
irrespective of actual expenses (30
percent of annual value)
- Municipal taxes and interest allowable
subject to provisions of IT Act
Income from Business or Profession Income from House property
Expenses with
respect to renting
activity
NATURE Expenses allowable subject to the head under which it is taxable
Method of accounting
Underlying principles
Depreciation allowance
Expenses
Disallowance

14. TAX DEDUCTABLE EXPENSES
Page 14
NATURE
Method of accounting
Underlying principles
Depreciation allowance
Expenses
Disallowance
Depreciation – loss or decline in value over useful life due to wear, tear and decay
Allowance for depreciation is subject to following conditions:
– Asset must be owned by the Assessee (beneficial ownership)
– It must be used for the purpose of business / profession
– Used during the relevant previous year
Depreciation allowance is allowed only against income under the head IFOS and PGBP
ALLOWANCE FOR DEPRECIATION

15. TAX DEDUCTABLE EXPENSES
Page 15
NATURE
In-house research of following expenses allowed
Revenue and capital expenditure (except cost of land)
Expenditure incurred during 3 years immediately preceding the
commencement of business (being salary, purchase of material used in
scientific business or capital expenses other than land) – allowed as
deduction in the year of commencement
Companies engaged in the business of bio-technology or in the business of
manufacture or production of any article or thing – 200 percent of any
expenses (except land and building cost). 150 percent from AY 2018-10 and
100 percent from AY 2021-22)
SCIENTIFIC RESEARCH
100%
200%
Note- Usually capital expenses
are not allowed unless
specifically allowed under
provisions
Amendments in Finance Act,
2016 to gradually phase out
deductions
Method of accounting
Underlying principles
Depreciation allowance
Expenses – scientific research
Disallowance

16. TAX DEDUCTABLE EXPENSES
Page 16
NATURE OTHER EXPENSES
Nature of
expenses
Account
ing
treatme
nt
Provisions of the Act
Preliminary
expenses
Record
ed in
respecti
ve
years
1/5 th of the qualifying expenses
allowed from the year of
commencement of business or
extension of undertaking
Expenses on
bonus issue
of shares/
debentures
Record
ed in
respecti
ve
years
- New business - 1/5 th of the
qualifying expenses allowed from
the year of commencement
Existing business – allowed in PY in
which such expenses are incurred
Method of accounting
Underlying principles
Depreciation allowance
Expenses – others
Disallowance

17. TAX DEDUCTABLE EXPENSES
Page 17
NATURE OTHER EXPENSES
Nature of
expenses
Account
ing
treatme
nt
Provisions of the Act
Interest
expenses
Record
ed in
respecti
ve years
- Must be used for the purpose of business
- Interest is paid or payable on such expenses
Interest
expenses for
acquisition
of asset
Record
ed in
respecti
ve years
- Not allowed as expense till the date when
such asset is put to use
- Expenses after the asset is put to use is
allowable subject to above conditions
Method of accounting
Underlying principles
Depreciation allowance
Expenses – others
Disallowance

18. TAX DEDUCTABLE EXPENSES
Page 18
NATURE OTHER EXPENSES
Nature of
expenses
Account
ing
treatme
nt
Provisions of the Act
Employers
contribution
to PF
Record
ed in
respecti
ve years
- To be allowed if paid within the due date of
fileting of return of income
Employees
contribution
to PF paid
by employer
Record
ed in
respecti
ve years
- To be allowed only if paid within the due
date specified under specified fund
- Judicial rulings allow the same if paid within
the due date of return of income
Method of accounting
Underlying principles
Depreciation allowance
Expenses – others
Disallowance

19. TAX DEDUCTABLE EXPENSES
Page 19
NATURE OTHER EXPENSES
Nature of
expenses
Account
ing
treatme
nt
Provisions of the Act
Provision for
bad and
doubtful
debts
Recorde
d in
respecti
ve years
- Disallowed
Method of accounting
Underlying principles
Depreciation allowance
Expenses – others
Disallowance

20. TAX DEDUCTABLE EXPENSES
Page 20
NATURE
Method of accounting
Underlying principles
Depreciation allowance
Expenses – others
Disallowance
OTHER EXPENSES
Nature of
expenses
Account
ing
treatme
nt
Provisions of the Act
Bad debts
Record
ed in
respecti
ve years
- Debt must have been taken into account in
computing assessable income
- Such debt is written of in books (no need to
prove that debt is not recoverable)
Bad debts
(after ICDS)
Not
applica
ble
- Revenue recognized only for tax purpose (no
entries in books)
- Deemed to be recorded in books
- Allowable if becomes irrecoverable
Debt must be incidental
and connected to
business or profession of
the assessee

21. TAX DEDUCTABLE EXPENSES
Page 21
NATURE OTHER EXPENSES
Conditions for deductibility of expenses other than expenses specifically provided
under Sections 30-36
- Not in the nature of
- Capital expenses
- Personal expenses
- Payments prohibited as per prevalent law
- Should be incurred in previous year
- Should be expended wholly and exclusively for the purpose of business or
profession
Method of accounting
Underlying principles
Depreciation allowance
Expenses – others
Disallowance

22. TAX DEDUCTABLE EXPENSES
Page 22
NATURE OTHER EXPENSES
Few instances of capital expenditure
- Expenditure incurred in connection with starting new project (not related to the
business or profession) which has to be abandoned
- Expenditure incurred on issue of fully convertible debentures – Being capital in
nature
- Expenses incurred in completing imperfect title to an asset – being capital in nature
- Fees paid to Registrar of Companies for enhancement of capital
Method of accounting
Underlying principles
Depreciation allowance
Expenses – others
Disallowance

23. TAX DEDUCTABLE EXPENSES
Page 23
NATURE OTHER EXPENSES
Few instances of revenue expenditure
- Compensation paid on account of negligence in carrying on business
- Contribution paid to the government in order to repair the road up to the tax
payer’s factory even if the road does not belong to him
- Expenses on issue of debentures
- Setting up of new business for the benefit of existing business
Method of accounting
Underlying principles
Depreciation allowance
Expenses – others
Disallowance

24. TAX DEDUCTABLE EXPENSES
Page 24
NATURE
OTHER EXPENSES
Few instances of expenses incurred by assessee which are not allowed
- Penalty for contravention of any specific statutory provision
- Expenses on gifts to medical practitioner by pharma companies (barred by Medical
Council of India)
- Commission paid for restraining certain party from participating in tender floated by
public sector organization
Few instances of allowable expenses
- Fine paid by assessee stock broker to NSE on account of unfair trade practices is not
for violation of law but in violation of conduct as prescribed by NSE
- Damages paid by assessee for breach of commercial contract is not liability incurred
for contravention of law, hence allowable
Method of accounting
Underlying principles
Depreciation allowance
Expenses – others
Disallowance

25. TAX DEDUCTABLE EXPENSES
Page 25
NATURE
SECTION 30
Rent, rates, taxes, repairs and insurance for buildings
- Rent for business premises
- Rent for premises only
- Covers the cost of repairs to the premises
- Land Revenue, local rates or municipal taxes
- Unregistered agreement should not disentitle
- Rent for closed or discontinued business?
Method of accounting
Underlying principles
Depreciation allowance
Expenses – others
Disallowance

26. TAX DEDUCTABLE EXPENSES
Page 26
NATURE
SECTION 31
Repairs and insurance of machinery, plant and furniture
- Used for business or profession
- Heart is not a plant - Shanthi Bhushan vs CIT (2011) 336 ITR 26 (Del)
- Limited to current repairs only
- Replacement of parts to be considered as repairs - CIT vs Janakiraman spinning mills
(275 ITR 403)
- Current repairs defined in CIT vs Chowgule & Co (214 ITR 523)
Method of accounting
Underlying principles
Depreciation allowance
Expenses – others
Disallowance

27. TAX DEDUCTABLE EXPENSES
Page 27
NATURE
SECTION 36
- Insurance
- Bonus or commission
- Interest on borrowed cap
- Provident fund payments
- Pension scheme
- Gratuity fund
- Animals
- Bad debts
- Banking cash transaction tax
- Credit guarantee fund trust
- Security transaction tax
Method of accounting
Underlying principles
Depreciation allowance
Expenses – others
Disallowance

28. TAX DEDUCTABLE EXPENSES
Page 28
NATURE
SECTION 37
- Residual section
- Provided for deduction of all expenditure wholly and exclusively for the purpose of
business
- Such expenditure should not be covered under the specific section ie 30 to 36
- Expenditure should not be of capital nature
- Expenditure should be incurred during PY
- Expenditure should not be of personal nature
Method of accounting
Underlying principles
Depreciation allowance
Expenses – others
Disallowance

29. TAX DEDUCTABLE EXPENSES
Page 29
NATURE
SECTION 37 – SOME CASES
- Payment of protection money to rowdies & police - CIT vs Neelavathi & Others 322
ITR 643 (2010)
- Pooja related expenses - Hira Ferro Alloys Limited vs DCIT 326 ITR 261,
Sanghameshwar Coffee Estates Ltd. [1986] 160 ITR 203, Kolhapur Sugar Mill Ltd
[1979] 119 ITR 387, Atlas Cycle Industries Ltd [1982] 134 ITR 458
- Business Promotion - Brihan Maharashtra Sugar Syndicate Ltd 28 DTR 265
- Prior Period Expenses - Urban Improvement Co (P) Ltd ITA No 3246/Mum/2006
- Donation - A.M. Mathur 117 ITD 274
- Replacement of Fire extinguishers - Yum Resturants (2012)14 (trib) ITR 420
- Penalties paid for infringement of law
Method of accounting
Underlying principles
Depreciation allowance
Expenses – others
Disallowance

30. TAX DEDUCTABLE EXPENSES
Page 30
Section 40
• Compliance to TDS
provisions
• NR Payments - Sec 40(a)(i)
• R Payments - Sec 40(a)(ia)
• Equalisation Levy
• Tax on profits not
allowable
• Payment to partners
subject to given limits
Section 40A
• Excessive unreasonable
expenses paid to related
parties
• Payments otherwise than
by account payee cheque
in excess of limit given per
day – Rule 6DD exceptions
• Provision for gratuity
(allowed on payment
basis)
Section 43B
• Certain deductions only on
payments basis
• Taxes, duty, cess, fee,
employers contribution to
PF, interest on loan, among
others
ALLOWANCE OF EXPENSES ARE SUBJECT TO
Suo-moto specified domestic and international transfer pricing adjustments (Section 92)
Method of accounting
Underlying principles
Depreciation allowance
Expenses – others
Disallowance
NATURE

31. TAX DEDUCTABLE EXPENSES
Page 31
NATURE Payment of foreign tax
Foreign Tax – Is it tax deductible ?
- Applicable provision – Section 40(a)(ii) of the Act. Explanation thereto stating that sum eligible for relief
under Section 90 / 91 is also hit by above provision
- Tax treaty entered as per Section 90 of the Act grants relief with respect such income which is chargeable
as per laws in force in both the countries or if taxes paid in both the countries on such income
Method of accounting
Underlying principles
Depreciation allowance
Expenses – others
Disallowance
- Availability of Foreign Tax credit when such income is eligible for deduction, exemption, chargeable at 0
percent, etc in either of the countries? (refer Note 1)
- Will lack of eligibility of credit of foreign taxes lead to foreign tax becoming tax deductible ?
Foreign Tax credit is subject to provisions of treaty and reference is also drawn to Karnataka High Court ruling
allowing tax credit in case of Wipro Ltd vs DCIT (company claiming Section 10A benefit)

32. TAX DEDUCTABLE EXPENSES
Page 32
NATURE Delayed payment of Provident Fund contribution
Method of accounting
Underlying principles
Depreciation allowance
Expenses – others
Disallowance
Delayed remittance of
PF contributions
Employees’ contribution
Paid after due date under relevant
welfare fund (but before due date of
filing return) – conflicting view by
various judicial bodies
Paid within the due date applicable
to relevant welfare fund - allowed as
deduction1
Employers’ contribution
Paid after due date under relevant
welfare fund (but before due date of
filing return) – allowed as per section
43B
Provisions with respect to employees
contribution
- Income in the hands of employer as per
section 2(24)(x) of the Act
- Such amount allowed as deduction if the
same is remitted before the due date as per
relevant act (Section 36(1)(va) of the Act
- Section 43B – payment basis – Applicable ?

33. TAX DEDUCTABLE EXPENSES
Page 33
NATURE Related party transactions
- Section 40A(2) of the Act - Any payment to a related person shall be disallowed to
the extent it is excess or unreasonable as per the Assessing Officer
- Provisions of Chapter X of the Act (Transfer Pricing) – international transactions and
specified domestic transactions (limit of Rs 20 crore per previous year) between
Associated Enterprises should be at arm’s length
Method of accounting
Underlying principles
Depreciation allowance
Expenses – others
Disallowance

34. TAX DEDUCTABLE EXPENSES
Page 34
NATURE Section 14A
- No deduction allowable with respect to income which is not forming part of total
income (exempt income)
- Tax officer has powers to compute costs with respect to such exempt income
- New rules to compute disallowance
- Amount of expenditure directly relating to income which does not form part
of total income; and
- 1 percent of the annual average of the monthly average of the opening and
closing balances of the value of investment, income from which does not or
shall not form part of total income
(such disallowance shall not exceed the total expenditure claimed by the assessee)
Method of accounting
Underlying principles
Depreciation allowance
Expenses – others
Disallowance

35. CONTENTS
BACKGROUND
TAX DEDUCTABLE EXPENSES
SELF ASSESSMENT QUESTIONS

36. Case Study - 1
Page 36
Assessee is liable to pay Rs 15,000 each towards two separate invoices. Cash payments is made towards the same on January 01, 2016
Tax deductibility of said expenses
- Is Section 40A(3) limit applicable expenditure wise or invoice wise?
Relevant provision of the Act:
“(3) Where the assessee incurs any expenditure in respect of which a payment or aggregate of payments made to a person in a day,
otherwise than by an account payee cheque drawn on a bank or account payee bank draft, exceeds twenty thousand rupees, no deduction
shall be allowed in respect of such expenditure”
The limit of Rs 20,000 is to be applied to the aggregate of cash payments made to a person during the day. As the aggregate exceeds Rs
20,000 Section 40A(3) would apply

37. Case Study – 2
Page 37
Assessee-company sells goods manufactured by it to its director for Rs 1,00,000. The market price of such goods is Rs 1,75,000.
The tax officer wants to invoke Sec 40A(2). Can he do so?
Relevant provision of the Act:
“(2)(a) Where the assessee incurs any expenditure in respect of which payment has been or is to be made to any person referred to in
clause (b) of this sub-section, and the Assessing Officer is of opinion that such expenditure is excessive or unreasonable having regard to
the fair market value of the goods, services or facilities for which the payment is made or the legitimate needs of the business or
profession of the assessee or the benefit derived by or accruing to him therefrom, so much of the expenditure as is so considered by him to
be excessive or unreasonable shall not be allowed as a deduction”
No expenditure has been incurred by the Assessee-company for which payment needs to be made. Section 40A(2) of the Act cannot be
invoked

38. Case Study – 3
Page 38
Mr. X purchases goods in cash from his brother for Rs 40,000, whose market value is Rs 35,000. Whether any part will be disallowed and
how?
Relevant provision of the Act:
Section 40A(2) of the Act (as referred earlier)
Section 40A(3) of the Act (as referred earlier)
Rs 5,000 should be disallowed under Section 40A(2) of the Act
Rs 35,000 should be disallowed under Section 40A(3) of the Act

39. Illustration
Page 39
Compute income taxable under the head ‘Profits and gains from business and profession’ of a company engaged in real estate activity and
renting of commercial space considering below facts:
Particulars Amount
in Rs
Income as per profit and loss statement 100
Income included above:
Interest income
Gain on sale of investments (Shares)
Rental income
10
12
18
Depreciation as per audited financials 30
Depreciation as per provisions of the Act 10
Loss on write off of fixed assets 5
Donation 5

40. Illustration
Page 40
Particulars Amount
in Rs
Expenditure towards increase in share capital 2
Provision for bonus
Bonus paid during the previous year
Bonus paid before due date of filing of return of income (out of provision for bonus of previous year)
10
5
8
Provision for doubtful debts 5
Provision for doubtful debts no longer required written back 10

41. Illustration
Page 41
Income as per profit and loss statement 100
Income considered under other heads of income
Interest income (10)
Gain on sale of investments (shares)
(12)
Rental income (entity engaged in real estate and commercial space renting – no adjustment)
Depreciation as per provisions of the Act
(10)
Bonus paid before due date of filing of return of income (out of provision for bonus of previous year)
(8)
Bonus paid during the previous year
(already part of profit and loss account – no adjustment)
Provision for doubtful debts no longer required written back
(10)
Draft computation

42. Illustration
Page 42
Donations
5
Depreciation as per audited financials
30
Loss on write off of fixed assets
5
Provision for bonus
10
Provision for doubtful debts
5
Expenditure towards increase in share capital
2
Profits and gains from business and profession
107
Draft computation

43. OPEN HOUSE & DISCUSSIONS
THANK YOU
Sandeep Jhunjhunwala, FCA
E: writetosandeepj@gmail.com
M: +91 97401 55469
Views expressed in the presentation are personal