Disallowance under section 40A(3) – Whether Automatic?

Introduction

Section 40A of the Income Tax Act, 1961 was inserted by the Finance Act, 1968 w.e.f. 01st April 1968 provides for disallowance of expenses or payments not deductible in certain circumstances while computing the income under the head Profit & Gains of Business or Profession. Another facet and part of the main provision in section 40A(3) which expressly disallows any payment falling in nature of expenditure in respect of which 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 or by use of electronic clearing system through a bank account exceeds ten thousand rupees. Section 40A(3) has further been amended by the Finance (No.2) Act, 2019 with effect from 01^st April 2020 to provide another immunity channel i.e. such other electronic mode as may be prescribed so as to avoid facing disallowance in respect of any expenditure incurred by the assessee. Some expressions used per se in the provision are of utmost importance likewise the expression `expenditure’, `account payee cheque’ `account payee bank draft’ `exceeds ten thousand rupees’, etc. A literal interpretation of these provisions establishes that besides the existence of an expenditure, payments through account payee cheques/bank drafts are a sine qua non for avoiding any disallowance under section 40A(3). Recently Hon’ble Karnataka High Court in M.K.Agrotech Private Limited vs. Additional Commissioner of Income Tax (2019) 176 DTR (Kar) 294/ (2019) 412 ITR 351 was confronted with the question `Whether disallowance under section 40A(3) stands attracted when it is noticeable that payments have not been made by account payee bank drafts which were not crossed’.

Facts

The assessee company namely M.K.Agrotech Private Limited was engaged in the manufacturing of refined oils, solvent oils, and de-mealed meals. The assessee in compliance with its statutory obligation filed its return of income for the assessment year 2005-06 declaring a total income of Rs.6,68,16,400/-. The return was processed under section 143(1) thereby leading to the determination of refund to the tune of Rs.20,60,121/-. The case was picked for scrutiny under regular provisions and accordingly statutory notice under section 143(2) was issued. The assessing officer in the course of assessment disallowed a sum of Commissioner (Appeals)  Rs.5,31,09,701/- on the ground that assessee had contravened the provisions of section 40A(3) by making payments to Challakere parties, hence as per the law applicable for the assessment year under reference i.e. 2005-06, 20 percent of the payments made were to be disallowed and consequently added to the income of the assessee. The assessee aggrieved by the findings of the assessment order filed an appeal before the agitating its claim that no disallowance under section 40A(3) is warranted. The Commissioner (Appeals) held that there was no case for concluding that the impugned purchases made by the assessee were bogus. However it upheld the payments made to Challakere parties wherein the total purchases for three parties amounted to Rs.1,36,57,416/-. The assessee still aggrieved by the findings traveled to the final fact-finding authority i.e. Income Tax Appellate Tribunal questioning the very basis of confirmation of the amount towards disallowance. The Tribunal further confirmed disallowance of Rs.27,31,483/- under section 40A(3) against which the assessee petitioned the writ court for redressal of its grievance.

The assessee contested its case before the writ court by contending that only ground for disallowance was with reference to three parties wherein the drafts have not been crossed i.e. Vaishnavi Oil Traders for Rs.1,04,51,051, Laxmi Trading Co. for Rs.7,15,294/- and Ratna Traders for Rs.24,91,071/-. The assessee argued that it is undisputed that drafts were not crossed but at the same time the end sources duly corroborate the stand of the assessee reflecting identity and genuineness of the said payment. Reliance was placed on the pronouncement of the Hon’ble Supreme Court of India in Attar Singh Gurmukh Singh vs. Income Tax Officer (1991) 97 CTR (SC) 251: 191 ITR 667 (SC) to contend that per ratio of the judgment, it is open for the assessee to furnish to the satisfaction of the assessing authority the circumstances under which the payment as prescribed under section 40A(3) was made and in the event it would not have been made by uncrossed bank drafts, the genuine difficulty that would have arisen to the payee. The principle object aligned to the provisions of section 40A(3) is to check the proliferation of black money which is in wide circulation. It was thus pleaded that where identity & genuineness of the transaction stood established, the rigors of the provision can further be relaxed and no disallowances can be made under the garb of section 40A(3). The revenue on the other hand contended that it is not disputed that payments were made in violation of the provisions of section 40A(3) and the demand drafts have since not been crossed, there is no error committed by the authorities below therefore the disallowances be accordingly sustained.

Observations of the Hon’ble High Court

The High Court took note of the provisions of section 40A(3) as was then prevailing i.e. applicable for the assessment year under reference i.e. assessment year 2005-06 to provide that `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 Hon’ble Court also took note of the exceptions provided in Rule 6DDwherein payments can be made otherwise by crossed demand drafts and accordingly be allowed for the purpose of computing business expenditure. The Hon’ble Court settled in the context of the issue before it by taking into consideration other ancillary circumstances associated with the transaction which led to disallowance under section 40A(3). The High Court noted that all the purchases made by the assessee from the aforesaid three parties were supported by the registered dealer invoices along with valid transit documents, freight charges, weighted slips, etc. of the respective suppliers.The stock register was also maintained by the assessee and the said documents were never disputed by the assessing officer. It was further noticed that letters were issued by the bankers which further indicated that the payment made to the suppliers was credited to their respective bank accounts. Therefore, all purchases made by the assessee were supported by valid dealer invoices. The Commissioner (Appeals) in the course of hearing before him categorically recorded a finding that parties were existent. Even their bank accounts were identifiable and barring one party, all other parties have duly filed their sales tax returns through the turnover disclosed is very small as compared to the purchases claimed by the appellant. The Commissioner (Appeals) concluded that since the transactions are made through the bank account of the assessee and considering the evidence on record in respect of purchases made by it, that the parties were in existence. However, he proceeded to confirm the disallowances sustained in the assessment. The High Court by taking into consideration the judgment of the Hon’ble Supreme Court in Attar Singh Gurmukh Singh vs. ITO (supra)settled per Para No.8 of its pronouncement as under:-

8. We are of the view that the judgment of the Hon’ble Supreme Court stated supra while considering the provisions of Section 40A(3) of the Act read with Rule 6 DD of the Rules, stands squarely applicable to the facts of the present case. In the aforesaid judgment of the Hon’ble Supreme Court, the question for consideration was the validity of Section 40A(3) and its applicability to the payments made in stock-in-trade. In considering the same, the Hon’ble Supreme Court held as under:

“In our opinion, there is little merit in this contention. Section 40A(3) must not be read in isolation or to the exclusion of Rule 6DD. The Section must be read along with the Rule. If read together, it will be clear that the provisions are not intended to restrict the business activities. There is no restriction on the assessee in his trading activities. Section 40A(3) only empowers the Assessing Officer to disallow the deduction claimed as expenditure in respect of which payment is not made by crossed cheque or crossed bank draft. The payment by crossed cheque or crossed bank draft is insisted on to enable the assessing authority to ascertain whether the payment was genuine or whether it was out of the income from undisclosed sources. The terms of Section 40A(3) are not absolute. Consideration of business expediency and other relevant factors are not excluded. The genuine and bonafide transactions are not taken out of the sweep of the Section. It is open to the assessee to furnish to the satisfaction of the assessing officer the circumstances under which the payment in the manner prescribed in Section 40A(3) was not practicable or would have caused genuine difficulty to the payee. It is also open to the assessee to identify the person who has received the cash payment. Rule 6DD provides that an assessee can be exempted from the requirement of payment by a crossed cheque or crossed bank draft in the circumstances specified under the rule. It will be clear from the provisions of Section 40A(3) and rule 6DD that they are intended to regulate the business transactions and to prevent the use of unaccounted money or reduce the chances to use black money for business transactions. See Mudiam Oil Company v. ITO [1973] 92 ITR 519 (AP). If the payment is made by a crossed cheque drawn on a bank or a crossed bank draft then it will be easier to ascertain, when the deduction is claimed, whether the payment was genuine and whether it was out of the income from disclosed sources. In interpreting a taxing statute the Court cannot be oblivious of the proliferation of black money which is under circulation in our country. Any restraint intended to curb the chances and opportunities to use or create black money should not be regarded as curtailing the freedom of trade or business.”

            The Court further settled that the main purpose of crossing a demand draft is to ensure that the payment is cleared by means of an account i.e. identifiable account. The payment is duly deposited in the bank account of the person in whose favor the demand draft has been drawn as it ensures the payee receives the payment and it is routed through bank channels. In the governing circumstances of the case, both the criteria of identifiable account as well as the deposit of payment by means of demand draft though uncrossed but routed through banking channel stands proved. In furtherance, the bank report also indicated that demand drafts were not crossed but the payments were credited into the accounts of payees. In light of these circumstances, the object of section 40A(3) stood satisfied in the presence of the corroborative material on record. It was further settled by way of Para No.11, 12 & 13 of the pronouncement of the Hon’ble High Court as under:-

11. Further, the only objection was as to why payments have not been made through crossed demand drafts. In fact, in its order, a question was asked as to why the payments were not made in crossed demand drafts. The same is answered by the assessee, who stated that, generally, suppliers require demand drafts for quick realization. For purchasing the demand drafts normally ‘yourself cheque’ will be issued to the bankers. The Bank may not have crossed the demand draft. It did not come to his notice.
12. We are of the view that expecting an answer for a specific question as to why the demand draft has not being crossed, would not be appropriate. In view of the fact that the Bank report would indicate that payees have received the said amounts with the concerned drafts, the finding of the Tribunal on this issue with regard to unsatisfactory answers given by the assessee falls into insignificance.
13. For the aforesaid reasons, the substantial question of law is answered by holding that the Tribunal was not justified in confirming the disallowance of Rs. 27,31,483/- under Section 40A(3) of the Act in the facts and circumstances of the case. Consequently, the appeal is allowed. The orders of the Tribunal, the Commissioner of Income Tax (Appeals) and the Assessing Officer are set aside on the issue of disallowance under Section 40A(3) of the Act. Consequently, the Assessing Officer to grant relief in terms of this order.

In furtherance, the consequential amendment incorporated in the provisions of section 40A(3) inserted by the Finance (No.2) Act of 2019 with effect from 01^st April, 2020prescribes other electronic modes by virtue of which the payments can be electronically transferred. Rule 6ABBA has been inserted by Income Tax (Third Amendment) Rules, 2020 with effect from 29^th January 2020 provides as under:- 

¹[6ABBA. The following shall be the other electronic modes for the purposes of clause (d) of first proviso to section 13A, clause (f) of sub-section (8) of section 35AD, sub-section (3), sub-section (3A), proviso to sub-section (3A) and sub-section (4) of section 40A, second proviso to clause (1) of Section 43, sub-section (4) of section 43CA, proviso to sub-section (1) of section 44AD, second proviso to sub-section (1) of section 50C, second proviso to sub-clause (b) of clause (x) of sub-section (2) of section 56, clause (b) of first proviso of clause (i) of Explanation to section 80JJAA, section 269SS, section 269ST and section 269T, namely:-

Principles emerging out of the High Court order

1. Disallowance under section 40A(3) is not automatic merely because payment has not been made in the fashion settled per terms of provisions.

2. The assessee will be in light of the pronouncement of the Hon’ble Supreme Court in Attar Singh Gurmukh Singh vs. Income Tax Officer entitled to furnish to the satisfaction of the assessing officer, the governing and/or compelling set of circumstances in which the payments stood made in violation of the provisions of section 40A(3).

3. The payments effected in the course of business, if they are genuine and bonafide are not outside the sweep of the provisions embedded in section 40A(3) when reading in conjunction with the provisions of Rule 6DD.

4. Even though payments have been made in violation of the mandate of section 40A(3), identification of the payee, channel/route of payment, credentials of the bank statements of the payee corroborating stance of having received the said payment will be accepted at mitigating circumstances for the purposes of making disallowances under section 40A(3).

5. The assessee is entitled to lead evidence in cases wherein potential disallowances have been identified under section 40A(3) by the assessing officers and accordingly the issues can be contested on the footing of exceptional circumstances provided under rule 6DD.

6. Factors besides cash payment such as registered dealer invoices, freight charges, weighted slips of the supplier, stock register maintained by the assessee, bank confirmations, sales tax returns of the parties will attribute towards mitigating circumstance for avoiding any disallowance under section 40A(3).

Tailpiece

          Disallowances cannot be triggered merely because payment has been made in violation of the provisions of section 40A(3). The assessee is entitled to lead further evidence to demonstrate that under what conditions of customary or other practice, the said payments were discharged. Though payments effected through banking/electronic channels acquire sanctity as compared to payments made through other modes and with coming into force of Rule 6ABBA with effect from 29^th January 2020, transacting through digital mediums will altogether be an enriching experience. Electronic transfers will facilitate easier, expeditious, and prompt settlement of myriad transactions being routed in the country which will help strengthen the economic foundation of the country at large. The authorities involved in the enforcement of the statutory provisions must not take advantage of assessee’s ignorance in light of the contents of Circular No.14 (XL-35) dated 11^th April 1955 issued by the Central Board of Direct Taxes of which the operative portion reads as under:-

3. Officers of the Department must not take advantage of the ignorance of an assessee as to his rights. It is one of their duties to assist a taxpayer in every reasonable way, particularly in the matter of claiming and securing reliefs and in this regard the Officers should take the initiative in guiding a taxpayer where proceedings or other particulars before them indicate that some refund or relief is due to him. This attitude would, in the long run, benefit the Department for it would inspire confidence in him that he may be sure of getting a square deal from the Department. Although therefore, the responsibility for claiming refunds and reliefs rests with assessees on whom it is imposed by law, officers should:— 

(a) draw their attention to any refunds or reliefs to which they appear to be clearly entitled but which they have omitted to claim for some reason or other; 

(b) freely advise them when approached by them as to their rights and liabilities and as to the procedure to be adopted for claiming refunds and reliefs

In the governing circumstances which may vary from case to case, reliefs should not be declined merely on the strengthen of technicalities and in the event payment though has been discharged in cash, the circumstances attributable to such payment be considered in light of the possible reasonability thereby reposing the faith of honest taxpayer in the tax administration of the country.

Sameer Bhatia is an Advocate practising in Punjab & Haryana High Court