Tag: Section 35

Section 35 – Amounts Not Deductible in Certain Circumstances [Old Sec 40] deals with disallowed expenditure while computing business income. This section provides that certain expenses are disallowed if there is non-compliance of law. If any TDS is not deducted or not paid to Government under Section 393, then 30% of such expense is disallowed. Also any tax, cess, penalty or interest on income-tax, and amount paid to non-resident without TDS compliance is fully disallowed. It ensures deduction is allowed only when assessee fulfills statutory obligations.

Inadmissible Expense in the Books of the Partnership form and LLP:

1. Remuneration to Non-Working Partners

Under Section 35(e)(i) [read with the earlier taxsutra excerpt as Sec. 35], any salary, bonus, commission, or remuneration paid to a partner who is not a working partner is wholly disallowed as a deduction, irrespective of authorisation in the partnership deed. Only partners actively engaged in the conduct of the firm’s or LLP’s business qualify for deductible remuneration. This restriction prevents firms from reducing taxable profits by routing payments to sleeping partners merely to shift income and reduce the firm’s overall tax incidence, ensuring deductions align strictly with genuine operational contribution to the business.

2. Unauthorised or Pre-Deed Remuneration and Interest

Remuneration to a working partner or interest to any partner is disallowed where it is not authorised by the partnership deed applicable for that period, or where it is authorised but relates to a period prior to the date of the deed, or was not covered by an earlier deed. Even a retrospective amendment to the partnership deed cannot validate such earlier unauthorised payments. This ensures that deduction claims are backed by a contemporaneous, legally valid instrument governing partner compensation, preventing firms from creating backdated documentation to justify deductions after the fact.

3. Excess Remuneration Beyond Book Profit Limits

Aggregate remuneration paid to all working partners, even if duly authorised by the deed, is disallowed to the extent it exceeds prescribed ceilings: on the first ₹6,00,000 of book profit (or ₹3,00,000 in case of a loss), the higher of ₹3,00,000 or 90% of book profit; and on the balance of book profit, 60%. Any remuneration paid above these statutory caps, regardless of deed authorisation, is inadmissible. This formula-based ceiling prevents firms from artificially inflating deductible remuneration to erode taxable business profits beyond what the law permits.

4. Excess Interest to Partners Beyond 12%

Interest paid to any partner, even where duly authorised by the partnership deed, is disallowed to the extent it exceeds 12% simple interest per annum. Special rules apply where an individual acts as a partner in a representative capacity — interest paid to such individual otherwise than in that capacity is excluded from this computation, while interest paid to the person represented is included. This cap ensures capital contributions by partners are compensated at a reasonable, market-aligned rate, preventing excessive interest payouts from being used to shift taxable profit out of the firm.

5. Non-Compliance with Firm/LLP Registration or Deed Requirements

Where a firm or LLP fails to comply with prescribed conditions (such as those under Section 325, governing deed filing/registration requirements), no deduction whatsoever is allowed for interest, salary, bonus, commission, or remuneration paid to any partner in computing PGBP income — irrespective of amount or authorisation. Correspondingly, such sums also escape taxation in the partners’ hands under the matching provision [Sec. 26(2)(g)]. This creates a strong compliance incentive, since non-adherence to procedural requirements results in total disallowance, not merely a capped restriction.

6. Disallowance for Non-Deduction of TDS under Section 194T

With payments to partners now brought within TDS under Section 194T (10% on salary, remuneration, commission, bonus, and interest exceeding ₹20,000 annually), failure to deduct or deposit such tax triggers disallowance of 30% of the expense under the provision corresponding to Section 40(a)(ia) of the earlier Act. This applies even where the payment is otherwise within the Section 35(e) limits, adding a compliance-linked layer of disallowance distinct from the substantive remuneration and interest ceilings discussed above, and reinforcing withholding-tax discipline for partner payments.

Computation of Book profit under 35(e):

Under Section 35(e), book profit is relevant for determining the allowable deduction of remuneration paid by a firm to its working partners. Book profit is computed by taking the net profit shown in the Profit and Loss Account for the relevant tax year and making adjustments prescribed under the provisions relating to Profits and Gains of Business or Profession. While determining book profit, the amount of remuneration already paid or payable to partners and debited to the Profit and Loss Account is added back. However, interest paid to partners is treated according to the applicable provisions. The resulting amount constitutes book profit for calculating allowable partner remuneration.

Computation of Book Profit

illustration

Suppose a firm’s net profit as per P&L Account is ₹8,00,000, after charging working partners’ remuneration of ₹3,00,000.

Thus, ₹11,00,000 will be considered as book profit for determining the permissible deduction of remuneration payable to working partners, subject to the limits and conditions prescribed under Section 35.

Impact of Disallowed Expenditure on Business Income:

1. Increase in Taxable Business Income

When an expenditure debited to the Profit and Loss Account is not allowable under the Income-tax Act, 2025, it is added back while computing taxable business income. Consequently, taxable profits increase even though the expenditure has reduced accounting profit. Disallowance may arise because an expense is personal, capital in nature, prohibited by law, or fails to satisfy conditions prescribed under the Act. For example, where ₹50,000 charged as an expense is disallowed, the same amount is added back to net profit for tax computation. Thus, disallowed expenditure creates a difference between accounting profit and taxable business income and may result in higher tax liability.

2. Personal Expenditure

Expenditure incurred for the personal purposes of the assessee is generally not deductible while computing profits and gains of business or profession. Only expenses satisfying the applicable requirements for business or professional purposes can reduce taxable business income. Therefore, where personal expenditure is recorded in business accounts and debited to the Profit and Loss Account, it must ordinarily be added back while determining taxable income. For example, personal household expenses, private travel expenses or other non-business payments cannot ordinarily be claimed merely because they have been recorded in the business books. Such disallowance prevents personal consumption from reducing the taxable profits of the business.

3. Capital Expenditure

An expenditure that is capital in nature is generally not allowed as a normal revenue deduction while computing business income, unless a specific provision permits its deduction. Capital expenditure normally relates to acquiring, improving or creating a capital asset or enduring business advantage. If such expenditure is incorrectly debited to the Profit and Loss Account, it is generally added back while computing taxable business income. However, the assessee may be entitled to depreciation or another specific deduction under the applicable provisions. Therefore, classification between capital and revenue expenditure is important because it directly affects the amount and timing of deductions available in computing taxable business profits.

4. Expenditure Prohibited by Law

Expenditure incurred for a purpose that constitutes an offence or is prohibited by law is not allowed as a deduction in computing business income. Similarly, specified payments relating to penalties, fines or other prohibited activities may be disallowed under the relevant provisions. Even if such expenditure has a connection with business operations and is recorded in the accounts, tax law prevents the taxpayer from obtaining a tax deduction for unlawful expenditure. Consequently, the amount debited to the Profit and Loss Account is added back while computing taxable business income. This ensures that tax deductions do not provide a financial benefit in respect of legally prohibited activities or payments.

5. Non-Compliance with Prescribed Conditions

Certain business expenditures are deductible only when the taxpayer satisfies specific statutory conditions, such as prescribed payment requirements, documentation, withholding of tax, or payment within specified periods. Failure to comply with these requirements may result in partial or complete disallowance of the expenditure. Consequently, the disallowed amount is added back to accounting profit while computing taxable business income. In some cases, a deduction may become available in a subsequent tax year when the prescribed condition is fulfilled. Therefore, taxpayers must comply with the relevant procedural and substantive requirements to avoid disallowances and ensure that legitimate business expenditure receives the deduction permitted under the Income-tax Act, 2025.