Monday, September 9, 2013

Disallowance of Cash Payments exceeding Section 40A(3) exception Rule 6DD


on Monday, September 9, 2013

1. History of section 40A(3):  Section 40A(3) was introduced by the Finance Act 1968 as a provision designed to counter evasion of tax through claims for expenditure shown to have been incurred in cash with a view to frustrating proper investigation by the Department as to the identity of the payee and the reasonableness of the payment.

The section has over the years gone many changes and vide the Finance Act of 2008 w.e.f. 1-4-2009 substantial changes in the whole scheme of Section 40A(3) have been made. Many of the issues relating to Section 40A(3) have been settled vide these latest amendments. For the sake of brevity this note does not delve into the legislative history of amendment to Section 40A(3) and concentrates on issues relevant for AY 2009-10 and beyond.

2. Scheme of Disallowance in Respect of Cash Payments
  • Disallowance under Section 40A(3): No deduction is allowed in respect of which a payment or aggregate of payments exceeding rupees twenty thousand are made to a person in a day otherwise than by an account payee cheque drawn on a bank or account payee bank draft.The disallowance under Section 40A(3) are relevant for computation of income under the head “income from business or profession” and by virtue of Section 58(2) these provisions also apply to computation of income under the head “income from other sources”.
  • Subsequent disallowance due to violation of Section 40A(3) in a year other than the year of allowance of deduction of expenses [Section 40A(3A)] : Where an allowance has been made in the assessment for any year in respect of any liability incurred  by the assessee for any expenditure and subsequently during any previous year a payment is made in violation of Section 40A(3) then such payment is deemed to be the profits and gains of business or profession and accordingly is chargeable to income-tax as income of the subsequent year.
  • No disallowance under circumstances prescribed in Rule 6DD
  • Higher exemption limit of rupees thirty five thousand for cash payment in case of transporters
3. Applicable Rule of Statutory Interpretation

Being a provision specifically designed to counter evasion of tax the principle of strict literal interpretation generally applicable to Taxing Statutes shall not apply. A provision or statute designed to prevent fraud upon the revenue is more properly a statute against fraud rather than a taxing statute and for this reason is liable for liberal construction in favour of revenue.

State of Tamil Nadu vs Kandaswamy AIR 1975 SC 1871 (para 26) & Hotel Balaji vs State of AP, AIR 1993 SC 1048.


4. Burden of proof

Whereas the burden of proof for establishing that payments exceeding rupees twenty thousand are made to a person in a Expenses or Payments not deductible under day otherwise than by an account payee cheque drawn on a bank or account payee bank draft lies on revenue the burden of establishing that the case falls under the exclusionary provisions of Rule 6DD lies on the assessee.

5. Crossed cheque versus account payee cheque

Over the years the provisions of Section 40A(3) have been made stringent. With effect from 13th July, 2006 vide the Taxation Laws (Amendment) Act, 2006 the change over from crossed cheques to account payee cheques was made. 

  • 5.1 Rationale of changing over to account payee explained: A crossed cheque or crossed bank draft is not a non-negotiable instrument. This has, at times, resulted in crossed cheques being endorsed making it difficult to trace final payee and thus defeating the provisions of Section 40A(3). However, as per the RBIs instructions to commercial banks, an account payee cheque or account payee bank draft cannot be credited to any account other than the account of the payee. The Act has accordingly amended the aforementioned subsection (3) and sub-section (4) to substitute the expression a crossed cheque drawn on a bank or by a crossed bank draft, in both the sub-sections, by an account payee cheque drawn on a bank or account payee bank draft in both the sub-sections, by an account payee cheque drawn on a bank or account payee bank draft.  CIRCULAR NO. 1/2007, DATED 27-4-2007
  • 5.2 Crossed cheque: As per Section 126 of the Negotiable Instruments Act, 1881 a crossed cheque is a cheque which is payable only through a collecting banker and not directly at the counter of the bank. Crossing ensures security to the holder of the cheque as only the collecting banker credits the proceeds to the account of the payee of the cheque. When two parallel transverse lines, with or without any words, are drawn generally, on the left hand top corner of the cheque. A crossed cheque does not affect the negotiability of the instrument and thus these can be endorsed but unlike a bearer cheque it cannot be encashed across the counter.
  • 5.3 Account payee cheque: Account payee cheques are not defined under the Negotiable Instruments Act, 1881. Making a cheque A/c payee is a result of custom, use and practice and the same is now legally accepted. As per English Law in this type of crossing the collecting banker is supposed to credit the amount of the cheque to the account of the payee only. The cheque remains transferable but the liability of the collecting banker is enhanced in case he credits the proceeds of the cheque so crossed to any person other than the payee. This position was endorsed in India vide Reserve Bank of India (RBI) circular DBOD.NO.BC.23/21.01.001/92 dated September 9, 1992 which said that banks which credited cheques drawn in their favour by other banks marked ‘A/c. payee’ to the accounts of constituents who were not named payees therein, without proper mandate of the drawer did so at their own risk and were held responsible for the unauthorized payment.
  • 5.4 After receiving complaints after the IPO (Demat) Scam, the RBI vide circular DBOD.BP.BC No. 56/21.01.001/ 2005-06 dated January 23, 2006 has prohibited the banks from crediting ‘A/c payee’ cheque to the account of any person other than the payee named therein. The RBI has since directed that banks that should not collect A/c payee cheques for any person other than the payee constituent and where the drawer/payee instructs the bank to credit the proceeds of collection to any account other than that of the payee, the instruction being contrary to the intended inherent character of the ‘A/c payee’ cheque, the bank should ask the drawer/payee to have the cheque or the account payee mandate thereon withdrawn by the drawer. After this an ‘A/c. payee’ is no longer transferable.
  • 5.5 The CBDT have clarified that the word ‘cheque’, which  is not defined in the Income-tax Act, will have the same meaning as in Section 6 of the Negotiable Instruments Act, viz., ‘a bill of exchange drawn on a specified banker and not expressed to be payable other than on demand’. It has also been clarified that the word ‘bank’ as used in Section 40A(3) is wide enough to include any person carrying on the business of banking, and thus would include a co-operative land mortgage bank or any other co-operative society carrying on the business of banking. Indigenous money-lenders’ banks are also ‘bank’, provided they are specifically notified under Section 49A of the Banking Regulations Act Circular No. 6-P, dated 6-7-1968
6. Law as on the date of making of payment to apply:

One of the new issues being raked up now is that wherein liabilities were incurred prior to 13.7.2006 and payments after this date have been made by crossed cheques no disallowance can be made as in the year of incurring of liability payment by crossed cheques was allowable. This is an erroneous proposition as 
  • (a) Section 40A(3) being an anti-evasion measure a purposive interpretation that curbs the mischief has to be given to the Section 
  • (b) In no way can it be held that the assessee gets a vested right in making a payment by crossed cheques in subsequent years as this mode of payment has been held by the Parliament to have defeated the purpose of introduction of the section itself. 
  • (c) In past whenever the limit of cash expenses in Section 40A(3) was enhanced the enhanced limit was made applicable to all payments made subsequent to this date irrespective of the fact that in the year in which the liability was incurred a lower limit might have been in place 

7. Provision is constitutionally valid –

Section 40A(3) cannot be said to be invalid on the ground that it places a restriction on the right to carry on business and is arbitrary [Attar Singh Gurmukh Singh v. ITO [1991] 191 ITR 667 (SC).]

Even after the deletion of sub-clauses (1) and (2) of rule 6DD(j), Section 40A(3) cannot be considered as constitutionally invalid. On the contrary, the objects of curbing the circulation of black money and regulating the business transactions become more strengthened and it avoids any undue advantage being taken by unscrupulous assesses or litigation being multiplied. 

One cannot plead ignorance of law and make cash payments contrary to law. It is too late in the day to accept any such proposition. In the present day banking scenario the mode of payment by way of crossed cheques or demand drafts cannot be said to be an onerous duty cast on an assessee, which can be made a foundation for attacking the validity of the provision [Smt. Ch. Mangayamma v. Union of India [1999] 106 Taxman 339/239 ITR 687 (AP).]

8. Meaning and scope of word ‘expenditure’ for purposes of Section 40A(3) :

Section 40A(3) refers to the expenditure incurred by the assessee in respect of which payment is made. It means all outgoings are brought under the word ‘expenditure’ for the purpose of the sub-section. The expenditure for purchasing the stock-in-trade is one of such outgoings. [Attar Singh Gurmukh Singh v. ITO [1991] 191 ITR 667 (SC). ]

Even if the payments were made by way of advances and were ultimately treated as discharging the liability to pay the price of the goods purchased, the payments so made must be considered to fall within the expression ‘expenditure’ incurred for payment of the price of the goods –Kejriwal Iron Stores v. CIT [1988] 169 ITR 12 (Raj.).

Payment for purchase of goods covered by 40A(3) –Argument that Section 40A(3) deals with only deductions dealt with in Sections 30 to 37 and cost price of goods is covered by Section 28 and hence Section 40A(3) will not apply, was rejected – The expression ‘expenditure’ used in Section 40A(3) should not be given too narrow a meaning to restrict it from applying to payments for purchase of goods – To give such a narrow interpretation to the expression ‘expenditure’ and to exclude from its meaning payments made for goods purchased is to make it difficult for the revenue to properly investigate the payments, to open the door wide to allow evasion and thus to defeat the very object which the provision was designed to achieve.

CIT VS Grewal group of Industries (P&H) 110 ITR 278 U.P. Hardware Store Vs CIT (All) 104 ITR 664
CIT Vs Kishan Chand Maheshwari Dass (P&H) 121 ITR 232
Sajowanlal Jaiswal Vs CIT (Ori) 103 ITR 706
Hari Chand Virender Paul Vs CIT (P&H) 140 ITR 148

9. Payment made in advancing loans and returning the principal amount of borrowed money not covered by Section 40A(3) :

Advancing of loans or repayment the principal amount of the loan do not constitute expenditure deductible in computing the taxable income. However, interest payments made in contravention of provisions of Section 40A(3) are disallowable, as interest is a deductible expenditure-Press Note : Dated 2-5-1969, issued by Ministry of Finance.

10. Limit applies to cash portion of payment –

Where the payment was made partly in cash and partly by way of post-dated cheques, Section 40A(3) will apply only if the cash payment exceeded the prescribed limit –

H.A. Nek Mohd. & Sons v. CIT [1982] 135 ITR 501 (All.).

11. Limit applies to all items in a bill, and not to individual items –

Section 40A(3) concentrates on the size of the payment and the manner of the payment. If different items are included Expenses or Payments not deductible under in a single bill, it would not be right to dissect the bill and find out whether each item of expenditure is above Rs. 10,000 (now Rs. 20,000); the proper way is to read the entries in a wholesome fashion

- Addl. CIT v. Shree Shanmuga Gunny Stores [1984] 146 ITR 600 (Mad.).

12. Genuineness of transaction not sufficient :

It would amount to defeating objective of enactment, if claim allowed on the basis of transaction is genuine, identity of party established etc. – Assessee has not been able to make out a case of unavoidable circumstances so as to claim benefit of Rule 6DD(j).

- T.G. Mutha Vs ITO (ITAT, Pune) 54 ITD 460

Assessee had bank account in the same place of customers –No reason to issue bearer cheques - Not merely genuineness of transaction, but existence of circumstances warranting cash payment to be proved.

Associated Engg. Enterprise Vs CIT (Gau) 216 ITR 366
Late Smt. Jyoti Chellaram Vs CIT (AP) 173 ITR 358
Evershine Platers Vs CIT (All) 295 ITR 349
Aggarwal Steel Traders Vs CIT (P & H) 250 ITR 738

Even if transaction is entered in the books of other party, unavoidable circumstances to be proven.

CIT Vs Assam Tribune (Gauhati) 221 ITR 488

Running account for commission in the books – Payments made out of them in excess of Rs. 2,500 in cash at various points – Section 40A(3) applies.

Porwal Udhyog (India) Vs CIT (MP) 135 ITR 591

In a place where banking facilities are available, exemption cannot be granted merely because recipient had not opened bank account – Addition under Section 40A(3) upheld.

ITO Vs Kenaram Saha & Subhash Saha (ITAT,SB-Kol) 116 ITD 

13. Provisions of Section 40A(3) will apply to transactions outside the books of accounts

Where income from an undisclosed business is brought to tax, provisions of Section 40A(3) will come into play. It was necessary to bear in mind that even if an exceptional or unavoidable circumstance was pleaded, the revenue must have data with it to verify the genuineness of the transaction and the identity of the recipient of the cash payment. If what the Tribunal stated was correct, the entire provision would be rendered otiose and that interpretation could never be placed on a provision. This case also held that Section 40A(3) would apply to Block Assessments.

In this case reasoning given by the ITAT while granting relief to the assessee in 48 ITD 202 (Ahd.) also included the rationale that provisions of Section 40A(3) would be inapplicable where income of assessee is estimated by invoking proviso to Section 145(1) on basis of gross profit by using comparative instances. While reversing this order,the Hon’ble High Court has impliedly also overruled this finding of the ITAT.

CIT Vs Hynoup Food and Oil Ind. P. Ltd. (Guj) 290 ITR 702

After considering the non obstante clause in s. 40A (1), we Expenses or Payments not deductible under hold that certain payments and expenses which would be otherwise deductible under Sections 28 to 43, would not be deductible if the conditions of Section 40A (3) of the Act, are satisfied. Thus, we reverse the conclusion of the CIT(A) on this legal proposition and hold that a disallowance under s. 40A (3) is permitted even in a case where the net profit has been estimated at a flat rate on the receipts.

ITO vs. D. D. HAZARE 45 ITD 595 (Bombay)

As regards Section 40A(3) not being taken into account where assessment is by estimation basis on GP rate, the principle invoked in the judgments relied upon is not of universal application. If the estimated income impliedly takes into consideration the expenditure incurred, the said principle may apply. If the expenditures which are legally not permissible has been taken into account, the same can certainly be disallowed. The judgments relied upon on behalf of the assessee did not discuss the issue of impermissible expenditure. 

Rule 6DD of the Rules allows cash expenditure to be taken into account if circumstances in which the expenditure is incurred can reasonably explained. In the present case, the assessee has not been able to cover its case under rule 6DD. In the circumstances, the Assessing Officer was justified in disallowing expenditures incurred in contravention of Section 40A(3). This case also held that Section 40A(3) would apply to Block Assessments. 

CIT vs. Sai Metal Works 241 CTR 377 (P & H)

Section 40A(3), read with Section 40(b), of the Income tax Act, 1961 - Business disallowance - Cash payment  exceeding prescribed limit - Assessment year 1989-90 - While computing total income of assessee-firm, Assessing Officer disallowed an amount of Rs. 5,15,000 under Section 40A(3) being amount of interest paid in cash to minor daughter of a partner - Facts revealed that there were no exigencies warranting payment in cash; that interest of Rs. 5,15,000 was paid on Rs. 10 lakhs for a period of four months showing that transaction was of a colourable nature; and that interest received by minor from firm actually represented amount received by partner and, thus, transaction was also hit by provisions of Section 40(b) - Whether on facts, Assessing Officer was justified in disallowing payment of interest - Held, yes.

CIT vs. Muthoot M. George Bankers 220 CTR 517 (Ker.)

14. Rule 6DD applicability of certain exceptional situations


The scope and applicability of certain exceptional situations spelt out in rule 6DD have been explained in CBDT circulars/ judicial decisions, and these are briefly summarised below:
  • Clause (a)- Payment made to institutions like RBI, SBI etc. :Rule 6DD(a) applies only for payments to institutions referred to therein and not for payment made to any party’s account maintained in such institutions – Payments made in cash to the account of the suppliers maintained with banks did not qualify for deduction. CIT Vs K. Abdu & Co. (Ker) 170 Taxman 297
  • Clause (b) – Payments made to Government under the rules requiring that such payment be made in legal tender. The CBDT have clarified that payments made to the Railways on account of freight charges or for booking of wagons, and payments towards sales tax/excise duty are to be considered under this clause. - Circular No. 34, dated 5-3-1970 
  • Clause (d)- Payments made by way of adjustment against the amount of any liability incurred by the payee for any goods supplied or services rendered by the assessee to such payee. This exemption is held to operate only when the adjustment is made directly in the payee’s account, and that the prohibition in Section 40A(3) is attracted to cases where book adjustments are not so directly made. CIT v. Kishan Chand Maheshwari Dass [1980] 121 ITR 232 (Punj. & Har.).
  • Clause (e) - Payments for agricultural produce - Under this sub-clause, payments for the purchase of agricultural or forest produce is excluded, only where the payments are to be made to the cultivator/grower/producer. If the produce undergoes change and then sold, the exclusion will operate.For example, payments made to a grower or producer of kapas ginned by him, or to a grower of paddy which has been converted by him into rice and then sold, the exclusion will still operate. Press Note, dated 2-5-1969 Payments to middlemen for the purchase of agricultural produce do not as such come under this sub-clause. Letter F. No. 1/22/69-TPL (Pt.), dated, 18-4-1969 Similarly, payments to arhatiyas do not fall for exclusion under this sub-clause. Similarly, payments to arhatiyas do not fall for exclusion under this sub-clause - Circular No. 34,  dated 5-3-1970. Circular No. 34, dated 5-3-1970 
  • Rule 6DD(e)(ii) provides relief from the operation of Section 40A(3), inter alia, where the payment exceeding a sum of Rs. 2,500 is made for the purchase of produce of animal husbandry to the producers of such articles. Where, however, the purchases were of hides and skins and the assessee had failed to establish that the payments were made to the producer, the aforesaid relief would not be available. Ideal Tannery v. CIT [1979] 117 ITR 34 (All.). Words ‘cultivator, grower or producer’ occurring at the end of Rule 6DD(e) qualify the words occurring in all the preceding four sub-clauses and not only in sub-clause (iv). Thus, the exemption is confined to grower or producer of forest produce and not available for purchases made from others. CIT v.Pehlaj Rai Daryanmal [1991] 190 ITR 242 (All.). Hoshiarpur District Co-operative Milk Producers Union Ltd. cannot be considered to be a producer of milk as its constitution does not permit individual producers to be its members and consequently, payment made by the assessee to the said union cannot be treated as payment made to producer of milk. Chanchal Dogra Vs ITO (HP) 67 DTR 108
  • Clause (j)- When bank is on holiday or on strike - This clause was inserted with effect from 1-12-1995, so as to exclude payments required to be made on a day on which the banks were closed either on account of holiday or strike. Prior to 1-12-1995 also, the exclusion was available under executive instructions - Circular No. 250, dated 11-1-1979 and Letter F. No. 142(14)/70-TPL, dated 28-9-1970. 
  • Clause (k)- payment made to agent : Employee is not ‘agent’ Dy. CIT v. Vijay Kumar Ramesh Chand & Co. [2007] 108 ITD 626 (Pune - Trib.) 

15. Return of paid cheques

In order to facilitate the production of paid cheques to the assessing authorities in order to prove that the payments have been made in the manner laid down in Section 40A(3), the CBDT have clarified that the banks must return the paid cheques to their constituents (i.e., the assessee) after obtaining a formal undertaking from them to the effect that they would retain the paid cheques for a period of 8 years, and produce them before the ITO whenever called upon to do so -Circular No. 33, dated 29-12-1969.

16. Documents /Information to be collected by the A.O.
  • i. Whether the payment of the cash is made directly to the farmer/ cultivator/ grower/ producer etc. or Brokers/Adhatiyas? This can be done from the actual verification of vouchers.
  • ii. Whether the Goods were purchased through APMC?
  • iii. In some cases depending upon the facts, cash book can be called for verification to ascertain the quantum of cash payment.
  • iv. Recipients’ location and availability of Banks at the place of transaction.
  • v. Details of the actual account in which the cheques have been cleared can be obtained from Bank.
This post is based on Book given to assessing officer by Department in a certain state in India.

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