Disallowance of cash payments
The statutory background
With a view to counter evasion of tax through claims for expenditure shown to have been incurred in cash, for the purpose of frustrating proper investigation by the Department as to the identity of the payee and the reasonableness of the payment, section 40A(3) was inserted by the Finance Act, 1968. This sub-section provided that any expenditure incurred by an assessee on or after 1-4-1969 in respect of which payment exceeded Rs. 2,500 and such payment was not made either by crossed cheque or crossed demand draft on a bank will not be allowed as a deduction. The scope and operation of this provision is also explained in the Press Note, dated 2-5-1969, wherein some points of doubt have also been c larified. A proviso was also incorporated to this sub-section according to which no disallowance would be made 'in such cases and under circumstances as may be prescribed, having regard to the nature and extent of banking facilities available, considerations of business expediency and other relevant factors'. Rule 6DD was inserted for the purpose of laying down the cases and circumstances in which no disallowance would be made even if such payments are made otherwise than by crossed cheque or crossed demand draft.
1-1 Monetary limits raised - The monetary limit of Rs. 2,500 was raised to Rs. 10,000 with effect from 1-4-1989 by the Direct Tax Laws (Amendment) Act, 1987, and was later raised to Rs. 20,000 with effect from 1-4-1997 by the Finance (No. 2) Act, 1996. [Refer Circular No. 522, dated 18-8-1988]. With effect from October 1, 2009 the monetary limit of Rs. 20,000/- under section 40A(3) has been raised to Rs. 35,000/- in the case of payment made for plying, hiring or leasing goods carriages.
1-2 Partial disallowance introduced - Upto 31-3-1996, the sub-section envisaged disallowance of the entire amount, if the payment was not made by crossed cheque or crossed demand draft. From 1-4-1996 this total ban has been replaced by a flat disallowance of 20 per cent of the payment. Thus, in respect of payments made on or after 1-4-1997, payments in excess of Rs. 20,000 not made by way of crossed cheque or crossed demand draft will suffer a disallowance of 20 per cent of such payments. This situation remained upto AY 2007-08 and w.e.f. AY 2008-09 100% of such expediture will not be allowable as deduction. The exceptional situations spelt out in rule 6DD(j) viz., (i) exceptional or unavoidable circumstances, (ii) impracticability of making payment by cheques/demand drafts, and (iii) genuine hardships, were removed with effect from 25-7-1995.
The exceptional situations
2 Under rule 6DD, as it stands with effect from 1-12-1995, the following payments have been excluded from the operation of section 40A(3), and such payments will not be disallowed for the sole reason that the payments were not made by crossed cheques or crossed demand drafts :
1. Where payment is made to banking and other credit institutions like RBI/SBI/Scheduled Banks/Commercial Banks in public and private sector/LIC/UTI/ICICI/IFCI/IDBI/Co-operative bank or land mortgage bank/Primary agricultural credit society/Primary credit society/Madras Industrial Investment Corporation Ltd., Madras/Andhra Pradesh Industrial Development Corporation Ltd., Hyderabad/Kerala State Industrial Development Corporation Ltd., Trivandrum/State Industrial and Investment Corporation of Maharashtra Ltd., Bombay/Public State Industrial Development Corporation Ltd., Chandigargh/National Industrial Development Corporation Ltd., New Delhi/Mysore State Industrial Investment and Development Corporation Ltd., Bangalore/Haryana State Industrial Development Corporation Ltd., Chandigarh/State Financial Corporation.
2. Payments to Central and State Governments, if the rules framed by such a Government provides for payment in legal tender, such as payment of direct taxes, customs or excise duties, sales tax, railway freight, etc. Thus, in case of payments made to railways on account of railway freight charges or for booking wagons, section 40A(3) will not apply - See Circular No. 34, dated 5-3-1970.
3. Payments made by book adjustment by an assessee in the account of payee against money due to assessee for any goods supplied or services rendered by him to payee.
4. Payments through the banking system, like letters of credit, mail transfers, telegraphic transfers, book adjustment in the same bank or between one bank and another, and bills of exchange including hundies made payable to a bank.
5. Payments to a cultivator, grower or producer towards purchase of agricultural or forest produce or produce of animal husbandry (including hides and skins) or dairy or poultry farming or fish or fish products or products of horticulture or apiculture, whether processed or not.
6. Payments to a producer towards purchase of his products if they are manufactured or processed without the aid of power in a cottage industry.
7. Payments made to a person who ordinarily resides or carries on business in a village which is not served by any bank. However, if payment is made to such a villager in a town having banking facilities, the exception will not operate.
8. Payments of terminal benefits like gratuity/retrenchment compensation, etc., and the aggragate of such sum does not exceed Rs. 50,000/-.
9. Salary paid to an employee (after deducting tax at source under section 192) when such employee is temporarily posted for a continuous period of 15 days or more in a place other than his normal place of duty or on a ship, and he does not maintain any account in any bank at such place or ship.
10. Payments required to be made on a day on which the banks are closed either on account of holiday or strike.
11. Payment made by any person to his agent who is required to make payment in cash for goods or services on behalf of such person.
12. Payment made by an authorised dealer/money changer against purchase of foreign currency or travellers cheques in the normal course of his business.
Constitutional validity
3 The provisions of section 40A(3) and rule 6DD were challenged as unconstitutional on the ground that they acted as restrictions on the right to carry on business and were also arbitrary. However, the Supreme Court upheld the validity of these provisions, in the case of Attar Singh Gurmukh Singh v. ITO [1991] 191 ITR 667. The Supreme Court observed :
"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. . . . The terms of section 40A(3) are not absolute. Considerations of business expediency and other relevant factors are not excluded. Genuine and bona fide 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. 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 business transactions and to prevent the use of unaccounted money or reduce the chances to use black money for business transactions. . . . 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." (p. 673)
The validity of these provisions were earlier upheld by the Andhra Pradesh High Court in the case of Mudiam Oil Co. v. ITO [1973] 92 ITR 519.
In CIT v. Hardware Exchange [1991] 190 ITR 61 (Gauhati), the Court has observed that rule 6DD cannot be used as an aid to construction of section 40A(3).
Meaning of 'expenditure'
4 The 'expenditure' referred to in section 40A(3) is not confined to expenditure that could be claimed as a deduction under section 37, but refers to any payment made by the assessee and taken into account in computing the total income under the provisions of the Act - Sajowanlal Jaiswal v. CIT [1976] 103 ITR 706 (Ori.). Thus, though the provision appears under the provisions relating to the computation of business income, it will apply to all payments made by an assessee, irrespective of the head of income under which they are classifiable. The provision will apply to salary payments, payments for rent, and the like. In fact, the CBDT had clarified at the time of introduction of the provision that it will apply also for the purposes of computation of income under 'other sources' - Circular No. 6-P, dated 6-7-1968 . The following clarifications/rulings in respect of certain specific types of payments must also be kept note of.
4-1 Acquisition of stock-in-trade/raw materials - In a series of decisions by various High Courts, it was held that the term 'expenditure' for the purpose of section 40A(3) will cover payments made for acquisition of stock-in-trade or raw materials. This view has since received the stamp of approval from the Supreme Court in the case of Attar Singh Gurmukh Singh v. ITO [1991] 191 ITR 667. The Supreme Court observed :
". . . it may be stated that the word 'expenditure' has not been defined in the Act. It is a word of wide import. Section 40A(3) refers to the expenditure incurred by the assessee in respect of which payment is made. It means that all outgoings are brought under the word 'expenditure' for the purpose of the section. The expenditure for purchasing stock-in-trade is one of such outgoings. The value of the stock-in-trade has to be taken into account while determining the gross profits under section 28 on principles of commercial accounting. The payments made for purchases would also be covered by the word 'expenditure' and such payments can be disallowed if they are made in cash in the sum exceeding the amount specified under section 40A(3). . . The rule also contemplates payments made for stock-in-trade and raw materials. …. Section 40A(3) is therefore attracted to payments made for acquiring stock-in-trade and other materials. . . ." (pp. 673-674)
The Supreme Court did not agree with the contrary view taken by the Gauhati High Court in the case of CIT v. Hardware Exchange [1991] 190 ITR 61.
4-2 Advances for purchases - 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 price of goods - Kejriwal Iron Stores v. CIT [1988] 169 ITR 12 (Raj.).
4-3 Acquisition of distribution rights - Where any amount is paid by a film distributor for acquiring distributorship of a film, they were paid in the course of the distributor's business to acquire the stock-in-trade, and hence, would fall within the concept of 'expenditure' under section 40A(3) - Akash Films v. CIT [1991] 190 ITR 32 (Kar.).
4-4 Loan transactions - The CBDT have clarified that, since advancing of loans and repayment of loans do not constitute deductible items in computing the taxable income, the connected payments will not constitute 'expenditure' for the purpose of section 40A(3), and hence the disallowance will not operate. However, where interest is paid on loans, the payment must satisfy the requirement of section 40A(3), as interest is a deductible expenditure - Refer Question 2 in Press Note, dated 2-5-1969, and Letter F. No. 1(22)/69-TPL (Pt.), dated 18-4-1969.
Meanings of 'Cheque' and 'Bank'
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.
How to apply monetary limit
6 For the application of monetary limit (presently, Rs. 20,000), the following aspects will be relevant.
6-1 When more than one payment is made on the same day - Sec. 40A(3) as amended w.e.f. 1.4.2009 clearly specify 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 on account payee cheque or bank draft exceed twenty thousand rupees no deduction shall be allowed in respect of such expenditure. Therefore, if payment is made in parts which is less than 20,000 but aggregate in a day exceeds Rs. 20,000/- the whole of the payment will be disallowed.
6-2 When payment is made partly in cash and partly by cheque - Where payment is made partly in cash, and the balance by way of delivery of post-dated bearer cheques, the payment of the money mentioned in the cheques would be taken to have been made on the date on which the cheques matured and were encashed. They were not payments made on the date on which the cheques were issued or given. Hence, the provisions of section 40A(3) will be attracted only if the cash portion of the payments exceeded the prescribed limit - H.A. Nek Mohd. & Sons v. CIT [1982] 135 ITR 501 (All.).
Scope of certain exceptional situations
7 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.
7-1 Payments to Government [Clause (b)] - Under clause (b) of rule 6DD, payments to Government are exempt from the operation of section 40A(3) if, under the rules framed by Government, such payment is required to 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.
7-2 Contractual payments - Where a manufacturer of tobacco had entered into an agreement in 1957 with a labour contractor for packing and despatching tobacco, and the agreement required that payments must be made in cash, it was held that the payments so made fell within the exception under this clause, since the agreements as well as the payments were found bona fide - CIT v. Ahmad Hussain [1984] 150 ITR 373 (All.).
7-3 Payments by book adjustment [Clause (d)] - Clause (e) of rule 6DD exempts payment 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.).
7-4 Payments for agricultural produce [Clause (e)] - Under this sub-clause, payments for the purchase of agricultural or forest produce are 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 - Circular No. 34, dated 5-3-1970. However, if the middleman or the arhatiya is an agent of the person actually procuring the goods, his case may be considered for exclusion under clause (e).
Note also the following case laws :
Rule 6DD(e)(ii) provides relief from the operation of section 40A(3), inter alia, where the payment exceeding a sum of Rs. 20,000 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.).
In Kanti Lal Purshottam & Co. v. CIT [1985] 155 ITR 519 (Raj.) the assessee-firm purchased Dhania for which it paid in cash in excess of Rs. 2,500 on certain occasions between 1-4-1969 and 2-6-1969. The ITO held that the said cash payments were caught by the mischief of section 40A(3) which was inserted from 1-4-1969 and the assessee had not been able to show any exceptional or unavoidable circumstances for the cash payment or that the payment was impracticable or would have caused genuine difficulty to the payee. The assessee contended, inter alia, that it was dealing in agricultural produce like Dhania and, therefore, was entitled to the benefit under rule 6DD(e)(i).
The Court held that the purpose of introducing section 40A(3) was to block the loopholes of making cash payments and claiming deductions with a view to frustrate investigation as to the identity of the recipients and the genuineness of the claim. In the instant case, there was no mala fide intention and the payments were found to be genuine and the identity of the payee was also not disputed and there was no mischief of tax evasion on behalf of the assessee. Section 40A(3) came into force from 1-4-1969 and the period during which the said cash payments were made ranged between 3-4-1969 and 2-6-1969. Some margin should also be given for the time taken in publishing the Gazette and receipt of the Gazette by the public. Every assessee does not subscribe to the Gazette and, therefore, the matters published in the Gazette come to the knowledge of the public after sometime only. Therefore, the assessee was entitled to the benefit of rule 6DD(j) and this should be taken as an exceptional or unavoidable circumstance. Further, the assessee was dealing with agricultural produce and was, therefore, entitled to the exemption under rule 6DD(e)(i) in respect of the payments. Accordingly, the said cash payments were not subject to disallowance under section 40A(3) - Kanti Lal Purshottam & Co. v. CIT [1985] 155 ITR 519 (Raj.).
7-5 When bank is on holiday or on strike [Clause (j)] - 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 [Annex 6DD.3] and Letter F. No. 142(14)/70-TPL, dated 28-9-1970 [Annex 6DD.3].