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Failure to deduct tax at source - disallowance restricted to 30%

rajat aggarwal 
on 07 August 2014

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As per the existing provision of section 40(a)(ia), any payment made by way of  interest, commission, brokerage, rent, royalty, fee for professional services, fee for  technical services, payment to a contractor or sub-contractor on which tax is  deductible at source but is not deducted is not allowed as deduction while computing  profit of the business or profession. Thus the entire expenditure incurred on this  account is disallowed and added back in the income on failure to deduct tax at  source. An idea how draconian this section 40(a)(ia) is, can be had from the  following example:-

An individual who is engaged in the business of export of readymade  garments, assuming having a sales of Rs.5 crores, the exporter instead of  having its own machineries and labour, gets the garments fabricated, printed,  embroidery, etc. on job work basis, it buys cloth from the market and incurs  expenditure on such purchase of Rs.1 crore. It incurs an expenditure of Rs.3 crore on account of fabrication, printing, embroidery, etc. as job charges. It  incurs overhead expenditure of Rs.80 Lakh and earns a net profit of Rs.20  Lakh. The tax liability on the net income of Rs.20 Lakh is Rs.4.43 Lakh, where  he pays before filing the return. Now visualize a situation that due to ignorance or inadvertence it has failed to deduct tax at source in respect of  the job charges paid Rs.3 Crore on which tax at source is required to be deducted at the rate of 1% i.e. default of TDS of Rs.3 Lakh only. The income  in such case, because of the operation of the Section 40(a)(ia) will be  computed at Rs.3,20,00,000/- since Rs.3 Crore paid as job charges without  TDS will be disallowed and added to the income. The additional tax payable on account of this disallowance will be Rs.1.02 Crore. Since the income of such person is just Rs.20 Lakh, it will be practically impossible for such person to  pay this liability of Rupees more than one crore. Such person may pay the tax  of Rs.3 Lakh which he has failed to deduct along with interest. In such a case  he will be eligible to claim expenditure of Rs.3 Crore in the year in which TDS is deposited, with the result that his income for that year will be loss of Rs.2.80,00,000/- assuming the income of that year is also Rs.20 Lakh. This loss he could carry forward for next eight years. Considering that the income is around Rs.20 Lakh per year in subsequent years, this person need another 14 years to set off the carry forward loss which in view of provision of section 72(3) can’t be carried forward for more than eight years. Just see the hardship. For a default to deduct and pay tax of Rs.3 Lakh, a tax liability of  Rs.32 Lakh i.e. more than 10 times.

Considering this hardship, the Finance (No.2) Bill, 2014 proposes to reduce disallowance of such expenditure to 30% as against 100% at present. The explanatory note in this regard recognize the fact that disallowance of the whole of the amount of expenditure results into undue hardship. Further disallowance of 30%  of the expenditure irrespective of the nature of such payment is not appropriate. In case of payment of interest, commission, rent, royalty, where tax is deductible at the rate of 10%, disallowance of 30% may be appropriate but in the case of payment to a contractor where tax is deductible at the rate of 2% or 1% the disallowance of 30% is not justified. The tax is deductible at the rate of 2% or 1% on payment to a  contractor on the assumption that the income component in such payment is not very high. Considering this, the disallowance in respect of payment to a contractor should not be 30 per cent and need to be proportionately reduced. It will be more appropriate to link the percentage of disallowance with the rate at which tax is deducted at source. 

Rajat Aggarwal

Partner)

RRA Consultant


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