Tax Implications where liabilities are paid off By way of book adjustment

As per provisions of Section 40A(3) 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, [or use of electronic clearing system through a bank account, exceeds ten thousand rupees,] no deduction shall be allowed in respect of such expenditure.

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 (hereinafter referred to as subsequent year) the assessee makes payment in respect thereof, otherwise than by an account payee cheque drawn on a bank or account payee bank draft, [or use of electronic clearing system through a bank account], the payment so made shall be deemed to be the profits and gains of business or profession and accordingly chargeable to income-tax as income of the subsequent year if the payment or aggregate of payments made to a person in a day, exceeds ten thousand rupees .

However, Rule 6DD provides an exception to Section 40A:

As per Rule 6DD(d), no disallowance under sub-section (3) of section 40A shall be made and no payment shall be deemed to be the profits and gains of business or profession under sub-section (3A) of section 40A where 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 in the case:

where the payment is 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

Let’s understand this through an example:

Scenario-1

Party X purchases goods from Party Z for Rs.1,00,000/- and also sale goods to Z Rs. 2,00,000/-. Therefore, for X, party Z is its creditor and debtor both. If X does not pay for the purchases made from Z and adjust the credit balance with Z’s debit balance outstanding as a debtor, then such type of adjustment does not contravene the section 40A(3) & 40A(3A)  as per the exception provided in the rule 6DD.

In this case Journal entry will be:

• Z  Creditor A/c  Dr. 1,00,000/-
• Z  Debtor A/c    Cr. 1,00,000/-

Relevant Case Law Rule 6DD: Held that, where the payments were effected to a customer on account of adjustment resulting out of an exchange of old jewellery with new jewellery, then it does get covered under the exception clause (d) of rule 6DD—DCIT v. Kirtilal Kalidas Jewellers (P.) Ltd. [2012] [ITAT]

Scenario-2

Where Party X purchases goods from Party A for Rs.1,00,000/- and sale goods to Party B for Rs.2,00,000/- . X set off outstanding balance of A with the balance of B through passing journal entry in his books as given below:

• A Creditor A/c Dr.  – Rs.1,00,000/-
• B Debtor A/c   Cr. –  Rs.1,00,000/-

The above transaction is in contravention of section 40A(3) & 40A(3A), since in this case the payment by book adjustment was not made to Party A directly who supplied the goods or services to Party X and thus the liability incurred for the purchase expense has been setoff through the mode other than specified in these sections.

Relevant Case Law Rule 6DD: Exception will not apply in cases where book adjustments were not made directly in the accounts of the supplier—CIT v. Kishan Chand Maheswari Dass [1980] 121 ITR 232 (Punj. & Har. High Court)

Disclaimer: Views expressed in the article are solely based on the author’s understanding of the relevant sections, laws, and rules. By no means, the information should be considered as professional advice.