Why Some Expenses Are Allowed Only On A Payment Basis Under Accrual Accounting

1. Accounting Profit vs Taxable Income - Judicial Recognition of the Divide

One of the most fundamental yet frequently misunderstood principles of income taxation is that profit as per the books of account is not necessarily equivalent to taxable income. While commercial accounting aims to evaluate business performance over a specified period, the Income-tax Act, 1961, focuses on determining legally taxable income, which may differ from accounting outcomes. This divergence is neither accidental nor incidental; it is intentional, structural, and supported by judicial authorisation.

The Income-tax Act is founded on the doctrine of real income; however, this doctrine does not function independently of statutory provisions. The determination of what constitutes "real income" must be made within the context of the Act itself. While accounting principles are relevant and esteemed, they do not possess supremacy. Instead, they operate under legislative directives.

This foundational distinction was authoritatively recognised by the Supreme Court in State Bank of Travancore v. CIT [(1986) 158 ITR 102 (SC), judgment dated 10 February 1986]. The Court held that accounting entries by themselves cannot create taxable income or allowable deductions unless the statute recognises such income or expenditure as real and enforceable. The doctrine of real income, the Court clarified, must be applied in accordance with the provisions of the Act, not independent of them.

This judgment establishes the jurisprudential foundation for understanding why certain expenses-despite being recognised in mercantile accounting-may nonetheless be postponed or disallowed under tax legislation. The Income-tax Act intentionally distinguishes between commercial reality and taxable reality, endorsing accounting outcomes when they accurately depict economic substance, while overriding them when historical evidence indicates that book entries alone can obscure the deferment of accountability.

2. Accrual Accounting - Accepted in Principle, Controlled in Application

The mercantile system of accounting occupies a central position in commercial law. Under this system, income and expenditure are recognised when they accrue, not when they are actually received or paid. This method better reflects economic reality, particularly for ongoing businesses.

The Supreme Court strongly confirmed the validity of accrual accounting in Kedarnath Jute Manufacturing Co. Ltd. v. CIT [(1971) 82 ITR 363 (SC), judgment dated August 23, 1971]. The Court held that a statutory liability arising within the accounting year can be deducted, even if it's contested or unpaid, provided the taxpayer adheres to the mercantile accounting system.

Nevertheless, the importance of this decision resides equally in what the Court omitted to state as in what it explicitly declared. The Court refrained from establishing accrual accounting as an inviolable principle, immune to legislative revision. The judgment was rendered in the absence of any statutory provision to the contrary. It acknowledged accrual accounting as the general rule, while permitting Parliament to introduce exceptions where deemed necessary.

This distinction becomes decisive once Section 43B is introduced. Kedarnath Jute does not grant an absolute right to accrual-based deduction; it merely recognises accrual, subject to the Act. Once the Act itself mandates payment as a condition, accrual yields to statutory command.

3. Legislative Intervention and Section 43B - Judicial Explanation of the Mischief

The insertion of Section 43B marks a conscious legislative correction. Parliament noticed a widespread practice in which taxpayers claimed deductions for statutory liabilities based on book entries while postponing actual payment for years, thereby enjoying tax benefits without discharging public obligations.

This legislative intent was authoritatively explained by the Supreme Court in Allied Motors (P) Ltd. v. CIT [(1997) 224 ITR 677 (SC), judgment dated 4 March 1997]. The Court observed that Section 43B was enacted to curb this mischief by linking deductions to actual payments. The provision was characterised as remedial and curative, not punitive.

The reasoning was reaffirmed and elaborated in CIT v. Alom Extrusions Ltd. [(2009) 319 ITR 306 (SC), judgment dated 25 November 2009]. The Court noted that employers were enjoying deductions while retaining unpaid statutory dues as working capital. Section 43B was held to be a deliberate legislative intervention to ensure that statutory compliance precedes tax benefit.

Thus, Section 43B represents a clear policy choice: where experience shows that accrual accounting facilitates deferment of statutory obligations, the law insists on economic finality through payment.

At this stage, it becomes clear that the legislative intervention was not aimed at rejecting accrual accounting, but at reminding taxpayers that fiscal recognition must ultimately follow real-world discharge; where this balance between promise and performance is disturbed, the law steps in to restore it. This philosophy finds quiet yet powerful expression in the following lines:

काग़ज़ों में लिखे वादे, बोझ नहीं बनते कानून के लिए,असली हिसाब वही है, जो अदा हो ज़मीन के लिए।जो देना था, वो दे दिया - यही कर्म की पहचान,वरना प्रविष्टियाँ रह जाती हैं, केवल शब्दों की दुकान।

[Promises written on paper do not carry weight in the eyes of the law; True accounting begins only when obligations touch the ground of action. What was due, when duly paid, that alone defines responsible conduct; Otherwise, entries remain mere words, trading in form without substance.]

4. Fiduciary Character of Employee-Related Dues - High Court Recognition

Among all liabilities subject to payment-based control, employee-related statutory dues occupy a special position due to their fiduciary character. These amounts are not merely business expenses; they are sums deducted from employees' salaries and held in trust by the employer.

This aspect was decisively articulated by the Gujarat High Court in CIT v. Gujarat State Road Transport Corporation [(2014) 366 ITR 170 (Gujarat HC), judgment dated 26 December 2013]. The Court held that employee contributions to PF and ESI do not belong to the employer. Any delay in deposit constitutes a breach of statutory obligation, and deduction cannot be allowed merely because the amount is ultimately paid.The judgment clearly distinguishes employee contributions from ordinary business expenses and underscores the ethical and fiduciary rationale for stricter tax treatment.

5. Employee Contribution vs Employer Contribution - Supreme Court's Final Verdict

The long-standing controversy regarding employee contributions was conclusively settled by the Supreme Court in Checkmate Services (P) Ltd. v. CIT [(2022) 448 ITR 518 (SC), judgment dated 12 October 2022]. The Court held that employee contributions to PF and ESI must be deposited within the due dates prescribed under the respective welfare legislations. Payment after those dates, even if made before filing the return under Section 139(1), does not cure the default.

The Supreme Court reasoned that employee contributions are amounts that have already accrued as income to employees and are merely held in the employer's custody. Allowing deductions based on delayed payment would amount to legitimising the retention of employees' money, something the legislature never intended. This judgment firmly places the accrual-versus-payment debate on a fiduciary and ethical footing, not merely a technical one.

6. Payment Basis Does Not Mean Adoption of Cash System - Judicial Clarification

A frequent misconception is that Section 43B converts the mercantile system into a cash system. Courts have decisively rejected this notion. The Karnataka High Court in CIT v. McDowell & Co. Ltd. [(2015) 370 ITR 609 (Karnataka HC), judgment dated 30 June 2014] clarified that Section 43B merely postpones the allowability of deduction until actual payment and does not alter the method of accounting. The assessee continues to recognise liabilities on an accrual basis in books; the tax law merely regulates the timing of deduction, not the accounting system itself.

From Principle to Practice - A Practitioner's Decision Framework

The judicial principles discussed so far acquire real significance only when they translate into accurate computation and defensible positions in practice. Disputes often arise not because the law is unclear, but because expenses are incorrectly classified at the outset.

The starting point for every practitioner must be the clear separation of book profit from taxable income. Ordinary commercial expenses-such as rent, professional fees, audit charges, utilities, and routine interest-belong to the accrual domain once the liability has crystallised and is reasonably ascertainable.

However, the moment an expense takes on the character of a statutory levy or an employee-related obligation, the analysis must shift. The relevant question is no longer whether the liability has accrued, but whether the legislature has expressly linked deductibility to actual payment. Section 43B is triggered not by suspicion, but by the nature of the liability itself.

Employee contributions demand the highest level of vigilance. Once deducted from salaries, these sums cease to be the employer's funds. Any delay in deposit is a statutory breach, and after Checkmate Services, no extended-time arguments survive. The professional's role is therefore preventive, not curative.

Equally important is explaining to clients that disallowance under these provisions is temporary and reversible. The law does not permanently deny genuine expenditure; it merely insists that statutory responsibility be fulfilled before fiscal benefit is granted.

7. Kirti Ltd. - Practical Illustration Reinforced by Judicial Authority

Applying the above principles, when Kirti Ltd. claims deduction for office rent, stationery, or professional fees on an accrual basis, the claim is consistent with accounting principles and judicial interpretation. However, when Kirti Ltd. delays payment of PF, ESI, or employee-related statutory dues, deduction is rightly denied, not because the expense is non-genuine, but because tax benefits cannot precede statutory compliance. Once payment is made, deduction becomes allowable, confirming the corrective-not punitive-nature of Section 43B.

Accrual vs Payment-Based Deductions - A Judicially Evolved Contrast

At this stage, it is helpful to pause and contrast the two approaches, not as accounting techniques, but as reflections of legislative trust and control.

This contrast reveals a consistent legislative pattern: trust where obligations are private; control where public interest or employee welfare is involved.

Closing Thoughts - From Mechanical Computation to Conscious Compliance

Ultimately, the distinction between expenses allowed on an accrual basis and those permitted only on a payment basis is neither accidental nor inconsistent. It is the outcome of a carefully evolved legislative philosophy that recognises taxation as a tool not merely for revenue collection, but for shaping responsible economic behaviour.

The Income-tax Act does not stop at asking whether an expense has been recorded in the books. It goes further and examines whether the underlying obligation has been meaningfully discharged-particularly where delay affects employees or public revenue. In doing so, it distinguishes between accounting truth and economic truth, accepting the former when it reflects reality and overriding it when experience has shown that book entries alone can conceal the deferral of responsibility.

Judicial interpretation over the years has consistently conveyed that taxation is not a mechanical exercise of numbers alone, but a reflection of conduct, intention, and responsibility. This ethical dimension can sometimes be communicated more effectively through verse than through statutory language. The following couplet captures this underlying truth with quiet clarity:

हिसाब सिर्फ़ अंकों का नहीं, नीयत का भी होता है,जो हक़ रोक ले मज़दूर का, वो मुनाफ़े में भी घाटे में होता है।

[Accounting is not only about numbers, but also about intent;One who withholds a worker's rightful due remains in loss, even while making profit.

For practising Chartered Accountants, internalising this philosophy elevates tax practice from mechanical compliance to value-driven advisory. The law, in its quiet but firm manner, conveys an enduring message:true expenditure is not what is promised on paper, but what is responsibly fulfilled in action.