In India, businesses and professionals are allowed to deduct certain expenses while calculating their taxable income. However, under the Income Tax Act, 1961, some expenses are disallowed under Section 37 and other relevant provisions. These disallowed expenses are not allowed to be claimed as deductions while calculating the profits and gains of business or profession (PGBP).
In this blog, we will look at expenses disallowed under PGBP, the reasons behind these disallowances, and how businesses can ensure they comply with tax laws while maximizing legitimate deductions.
What is PGBP?
PGBP (Profits and Gains of Business or Profession) refers to the income earned by a taxpayer from carrying out any business or profession. This is calculated under Section 28 of the Income Tax Act, and businesses can deduct various expenses incurred during the course of their operations. These expenses reduce the taxable income and hence the tax payable.
However, not all expenses are allowed under the tax laws. Disallowed expenses are those that, under specific provisions of the Income Tax Act, cannot be deducted from business income.
Common Expenses Disallowed Under PGBP
While there is a broad category of allowable expenses, here are some of the most common expenses disallowed under PGBP:
1. Personal Expenses of the Business Owner
The Income Tax Act disallows personal expenses from being deducted as business expenses. These include:
Personal travel expenses.
Personal meals and entertainment.
Family-related expenses, even if they are indirectly associated with business activities.
Example: A business owner traveling for personal reasons but claiming it as a business expense would be disallowed by the Income Tax authorities.
2. Capital Expenditure
Expenditure on assets that have a lasting value is considered capital expenditure and cannot be deducted from business income. Capital expenditures should be claimed through depreciation over time.
Example: Purchase of land, buildings, machinery, and vehicles.
However, businesses can claim depreciation on these assets under Section 32 of the Income Tax Act.
3. Illegal Payments
Any payment made that is considered illegal or contrary to public policy is disallowed. This includes:
Bribes or kickbacks.
Payments to fraudulent schemes.
Section 37 of the Income Tax Act clearly states that expenses incurred for illegal activities cannot be claimed as business expenses.
4. Excessive Remuneration to Partners/Directors
Any payment of excessive remuneration to partners or directors of a firm or company is disallowed. This could include:
Salary payments that exceed the limits specified in the Partnership Deed or Articles of Association.
Excessive payments made to directors that are not justifiable considering the business’s financial situation.
Such payments are seen as unreasonable and are not allowed as deductions.
5. Fines and Penalties
The Income Tax Act disallows expenses related to:
Fines.
Penalties imposed for any violations of laws.
Penalty for late payment of taxes or any dues.
These payments are considered as expenses for the violation of law, and therefore, they cannot be claimed as deductions for business purposes.
6. Unreasonable/Excessive Advertisement and Promotion Expenses
While advertising is a legitimate business expense, excessive or unreasonable advertising expenses are sometimes disallowed. This is particularly the case when the expenditure is disproportionate to the size or nature of the business.
Example: If a small business claims an amount significantly higher than industry standards for advertisement or promotion, the tax authorities may disallow the excess amount.
7. Interest on Unpaid Taxes
Interest payments on taxes that remain unpaid are not deductible. The Income Tax Act states that any interest paid for the late payment of income tax, GST, or other statutory dues is a penalty and hence not allowed as a business expense.
Example: Interest paid on delayed payment of Income Tax cannot be claimed as an expense.
8. Excessive Depreciation
Businesses can claim depreciation on tangible assets (such as machinery, vehicles, etc.) under Section 32 of the Income Tax Act. However, if a business claims excessive depreciation or applies depreciation on assets not used for business, it will be disallowed.
For example, if a vehicle is used primarily for personal purposes but depreciation is claimed under PGBP, this claim will be disallowed.
9. Losses from Speculative Business
According to the Income Tax Act, losses incurred in speculative transactions (such as day trading, futures & options trading, or trading in shares) are not allowed to be set off against other business income.
These losses can only be carried forward and adjusted against future speculative income.
10. Provision for Bad Debts (Not Actual Write-off)
While businesses can claim a deduction for bad debts that are actually written off, the provision for bad debts is not an allowable expense. A provision is merely an estimate, and it cannot be deducted unless the debt is written off as irrecoverable.
Example: A business estimates a certain percentage of accounts receivable will not be recovered and creates a provision, but the debt is not written off. This provision is not deductible under PGBP.
11. Payments to Related Parties Not at Arm's Length
The Income Tax Act disallows expenses paid to related parties (such as family members, relatives, or affiliates) if those expenses are not at an arm's length price. Transactions between related parties must be conducted as if they were unrelated entities, i.e., at market prices.
For example, payments to related entities for goods or services that are priced significantly higher than what is available in the market are disallowed.
12. Donations to Political Parties (Section 37(2))
Though businesses can claim deductions for donations made to charitable organizations, donations made to political parties are disallowed under Section 37(2).
How Can Businesses Ensure Compliance?
Maintain Proper Documentation: Ensure all expenses are backed by proper invoices, receipts, and documentation. This is especially crucial when dealing with disallowed expenses.
Separate Personal and Business Expenses: Maintain clear boundaries between personal and business finances to avoid mixing up deductible and disallowed expenses.
Consult a Tax Expert: It’s always advisable to consult a tax professional to ensure that you are claiming only legitimate expenses and are not subject to any tax disallowances.
Review Regularly: Regularly review your business expenses and compare them with industry standards to ensure they remain reasonable.
Conclusion
Understanding which expenses are disallowed under PGBP is crucial for accurate tax filing and to avoid unnecessary penalties. Some expenses may be disallowed for reasons ranging from personal nature to illegal activities, while others may need to be claimed in a different way, such as through depreciation.
By being aware of these disallowances, maintaining proper records, and following the provisions of the Income Tax Act, businesses can ensure that they comply with the law and avoid costly mistakes. Always consult with tax professionals for clarity on any specific issues you may face.
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