The tax audit requirement under the Income-tax Act, 1961 compels businesses crossing the specified turnover threshold to furnish a detailed report in Form 3CD. Each clause of the form serves as a tool for capturing critical tax and compliance information. Among these, Clause 22 holds a unique position because it relates to the intersection of two separate legislations: the Income-tax Act, 1961 and the Micro, Small and Medium Enterprises Development Act, 2006.
The intention behind Clause 22 is to ensure that businesses delaying payments to micro and small enterprises beyond the stipulated timeline under the MSMED Act do not derive a tax benefit by claiming the interest expense in their profit and loss account. This clause forces transparency and discourages delayed settlements by denying tax deductions for penal interest.
Overview of MSMED Act Provisions
Payment Timeline under Section 15
The MSMED Act defines strict rules for payment to suppliers who are registered as micro or small enterprises. Section 15 specifies that payment must be made within the agreed period, provided it does not exceed 45 days from the date of acceptance or deemed acceptance of goods or services. If no period is agreed, payment must be made within 15 days.
Interest Liability under Section 16
Where a buyer fails to make payment within the prescribed period, Section 16 imposes an interest liability. The rate of interest is fixed at three times the bank rate notified by the Reserve Bank of India. This is not negotiable and is much higher than prevailing commercial borrowing rates, thereby serving as a strong deterrent against delays.
Financial Statement Disclosure under Section 22
Enterprises that are required to get their accounts audited must disclose outstanding dues to MSME suppliers. The disclosure includes both principal amounts and interest payable. This ensures visibility of obligations in the audited accounts and prevents concealment of liability.
Disallowance under Section 23
Section 23 provides the direct link to the Income-tax Act. It states that any interest payable or paid under Section 16 shall not be allowed as deduction while computing taxable income. This overrides the general provisions of the Income-tax Act that normally permit deduction of interest expenses incurred in the course of business.
Requirements of Clause 22 of Form 3CD
Clause 22 of the tax audit report requires auditors to report the amount of interest inadmissible under Section 23 of the MSMED Act. The objective is to ensure that any such interest recorded in the books does not escape scrutiny.
The reporting requirement under Clause 22 can be summarized as follows:
- Identify all suppliers registered under the MSMED Act.
- Ascertain whether payments have been delayed beyond the permissible timeline.
- Verify if interest under Section 16 has been paid, provided for, or debited in the accounts.
- Report the exact amount disallowable under Section 23 if such interest is charged to the profit and loss account.
- If no provision for interest is made and no payment is made, the auditor is not required to quantify any figure.
Audit Procedures for Clause 22
Identifying MSME Suppliers
The first task of the auditor is to obtain a complete list of suppliers registered as micro or small enterprises. The management must provide Udyam Registration Certificates of these suppliers as evidence. Since medium enterprises do not fall under the purview of Sections 15 to 23 for interest purposes, the auditor should ensure that only micro and small suppliers are included.
Reviewing Trade Payables and Ageing
Once suppliers are identified, the auditor should review trade payables in the books of account. An ageing analysis of outstanding balances is prepared to assess whether payments have been made within the prescribed period. This helps in pinpointing the extent of delay for each supplier.
Verification of Interest Recognition
The auditor must check whether interest payable under Section 16 has been debited to the profit and loss account. If such an entry exists, the amount is reported in Clause 22 as inadmissible. If no such entry is found, the auditor has to assess whether the liability has actually arisen but has been ignored by the management.
Cross-check with Statutory Filings
For companies, the auditor should cross-verify disclosures of outstanding dues to MSMEs in the notes to accounts as mandated by Section 22 of the MSMED Act. Further, companies are required to file Form MSME-1 with the Registrar of Companies, disclosing the amounts due to MSME suppliers that remain unpaid beyond 45 days. These statutory disclosures provide valuable corroborative evidence.
Handling Absence of Information
In many cases, management may not maintain clear records of which suppliers qualify as MSMEs. If complete information is not available, the auditor should report this limitation in the tax audit report, stating that details of interest payable to MSMEs are not ascertainable.
Evaluating Impact on Audit Opinion
Where the enterprise follows a mercantile system of accounting, liability for interest arises by law even if the supplier has not demanded it. If no provision is made despite material delays, the auditor must evaluate whether financial statements give a true and fair view. This may require qualification in the statutory audit report.
Illustrative Scenarios
Example 1: Interest Provided in Accounts
A company purchases raw material worth ₹40,00,000 from a micro enterprise with an agreed credit period of 30 days. Payment is made after 90 days. RBI bank rate is 6 percent.
- Delay = 60 days
- Applicable interest rate = 18 percent per annum (3 times bank rate)
- Interest = 40,00,000 × 18% × 60/365 ≈ ₹1,18,356
If this interest is debited to a profit and loss account, it becomes inadmissible and must be reported under Clause 22.
Example 2: No Provision for Interest
In the same case, if the company does not account for interest in the books, the auditor must assess whether such non-recognition affects true and fair view. In the tax audit report, however, no figure is reported under Clause 22 as there is no debit entry.
Example 3: Supplier Not Identified as MSME
Suppose the company fails to provide Udyam Registration details of suppliers. The auditor cannot ascertain whether suppliers qualify as MSMEs. In such a case, the auditor should report limitations of scope, clearly stating that requisite information is not made available.
Judicial Perspective
Judicial pronouncements have consistently upheld that interest under Section 16 is penal and compensatory in nature, not deductible under the Income-tax Act. Courts have clarified that the statutory mandate under Section 23 overrides general provisions. This means even if the interest is genuine and incurred for business, it cannot be claimed as deduction once it falls within Section 16.
Challenges in Implementation
Lack of Information from Management
Often businesses do not maintain an updated record of suppliers registered under MSMED Act. Without Udyam Certificates, auditors face difficulty in identification.
Reluctance to Recognize Interest
Many enterprises adopt the stance that since suppliers have not raised a demand, there is no liability. However, the law imposes liability automatically upon delay, irrespective of whether a claim is made.
Volume of Suppliers
Large corporations dealing with thousands of vendors face practical challenges in identifying all MSME suppliers and checking compliance with payment timelines.
Materiality and Opinion Impact
Auditors are required to apply professional judgment in deciding whether non-recognition of interest warrants qualification in the main audit report. This requires balancing between legal requirements and materiality considerations.
Best Practices for Businesses
- Collect and maintain Udyam Registration Certificates of all micro and small suppliers at the time of vendor onboarding.
- Perform regular review of outstanding dues and generate ageing reports to monitor compliance.
- Disclose dues to MSMEs transparently in financial statements in line with Section 22 of the MSMED Act.
- Ensure timely filing of Form MSME-1 with the Registrar of Companies and reconcile figures with accounting records.
- Create internal controls for timely payments to MSME suppliers to avoid accrual of penal interest.
Role of Auditors in Ensuring Compliance
Auditors play a significant role in implementing the spirit of Clause 22. By scrutinizing supplier information, validating payment timelines, and checking recognition of interest, auditors ensure that enterprises do not enjoy tax benefits from their delays. Reporting under Clause 22 acts as a deterrent against late payments and strengthens the protection given to MSMEs under law.
Clause 23 – Payments to Specified Persons under Section 40A(2)(b)
The Income-tax Act, 1961 incorporates several provisions to prevent practices that may erode the tax base through diversion of profits to related parties. Section 40A(2)(b) specifically targets transactions between businesses and persons having close connections with them. The intent is not to prohibit such transactions but to ensure that they are conducted at arm’s length and that excessive or unreasonable payments are not allowed as deductions in computing taxable income.
Clause 23 of the tax audit report is designed to capture details of payments made to these specified persons. The reporting framework ensures that tax authorities can closely examine whether such payments are genuine, reasonable, and commensurate with business needs.
Understanding Section 40A(2)(b)
Objective of the Provision
Section 40A(2) empowers the assessing officer to disallow expenditure incurred in respect of payments to related parties if the amount is considered excessive or unreasonable in comparison to the fair market value, business needs, or benefits derived. Sub-clause (b) identifies the persons to whom this provision applies.
Who are Specified Persons
The definition of specified persons under Section 40A(2)(b) is wide and includes:
- Relatives of the assessee in case of an individual.
- Directors, partners, members, or relatives of such persons in case of a company, partnership firm, or association.
- Substantial shareholders holding not less than 20 percent of voting power in a company, or relatives of such shareholders.
- Entities in which the assessee has substantial interest or where such persons have substantial interest.
This expansive definition ensures that all possible channels of profit diversion through related party transactions are covered.
Scope of Payments Covered
Section 40A(2)(b) does not restrict the nature of expenditure. Any type of payment, whether for goods, services, interest, rent, royalty, remuneration, or other contractual obligations, may fall under its purview. What matters is whether the payment is excessive compared to what would have been incurred with an unrelated party.
Requirements of Clause 23 of Form 3CD
Clause 23 requires the tax auditor to furnish particulars of payments made to persons specified under Section 40A(2)(b). The following details are to be reported for each transaction:
- Name of the specified person
- Relationship with the assessee
- PAN of the specified person
- Nature of payment
- Amount paid or payable
- Date of transaction
The reporting obligation exists irrespective of whether the payments are reasonable or excessive. The auditor is not required to judge the appropriateness of amounts. The final determination of excessiveness lies with the assessing officer during assessment.
Audit Procedures for Clause 23
Obtaining List of Specified Persons
The auditor should request management to provide a comprehensive list of specified persons covered under Section 40A(2)(b). This list should be supported with necessary documents such as shareholding records, partnership deeds, directorship details, and relationship confirmations.
Cross-verifying with Financial Statements
Disclosures relating to related parties in the financial statements, prepared under Accounting Standard 18 or corresponding Ind AS requirements, provide a strong starting point. However, the definition of related parties under accounting standards may not exactly match Section 40A(2)(b). The auditor must reconcile the two and ensure completeness.
Examining the Ledger Accounts
Ledger accounts of directors, partners, shareholders, relatives, and other related entities must be examined. This helps in identifying direct and indirect transactions such as salary, interest, rent, professional fees, purchases, or sales.
Grouping Similar Transactions
Where the volume of transactions is large, grouping may be applied for similar nature transactions with the same person. For example, recurring monthly rent to a director for office premises can be reported in aggregate.
Ensuring Accuracy of PAN
The auditor should ensure that PAN details of specified persons are correctly reported, since tax authorities use these details for cross-verification and data matching.
Reporting All Payments
It is important to note that all payments to specified persons must be reported, regardless of their materiality or whether they are in the nature of routine expenses. The audit report is expected to provide complete disclosure without applying thresholds.
Illustrative Examples
Example 1: Salary to Director
A private limited company pays a monthly salary of ₹2,00,000 to one of its directors. Since a director falls within the definition of specified persons, the auditor reports the payment in Clause 23 with details such as name, relationship, PAN, nature of payment (salary), date, and total amount for the year.
Example 2: Rent to Relative of Partner
A partnership firm takes a building on rent from the brother of a partner. Although the brother is not a partner, he qualifies as a specified person by virtue of being a relative. Payments made as rent must therefore be reported in Clause 23.
Example 3: Purchases from Related Company
A company purchases goods worth ₹50,00,000 from another company in which one of its directors holds 25 percent equity. Since substantial interest exists, payments for such purchases fall within the reporting requirement of Clause 23.
Example 4: Loan Interest to Relative
An assessee pays interest on loan to his son. Being a relative, the son qualifies as a specified person. The amount of interest paid must be reported even though the rate of interest may be reasonable.
Judicial Interpretations
Courts have consistently held that the assessing officer has the authority to scrutinize payments to related parties to check for excessiveness. However, disallowance cannot be made merely because payments are made to specified persons. It is essential for the officer to demonstrate that payments exceed fair market value or are not justified by business needs.
In several judgments, courts have emphasized that commercial expediency and legitimate needs of business must be considered. Where payments are made at prevailing market rates or where services are actually rendered, they cannot be disallowed merely because the recipient is a related party.
Distinction Between Accounting Standards and Tax Provisions
Accounting Standard 18 and corresponding Ind AS require disclosure of related party transactions in financial statements. The definition of related parties under these standards is broader and may include entities that do not fall under Section 40A(2)(b). Conversely, Section 40A(2)(b) includes certain persons such as relatives and entities with substantial interest that may not qualify as related parties under accounting standards.
Auditors must therefore exercise care in reconciling disclosures in financial statements with those required in Clause 23. Reliance solely on financial statement disclosures may lead to incomplete reporting.
Challenges in Implementation
Identifying All Specified Persons
In large organizations, tracking relationships of directors, shareholders, partners, and their relatives can be a complex task. Inadequate disclosure from management can result in incomplete reporting.
Differentiating Commercial Transactions
Many times, transactions with specified persons are routine and at market rates. Businesses often question the need to report such payments. However, Clause 23 requires full reporting irrespective of reasonableness.
Risk of Overlap with Other Clauses
Certain payments reported in Clause 23 may also appear under other clauses such as remuneration to directors or interest disallowances. The auditor must ensure consistency across clauses to avoid contradictions.
Volume of Data
For companies with thousands of related party transactions, compiling data in the required format can be a significant compliance exercise. Auditors must design efficient methods for grouping and summarization.
Best Practices for Businesses
- Maintain an updated register of specified persons as per Section 40A(2)(b) at the beginning of every financial year.
- Reconcile the list of specified persons with related party disclosures made under accounting standards.
- Implement internal controls to capture all payments to specified persons in the accounting system for easy reporting.
- Ensure that payments are supported by proper agreements, invoices, and documentation to establish commercial justification.
- Regularly review payments to specified persons to confirm that they are not excessive compared to market standards.
Role of Auditors
Auditors serve as a vital link in ensuring that businesses comply with the disclosure requirements of Clause 23. By carefully verifying the completeness of the specified persons list, reconciling related party disclosures, and examining ledgers, auditors provide transparency in transactions involving closely connected parties. Their responsibility, however, is limited to reporting facts and not commenting on excessiveness or reasonableness of payments.
Clause 24 and Clause 25 – Deemed Business Income and Profits Chargeable under Section 41
The tax audit report requires detailed disclosures of various income items that arise not only from regular business operations but also from specific events where earlier deductions or benefits claimed by the assessee need to be reversed or taxed. Two important reporting clauses under this framework are Clause 24 and Clause 25. Clause 24 deals with amounts deemed as business income under specific provisions such as investment-linked deductions and special reserve schemes. Clause 25 covers situations where recoveries, write-backs, or cessation of liabilities result in income chargeable under Section 41 of the Income-tax Act.
These clauses are designed to prevent misuse of deductions granted under the Act and to ensure that benefits availed in earlier years are taxed appropriately when the corresponding conditions are violated or when liabilities cease to exist.
Clause 24: Amounts Deemed as Business Income under Specific Sections
Purpose of Clause 24
Clause 24 requires reporting of any amount deemed to be business income under certain provisions of the Act. These provisions generally relate to deductions allowed to the assessee in earlier years for specific objectives such as investment in new assets, promotion of backward areas, or creation of special reserves. If the conditions attached to such deductions are subsequently violated, the deduction already claimed is withdrawn and treated as business income in the year of violation.
Relevant Sections Covered
Section 32AC
This section was introduced to encourage investment in plant and machinery by allowing a deduction of 15 percent of the cost of new assets acquired and installed during a specified period (2013 to 2015). However, if the asset is sold or otherwise transferred within five years from the date of acquisition, the deduction earlier claimed becomes taxable in the year of transfer.
Section 32AD
This provision granted a deduction of 15 percent for investment in new assets in notified backward areas of Andhra Pradesh, Bihar, Telangana, and West Bengal between 2015 and 2020. If the new asset is sold within five years, the deduction claimed is deemed as business income in the year of violation.
Section 33AB
This section allows a deduction to businesses engaged in growing and manufacturing tea, coffee, or rubber for amounts deposited in a special account with NABARD or invested in approved schemes. If the deposited amount is withdrawn for non-specified purposes or the conditions are not met, the amount is treated as business income.
Section 33ABA
Businesses engaged in extraction or production of petroleum or natural gas can claim deduction for amounts deposited in a site restoration fund. If the amount is withdrawn for purposes other than site restoration, or if the scheme conditions are violated, the withdrawn amount is deemed as business income.
Section 33AC
This provision, earlier applicable to shipping businesses, allowed creation of a reserve out of profits for acquisition of new ships. The section was discontinued from assessment year 2005-06 onwards. However, in cases where reserve created earlier is withdrawn, the withdrawn amount is treated as business income.
Auditor’s Role under Clause 24
The auditor must verify whether the assessee had claimed any deductions under the above sections in earlier years. If so, the auditor should check whether the conditions continue to be satisfied. In case of violation, the corresponding amount must be reported as deemed income in Clause 24.
Key Audit Steps
- Obtain a schedule of deductions claimed under Sections 32AC, 32AD, 33AB, 33ABA, and 33AC in earlier years.
- Review additions to and disposals of fixed assets to check compliance with holding periods.
- Examine withdrawals from special reserve accounts or site restoration funds and verify whether such withdrawals were used for permitted purposes.
- Report amounts that become taxable in the current year due to violation of conditions.
Importance of Reporting
These provisions aim to ensure that tax incentives are availed only for genuine purposes. Reporting under Clause 24 prevents misuse where businesses claim deductions and later divert the benefits. By mandating disclosure, the tax audit process strengthens compliance and aids tax authorities in detecting violations.
Clause 25: Profits Chargeable to Tax under Section 41
Purpose of Clause 25
Clause 25 requires reporting of profits and gains chargeable to tax under Section 41. This section covers situations where amounts previously allowed as deduction or expenditure become taxable on recovery or cessation. It ensures symmetry in taxation by withdrawing earlier benefits once the obligation ceases or recovery happens.
Key Provisions of Section 41
Section 41(1) – Remission or Cessation of Trading Liability
If an assessee has obtained a deduction in respect of a trading liability in an earlier year and later the liability is remitted, ceased, or written back, the value of benefit is treated as business income. This applies even if cessation is voluntary or arises by unilateral act of writing back the liability in the books of account.
For example, if a supplier forgives outstanding dues or if the assessee writes back old unpaid liabilities, the amount becomes taxable under Section 41(1).
Section 41(2) – Balancing Charge for Power Companies
Where an undertaking engaged in generation or distribution of power sells, discards, demolishes, or destroys assets used for the business, the excess of sale proceeds over written down value (limited to depreciation allowed earlier) is treated as business income.
Section 41(3) – Sale of Scientific Research Assets
When an asset used for scientific research and earlier allowed as deduction is sold, the sale consideration (limited to the deduction allowed) is deemed as business income.
Section 41(4) – Recovery of Bad Debts
If bad debts written off and allowed as deduction in earlier years are subsequently recovered, the amount recovered is deemed as business income in the year of recovery.
Section 41(4A) – Withdrawal from Special Reserve
Financial institutions that had claimed deduction for transfer to special reserve under Section 36(1)(viii) must treat any subsequent withdrawal from such reserve as business income.
Section 41(5) – Set-off of Losses of Discontinued Business
Even if a business is discontinued, unabsorbed losses relating to that business can be set off against income deemed under Section 41. This allows fair treatment where deemed income arises long after discontinuance.
Auditor’s Role under Clause 25
The auditor must identify all transactions and events resulting in income under Section 41. Since many of these incomes may not be directly routed through the profit and loss account, the auditor has to exercise caution.
Key Audit Steps
- Review ledger accounts for adjustments, write-backs, or recoveries of liabilities and provisions.
- Examine notes to account for disclosure of liabilities no longer payable.
- Check asset disposal schedules for power generation undertakings.
- Verify recoveries of bad debts with bank statements and cash receipts.
- Inspect withdrawals from special reserves.
- Ensure that such incomes are reported in Clause 25 even if not credited to the profit and loss account.
Illustrative Examples
Example 1: Liability Written Back
A company had outstanding trade creditors of ₹10,00,000 for more than five years. During the current year, the liability was written back in the books. This amount becomes taxable under Section 41(1) and must be reported in Clause 25.
Example 2: Sale of Scientific Research Asset
A business had purchased equipment for scientific research costing ₹5,00,000 in respect of which deduction was allowed in earlier years. The equipment was sold for ₹2,50,000. The sale consideration is deemed business income and reported under Clause 25.
Example 3: Recovery of Bad Debt
An assessee had written off a debtor as bad debt two years ago and claimed deduction. During the current year, the debtor repaid ₹1,00,000. This amount is taxable under Section 41(4) and must be reported.
Example 4: Withdrawal from Reserve
A financial institution withdrew ₹50,00,000 from a special reserve created under Section 36(1)(viii). The amount withdrawn is treated as business income and reported under Clause 25.
Judicial Interpretations
The courts have clarified several aspects of Section 41. In the case of CIT v. Sugauli Sugar Works, it was held that mere expiry of limitation period for recovery of liability does not amount to cessation. Only when the liability is actually written back or the creditor waives it does Section 41(1) apply.
Similarly, courts have emphasized that Section 41 requires that a deduction should have been claimed earlier. If no deduction was claimed, subsequent remission cannot be taxed.
Challenges in Reporting under Clause 25
- Identifying liabilities that have ceased without formal communication can be difficult.
- Businesses may adjust recoveries or write-backs directly in reserves without routing through profit and loss, which requires auditors to exercise additional scrutiny.
- For large organizations, reconciling historical deductions and tracking recoveries over many years is a complex task.
Best Practices for Businesses
- Maintain detailed records of deductions claimed under special sections.
- Track outstanding liabilities and regularly review their status with creditors.
- Record recoveries of bad debts and withdrawals from reserves transparently in books.
- Disclose all such incomes clearly in financial statements for easy audit verification.
Conclusion
The provisions contained in Clause 22 to Clause 25 of the tax audit report underline the philosophy of transparency, compliance, and accountability in tax reporting. Each clause is directed at ensuring that deductions, expenses, and liabilities claimed by businesses in earlier years are monitored carefully and taxed appropriately if conditions are not fulfilled or if benefits are later reversed.
Clause 22 highlights the inadmissibility of interest payable under the MSMED Act, reinforcing the protection of micro and small enterprises by discouraging delayed payments from larger entities. It places responsibility on auditors to identify such interest and ensure that it is not claimed as deductible expenditure under the Income-tax Act.
Clause 23 focuses on transactions with specified persons under Section 40A(2)(b). It ensures that dealings with related parties are disclosed comprehensively, thereby reducing the risk of tax avoidance through excessive or unreasonable payments. By requiring reporting of such payments irrespective of their reasonableness, the clause provides tax authorities with the necessary visibility to examine such transactions.
Clause 24 deals with deemed income under special provisions where deductions had been availed for promoting specific policy goals such as investment in new assets, development of backward areas, or creation of special reserves. By taxing such amounts upon violation of conditions, this clause prevents misuse of incentives while ensuring that only genuine long-term compliance benefits from such schemes.
Clause 25 encapsulates the broader principle that recoveries, remissions, or cessation of liabilities previously claimed as deductions cannot escape taxation. It covers a wide spectrum, from recovery of bad debts to write-backs of liabilities and withdrawals from reserves, thereby safeguarding the integrity of taxable income.
For auditors, these clauses demand not just technical understanding of the law but also careful scrutiny of transactions, reserves, liabilities, and recoveries. For businesses, they highlight the importance of robust compliance systems, accurate disclosures, and maintaining detailed documentation to support deductions claimed in earlier years.
Collectively, Clause 22 to Clause 25 ensure that tax incentives are not abused, liabilities are correctly reflected, and income is reported fairly. They enhance the credibility of financial reporting and provide tax authorities with the assurance that no undue advantage is retained by the assessee. In essence, these provisions strengthen the balance between taxpayer benefits and revenue protection, aligning business practices with the broader objectives of fairness and equity in taxation.