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The system of tax audit under the Income Tax Act, 1961 is designed to enhance transparency and accountability in the way taxpayers report their financial data. It plays an important role in ensuring that taxpayers adhere to the legal framework while auditors act as independent examiners of accounts. Among the several components of the tax audit report, Form 3CD has a special significance because it contains specific clauses where auditors must disclose detailed information on disallowances, compliance failures, and inadmissible expenses. Within Form 3CD, Clauses 21(b) to 21(d) cover critical aspects relating to disallowed expenses. These include payments where tax has not been deducted or deposited, remuneration made to partners or members in firms and LLPs, and other associated reporting obligations.

We focus on understanding Clauses 21(b), 21(c), and 21(d) in detail. The discussion highlights their practical relevance, statutory backing, and the responsibilities imposed on auditors. By exploring these provisions, auditors, tax professionals, and businesses can gain clarity about how to maintain compliance and avoid unnecessary disputes with the tax authorities.

The Role of Form 3CD in Tax Audit

Form 3CD is essentially a detailed statement of particulars required under section 44AB of the Income Tax Act, 1961. It contains a structured set of clauses, each requiring disclosure on specific matters ranging from accounting policies to compliance with statutory provisions. The form guides the auditor in presenting financial facts in a standardized manner so that the tax authorities can examine whether the taxpayer has adhered to the requirements of the law.

One of the core areas of disclosure within Form 3CD is related to expenses claimed by taxpayers in their profit and loss account. The Income Tax Act contains various provisions that restrict or disallow certain expenses when they are not made in compliance with the law. Clauses 21(b) to 21(i) collectively focus on this subject. In particular, Clauses 21(b) to 21(d) require the auditor to report on payments where tax was not deducted or deposited and remuneration to partners or members in entities such as firms and LLPs.

Clause 21(b): Payments to Residents Without Deduction of TDS

Clause 21(b) is concerned with situations where payments are made to residents but the payer fails to deduct tax at source in accordance with the provisions of Chapter XVII-B of the Income Tax Act. Under section 40(a)(ia), such payments can be disallowed while computing taxable income if tax was not deducted or if deducted but not deposited within the stipulated time.

The purpose of this clause is to ensure that the system of tax deduction at source is implemented effectively. TDS acts as a tool for the government to collect tax at the very source of income and minimize evasion. Any lapse in deducting or depositing tax not only deprives the government of timely revenue but also leads to disallowance for the taxpayer, increasing their tax liability.

Auditors, while reporting under this clause, are expected to furnish particulars of payments where tax was not deducted or where it was deducted but not deposited within the prescribed due dates. This disclosure helps the tax authorities in identifying default cases and applying the provisions of disallowance accordingly.

For example, if a business pays professional fees of a substantial amount to a resident consultant but fails to deduct TDS as required under section 194J, the auditor must report the details of such payment in Clause 21(b). The Income Tax Department can then invoke section 40(a)(ia) to disallow the expenditure in the hands of the payer, unless the conditions specified in the proviso are satisfied.

Compliance Challenges Under Clause 21(b)

Many businesses face challenges in ensuring complete compliance with TDS provisions. The complexity arises due to multiple sections, varying thresholds, and different rates of deduction. Errors may occur due to misinterpretation of the nature of payment, application of incorrect rates, or oversight in depositing deducted tax. The auditor’s responsibility is not to evaluate whether the disallowance should apply but to disclose facts in the report. This distinction is important as it safeguards the auditor’s independence while allowing the authorities to make their assessment.

In practice, auditors often request detailed ledgers of expenses, vendor-wise payment records, and TDS challans to verify compliance. They may also reconcile TDS returns filed by the taxpayer with the books of accounts to identify discrepancies. These steps help in accurate reporting under Clause 21(b).

Clause 21(c): Payments to Non-Residents Without Deduction of TDS

Clause 21(c) deals with disallowance of payments made to non-residents where the payer fails to deduct or deposit tax at source. Sections 195 and 40(a)(i) of the Income Tax Act govern such cases. Section 195 mandates that any payment to a non-resident which is chargeable to tax in India should be subject to deduction of tax at source. If tax is not deducted or deposited, the expenditure is liable to be disallowed under section 40(a)(i).

The objective behind this clause is to prevent tax leakage in cross-border transactions. Payments made to non-residents such as royalties, fees for technical services, interest, or other charges often attract TDS obligations in India. If these are not complied with, the government loses revenue and the taxpayer is denied deduction of the related expense.

Auditors must report instances where the taxpayer failed to deduct tax while making payments to non-residents. They are required to furnish details such as the name of the payee, amount paid, nature of payment, and the amount of tax not deducted or deposited. Unlike domestic TDS provisions, international transactions often require careful evaluation of double taxation avoidance agreements, nature of services, and the source of income.

Practical Scenarios Under Clause 21(c)

To illustrate, consider a company that avails technical consultancy services from a foreign firm. If the payment for such services is taxable in India under the Income Tax Act or under an applicable tax treaty, the Indian company must deduct tax at source while making payment. If it fails to do so, the auditor must report this under Clause 21(c). Similarly, if royalty payments for use of intellectual property are made to a foreign entity without TDS deduction, they will also come under the purview of this clause.

One of the common difficulties here is determining whether the payment is chargeable to tax in India. Businesses may argue that the service was rendered outside India and hence not taxable. However, the auditor’s role is limited to reporting factual non-deduction of tax, without opining on the chargeability of income. This distinction once again emphasizes that the auditor provides information rather than interpretation in most cases.

Clause 21(d): Remuneration to Partners and Members in Firms and LLPs

Clause 21(d) is related to disallowances concerning payments made by a firm or LLP to its partners or members. Section 40(b) of the Income Tax Act governs these situations. It specifies that certain payments to partners, such as remuneration, interest, bonus, or commission, are not deductible unless they satisfy prescribed conditions.

The provision allows deduction of remuneration or interest to partners only if authorized by the partnership deed and within the limits laid down by the Act. For example, remuneration is allowable only when it is authorized by the deed and relates to working partners. The amount must also not exceed the statutory limits, which are based on a percentage of book profits. Similarly, interest on capital is allowed only if specified in the deed and subject to a maximum rate of twelve percent.

Auditors, while reporting under Clause 21(d), must disclose cases where the firm has made payments in contravention of these rules. For instance, if a firm pays a fixed monthly salary to a partner without such authorization in the deed, the payment becomes inadmissible. The auditor must highlight these details in the report.

Importance of Clause 21(d) in Maintaining Transparency

This clause is significant because it ensures that profit-sharing arrangements between partners are transparent and within legal boundaries. Without such restrictions, firms could reduce their taxable profits by making excessive or unauthorized payments to partners. By mandating disclosure of such disallowances, the law aims to prevent misuse and safeguard revenue.

For auditors, this clause requires a thorough examination of the partnership deed and verification of compliance with section 40(b). They must check whether the deed contains specific clauses authorizing remuneration or interest, whether the payments align with these provisions, and whether statutory limits have been observed.

Auditor’s Responsibility in Clauses 21(b) to 21(d)

Across Clauses 21(b), 21(c), and 21(d), the auditor’s primary role is to present factual details rather than judgments. The auditor must collect necessary records, verify compliance with statutory requirements, and disclose any non-compliance in the Form 3CD report. While the tax authorities will eventually decide the allowability or disallowance of expenses, the auditor ensures that the information provided is complete and accurate.

In fulfilling these responsibilities, auditors rely on various procedures such as reconciling TDS returns with books of accounts, examining agreements with vendors or non-resident parties, and reviewing partnership deeds. They must also document their work adequately to support their reporting.

Exploring Clauses 21(e) to 21(g) of Form 3CD Under the Income Tax Act, 1961

The reporting obligations under Form 3CD extend to several clauses that deal with disallowed expenses. While Clauses 21(b) to 21(d) focus on payments related to TDS compliance and partner remuneration, Clauses 21(e) to 21(g) address areas involving payments through non-permissible modes, inadmissible provisions for gratuity, and certain employee welfare contributions. These clauses play a vital role in safeguarding the integrity of financial reporting and ensuring that businesses do not claim expenses which are expressly disallowed under the Income Tax Act, 1961.

We examine Clauses 21(e), 21(f), and 21(g) in detail. Each clause is explained with its statutory background, practical implications, and auditor’s responsibilities. By understanding these clauses, professionals can strengthen their compliance systems and reduce the risk of disallowances.

Clause 21(e): Payments Through Non-Permissible Modes

Clause 21(e) deals with disallowance of payments made otherwise than by account payee cheque, account payee bank draft, or electronic clearing system as prescribed under section 40A(3) of the Income Tax Act. This provision restricts cash payments above a certain threshold to promote transparency and discourage unaccounted transactions.

Under section 40A(3), if a taxpayer incurs an expenditure and makes payment exceeding the specified limit in cash, such expenditure is not allowable as a deduction. At present, the threshold stands at ten thousand rupees per day per person, subject to certain exceptions. The exceptions are listed under rule 6DD of the Income Tax Rules and include circumstances like payments in villages without banking facilities, payments to government bodies, and payments made on bank holidays.

The intent of this clause is clear: large payments should pass through banking channels to create a verifiable record. This measure curtails the use of unaccounted money and aligns with the government’s objective of encouraging a transparent economy.

Compliance Issues in Clause 21(e)

In practice, businesses often face difficulties when genuine commercial situations force them to make cash payments. For example, transport operators, farmers, or suppliers in remote areas may insist on cash payments. While rule 6DD provides certain relaxations, auditors must carefully examine whether the case falls within these exceptions. If not, the expenditure becomes inadmissible, regardless of business necessity.

Auditors reporting under Clause 21(e) must collect complete details of payments exceeding the prescribed limit, verify the mode of payment, and disclose any non-compliance. They must also check whether the taxpayer has maintained supporting documents justifying exceptions under rule 6DD. Failure to document such exceptions adequately can result in disallowance during assessment.

Illustrative Example for Clause 21(e)

Consider a construction company that makes a cash payment of fifty thousand rupees to a contractor for urgent material supply. Since the payment exceeds the threshold and was not made through account payee cheque or electronic mode, it violates section 40A(3). Unless the case qualifies under rule 6DD exceptions, the auditor must report this payment under Clause 21(e), and the expenditure will not be allowed as deduction in the computation of income.

Clause 21(f): Provisions for Gratuity

Clause 21(f) pertains to provisions made for payment of gratuity to employees that are not allowable under section 40A(7) of the Income Tax Act. The law specifically disallows deduction of any provision for gratuity unless two conditions are met:

• The provision is made for the purpose of payment of gratuity that has become payable during the year, or

• The provision is made towards an approved gratuity fund created for the exclusive benefit of employees.

This provision ensures that gratuity expenses are recognized only when they are actually payable or when funds are irrevocably set aside in approved gratuity funds. Provisions created on an ad hoc basis or without approval are not allowed as deductions because they do not represent an actual liability incurred during the year.

Compliance Implications of Clause 21(f)

Many businesses create provisions for gratuity based on actuarial valuations or estimates. While this reflects sound accounting practice, the Income Tax Act allows deduction only when gratuity is paid or when it is transferred to an approved gratuity fund. Hence, companies may find that their accounting expense for gratuity differs from the amount allowable for tax purposes.

Auditors reporting under Clause 21(f) must verify whether the provisions created meet the criteria laid down under section 40A(7). If the provision is not linked to actual payment or an approved fund, the auditor must report the same as inadmissible. This requires careful review of actuarial reports, fund approval status, and payment records.

Example for Clause 21(f)

Suppose a company provides for gratuity liability of ten lakh rupees in its accounts based on actuarial valuation. Out of this, only two lakh rupees is actually paid to employees who retired during the year, and another three lakh rupees is contributed to an approved gratuity fund. 

In such a case, only five lakh rupees will be allowable under the Act, while the remaining five lakh rupees provision will be disallowed. The auditor must clearly report the inadmissible portion under Clause 21(f).

Clause 21(g): Employee Welfare Payments

Clause 21(g) requires reporting of disallowances related to employee welfare funds such as provident fund, superannuation fund, or other similar funds under section 40A(9) of the Income Tax Act. According to this provision, any contribution by an employer to a fund that is not recognized or approved under the Act is not allowable as a deduction.

The purpose of this restriction is to prevent employers from claiming deductions for contributions to unapproved funds which may not be regulated or used for the benefit of employees. Contributions to recognized provident funds, approved superannuation funds, and approved gratuity funds are allowable, but any payments made to unrecognized funds are inadmissible.

Practical Issues Under Clause 21(g)

Employers may sometimes create internal welfare funds or schemes to provide benefits to employees. While these may serve genuine welfare purposes, they are not recognized under the Act unless specifically approved. Contributions to such funds are disallowed.

For instance, if a company sets aside a portion of its profits into an employee benevolent fund managed internally without approval, the contribution cannot be claimed as a deduction. Similarly, payments towards informal medical welfare trusts or other non-approved funds are also inadmissible.

Auditors must identify all contributions made by the employer, verify whether the fund is recognized or approved, and report any inadmissible contributions. They should also examine trust deeds, approval letters from the tax authorities, and contribution records to determine compliance.

Example for Clause 21(g)

Imagine an employer contributes two lakh rupees towards a company-created employee welfare fund which is not recognized under the Act. At the same time, it also contributes three lakh rupees towards a recognized provident fund. In such a scenario, the three lakh rupees contribution is allowable as deduction, but the two lakh rupees contribution will be disallowed under section 40A(9). The auditor must report this under Clause 21(g).

Auditor’s Role in Clauses 21(e) to 21(g)

The responsibility of auditors in reporting under Clauses 21(e) to 21(g) is significant because these clauses directly relate to ensuring transparent expenditure practices. Auditors must:

• Examine payment records and modes to identify cash payments exceeding limits.

• Verify gratuity provisions and ensure they are either paid or transferred to approved funds.

• Check contributions to employee welfare funds and confirm their approval status.

While performing these tasks, auditors are not required to decide the allowability of expenses. Their role is limited to reporting factual details which enable tax authorities to apply the law effectively. This distinction protects the auditor’s independence and ensures objective reporting.

Broader Impact of Clauses 21(e) to 21(g)

Together, these clauses strengthen compliance by discouraging cash transactions, ensuring proper funding of gratuity obligations, and preventing deductions for contributions to unrecognized employee welfare schemes. They reflect the legislature’s intent to balance genuine business expenditure with the need to safeguard revenue.

From a taxpayer’s perspective, these clauses highlight the importance of maintaining accurate records, using approved channels, and seeking approvals where required. For auditors, they underscore the need for diligence in verifying payments, provisions, and contributions.

Clauses 21(h) and 21(i) of Form 3CD Under the Income Tax Act, 1961

Form 3CD serves as a structured reporting mechanism for tax auditors, requiring disclosure of expenses and liabilities that are disallowed under the Income Tax Act, 1961. After examining Clauses 21(b) to 21(g), we now turn to Clauses 21(h) and 21(i). These provisions address the reporting of contingent liabilities and other disallowances that fall outside the specific categories covered by earlier clauses.

Clauses 21(h) and 21(i) emphasize the principle that only real, ascertained, and lawful expenditures are deductible in computing taxable income. Any provisions, liabilities, or expenses that lack finality or certainty are treated as inadmissible. We explored the scope of these clauses, their statutory background, the auditor’s role, and the compliance implications for taxpayers.

Clause 21(h): Reporting of Contingent Liabilities

Clause 21(h) requires auditors to report contingent liabilities debited to the profit and loss account. Under the Income Tax Act, contingent liabilities are not recognized as deductible expenses because they do not represent actual obligations incurred during the year. Instead, they are uncertain obligations that may or may not materialize depending on the outcome of future events.

The distinction between an accrued liability and a contingent liability is critical. Accrued liabilities arise out of obligations that are definite and have already crystallized, while contingent liabilities depend on uncertain future conditions. For instance, a liability arising from pending litigation or a guarantee given by the business is considered contingent until the outcome becomes certain.

Treatment of Contingent Liabilities

Section 37 of the Income Tax Act allows deduction of business expenditure only if it is incurred wholly and exclusively for the purpose of the business during the relevant year. Since contingent liabilities are not expenses actually incurred, they do not qualify under this provision. Even if accounted for in financial statements under accounting principles, such liabilities cannot be claimed as deductions for tax purposes.

For example, if a company makes a provision for damages payable in an ongoing lawsuit without the court having delivered judgment, such provision is contingent. The expense is not allowable for tax computation, and the auditor must report it under Clause 21(h).

Auditor’s Responsibility Under Clause 21(h)

Auditors are required to review the profit and loss account and identify any provisions or charges related to contingent liabilities. They must ensure that these items are disclosed in the tax audit report to highlight the inadmissibility under the Income Tax Act. The auditor’s role is not to determine whether the liability is ultimately allowable but to report the existence of such contingent charges when debited to the accounts.

In practice, this requires the auditor to:

• Examine provisions created in the accounts for legal claims, guarantees, warranties, and penalties.

• Verify management notes and board resolutions for disclosure of contingent items.

• Report any such provisions debited to profit and loss under Clause 21(h).

Examples Illustrating Clause 21(h)

• A company provides five lakh rupees in its accounts as an estimated liability for a tax demand under dispute. Since the demand is contested and pending appeal, it is contingent. The provision is not deductible, and the auditor must report it.

• A manufacturer provides one lakh rupees for product warranty claims expected in future years. Unless claims have already arisen, the provision remains contingent and cannot be deducted. It must be disclosed under Clause 21(h).

Judicial Interpretations of Contingent Liabilities

Courts have consistently held that only accrued liabilities are allowable for tax deduction. In several judgments, it has been clarified that contingent liabilities, even if recognized under accounting standards, are not deductible unless they crystallize into actual obligations. This principle strengthens the auditor’s reporting duty under Clause 21(h).

Clause 21(i): Other Disallowable Items

Clause 21(i) is a residuary provision. It requires disclosure of amounts inadmissible under the Act that are not specifically covered under Clauses 21(b) to 21(h). This ensures that no disallowance escapes reporting simply because it does not fall within the earlier defined categories.

This clause captures a broad range of items that may be disallowed under different provisions of the Act, such as:

• Personal expenses charged to the business.

• Expenditure incurred for purposes prohibited by law.

• Expenditure not incurred for business purposes.

• Deductions restricted under special provisions not covered earlier.

By including this residuary clause, the form ensures comprehensive reporting of all inadmissible items, leaving no gap for omission.

Scope of Clause 21(i)

The scope of Clause 21(i) is wide and may include disallowances arising from diverse provisions such as:

• Disallowance of expenditure incurred for corporate social responsibility under section 37.

• Disallowance of fines and penalties paid for violation of law.

• Disallowance of personal expenditure of partners or directors charged to business.

• Any other expenditure expressly prohibited under the Income Tax Act.

Auditors must therefore exercise professional judgment and ensure that all such inadmissible amounts are reported in the tax audit report.

Auditor’s Responsibility Under Clause 21(i)

The auditor must carefully review the accounts, management representations, and supporting documents to identify any expenditure that falls within the ambit of Clause 21(i). This involves:

• Scrutinizing expense heads for personal or non-business expenses.

• Checking for fines, penalties, or legal charges not allowable under the Act.

• Reviewing provisions of law to determine whether specific expenditures are prohibited.

The auditor is not required to give an opinion on allowability beyond reporting factual details. However, they must exercise diligence in identifying all such items for reporting.

Examples Illustrating Clause 21(i)

• A business charges the personal travel expenses of a director to its profit and loss account. Since this is personal expenditure, it is inadmissible under the Act and must be reported under Clause 21(i).

• A company pays a penalty for non-compliance with statutory provisions and debits it to a profit and loss account. Such penalties are not allowable as deductions, and the auditor must disclose them.

• A firm claims deduction for donations or contributions not covered under specified sections. These are not allowable and fall within the reporting scope of Clause 21(i).

Comparison of Clause 21(h) and Clause 21(i)

While Clause 21(h) specifically deals with contingent liabilities debited to profit and loss, Clause 21(i) serves as a general clause covering all other inadmissible expenses. Together, these clauses ensure that the reporting framework captures both specific and residual disallowances. This comprehensive approach minimizes the possibility of unreported non-compliant items in tax audit.

Challenges in Implementation

Both Clause 21(h) and 21(i) present practical challenges to auditors and taxpayers. Distinguishing between contingent and accrued liabilities often requires professional judgment. Similarly, identifying expenses prohibited under law or unrelated to business activities demands thorough scrutiny.

Taxpayers must maintain detailed records and provide full disclosures to auditors. Failure to do so can lead to reporting issues, assessment disputes, and potential penalties. For auditors, maintaining independence while relying on management representations is a delicate balance that requires careful documentation.

Broader Compliance Implications

Clauses 21(h) and 21(i) underline the principle that tax deductions are available only for genuine, business-related, and lawful expenditures. By disallowing contingent and inadmissible items, the Income Tax Act ensures that taxable income reflects actual business costs rather than estimated or unlawful charges.

These clauses also enhance transparency in financial reporting by compelling businesses to disclose provisions and expenses that might otherwise remain hidden. For auditors, they represent an important responsibility in maintaining the integrity of tax audits and ensuring compliance with statutory requirements.

Conclusion

Clauses 21(b) to 21(i) of Form 3CD under the Income Tax Act, 1961 serve as a structured framework for reporting disallowable expenses, ensuring that only legitimate and compliant business expenditures are considered while computing taxable income. Each clause carries a specific focus: from disallowances linked to TDS non-compliance, remuneration to partners and members, and payments made through impermissible modes, to inadmissible provisions for gratuity, welfare expenses, contingent liabilities, and residual disallowances.

Collectively, these provisions reinforce the principle that tax deductions are a matter of compliance and cannot be claimed for expenses that are unlawful, contingent, or unrelated to business. For taxpayers, this demands meticulous record-keeping, transparent disclosures, and adherence to prescribed payment and deduction norms. For auditors, the responsibility lies in reporting facts objectively, ensuring accuracy, and safeguarding the integrity of the tax audit process.

In essence, Clauses 21(b) to 21(i) highlight the importance of discipline in financial and tax reporting. By filtering out inadmissible items and compelling detailed disclosures, they promote fairness, compliance, and accountability. Businesses that align their practices with these requirements not only reduce the risk of disputes and penalties but also contribute to building a transparent tax ecosystem that upholds the true intent of the Income Tax Act.