Tax Audit Clauses 26 to 29 Explained: Complete Guide with Case Laws and ICAI Guidance - Free Invoice Generator

The Income-tax Act, 1961 mandates a tax audit under section 44AB for certain categories of taxpayers. The prescribed format for reporting is Form 3CD, which requires auditors to certify numerous particulars about the business or profession of the assessee. Among these, clauses 26 to 29 carry significant importance as they deal with statutory liabilities, indirect tax credits, prior period adjustments, and specific transactions relating to shares and deemed income.

We focus on clause 26 and clause 27. Clause 26 requires reporting of liabilities covered by section 43B, which mandates actual payment for deduction of certain expenses. Clause 27 deals with reporting of CENVAT and GST credits and disclosure of prior period income and expenses. Both clauses are practical in nature and need meticulous reconciliation with books of accounts, statutory records, and supporting documentation.

Understanding Section 43B and its Impact

Section 43B was introduced to prevent taxpayers from claiming deductions for statutory liabilities without actually paying them. Under the mercantile system, expenses can be claimed on accrual, but this often led to cases where taxes, duties, or employee-related contributions were claimed as deduction while the amounts remained unpaid for long periods. To curb this practice, section 43B makes it mandatory that certain expenses are allowable only when paid.

The section is overriding in nature and applies irrespective of the accounting method followed. The legislative intent is to ensure synchronization of tax deductions with actual cash outflow to the government or statutory authorities.

Nature of Expenses Covered under Section 43B

The following expenses fall within the ambit of section 43B and need careful reporting:

Taxes, duties, cess or fees payable under any law other than income tax.
Employer’s contribution to provident fund, superannuation fund, gratuity fund, or other employee welfare funds.
Bonus or commission payable to employees.
Interest payable on loans or borrowings from public financial institutions, scheduled banks, cooperative banks, or NBFCs.
Leave encashment payable to employees.
Any payment to the Indian Railways for use of assets.

The rule of deduction is simple: if the liability is paid by the end of the previous year, deduction is allowed in the same year. If the payment is made after the end of the year but before the due date of filing the return of income under section 139(1), deduction is also allowed in that year, subject to certain categories of liabilities. If unpaid even after the due date, the deduction is disallowed and carried forward.

Clause 26(i)(A) – Reporting of Pre-existing Liabilities

Clause 26(i)(A) requires reporting of liabilities that existed on the first day of the previous year. These are items that were not allowed as deduction in earlier assessments due to non-payment under section 43B. The auditor must report:

Nature of the liability, such as excise duty, customs duty, service tax, or provident fund contribution.
The amount payable as on the first day of the previous year.
Whether such an amount was paid during the year.
If still unpaid, details of non-payment must be disclosed.

It is important to note that for pre-existing liabilities, the relief of payment up to the due date of filing the return under section 139(1) does not apply. Deduction is permissible only if actual payment is made during the year itself.

Clause 26(i)(B) – Reporting of Current Year Liabilities

This sub-clause deals with liabilities incurred during the previous year. The treatment here is different from pre-existing liabilities. If the liability is discharged either during the year or on or before the due date of filing the return, the deduction is allowed. If not paid within this timeframe, the expense is disallowed.

The auditor is required to report:

The nature of the liability such as GST, VAT, excise duty, customs duty, or cess.
The date and mode of payment.
Whether the expense has been routed through the profit and loss account.
Amount disallowed for non-payment within the prescribed period.

This clause essentially links the allowability of deductions with timely statutory compliance and ensures that businesses do not enjoy a tax benefit unless liabilities are paid in time.

Auditor’s Role in Reporting under Clause 26

The responsibility of the auditor under clause 26 is not merely to compile figures but to critically evaluate whether payments meet the conditions prescribed under section 43B. The auditor must:

Examine challans, payment receipts, and bank statements to verify actual discharge of liabilities.
Reconcile statutory liabilities with books of accounts.
Segregate carried forward liabilities from current year liabilities.
Ensure reporting of correct amounts without opining on allowability, as the final determination rests with the assessing officer.
Document cases of deferred payments under state incentive schemes with reference to applicable circulars and judicial pronouncements.

Judicial Rulings and CBDT Clarifications on Section 43B

Several judicial decisions have shaped the interpretation of section 43B and clarified its application in diverse situations. Some notable cases include:

In the case of Gujarat Polycrete and Goodluck Silicate, it was held that where state laws provide that deferred sales tax payment is treated as discharge of liability, the same is considered actual payment for section 43B purposes.
In CIT v. McDowell & Co, the Supreme Court clarified that furnishing a bank guarantee is not equivalent to payment.
In Modipon Ltd and Maruti Suzuki India Ltd, advance deposit of excise duty was accepted as actual payment.
In Mineral Area Development Authority v. SAIL, royalty on minerals was held to be in the nature of tax.
In McDowell & Co, the bottling fee was held not to be a tax.
In Berger Paints, excise duty paid during the year was allowed as deduction regardless of its treatment in stock valuation.

These rulings emphasize the need for auditors to carefully identify the nature of liability and the method of discharge before reporting under clause 26.

Clause 27 – Reporting on CENVAT and GST Credits

Clause 27 requires reporting of balances and movements in indirect tax credits such as CENVAT and GST input credits. The purpose is to ensure proper disclosure of unutilized credit balances which may have a bearing on the financial position of the assessee.

CENVAT Credit Reporting

The auditor must report:

Credit carried forward from the earlier year.
Credit availed during the current year.
Credit utilized against tax liability.
Balance of unutilized credit at year end.

This requires verification of CENVAT records, reconciliation with statutory returns, and cross-checking with the financial statements. Any mismatch must be analyzed and explained.

GST Input Tax Credit

With the advent of GST, CENVAT credit has been subsumed into input tax credit under GST. However, since Form 3CD has not yet been amended to specifically include GST ITC reporting under clause 27, auditors follow a cautious approach.

In practice, many auditors do not report GST ITC balances under this clause until further guidance is issued by CBDT. Nevertheless, from a transparency perspective, maintaining proper reconciliation of ITC between books, returns, and the electronic credit ledger remains an essential audit procedure.

Clause 27(b) – Prior Period Items

Prior period items refer to income or expenses relating to earlier years but recorded in the profit and loss account of the current year. This could happen due to errors, omissions, or delayed crystallization of liabilities.

The auditor must report:

Nature and particulars of such items.
Amount involved.
The financial year to which the item relates.
Remarks explaining the reason for delayed recognition.

Prior period adjustments are a common feature in organizations with large operations where reconciliations are complex. However, the auditor must distinguish these from crystallized current year liabilities. For instance, an invoice received late but pertaining to current year services should not be treated as prior period. Similarly, sales or purchase returns are not covered as prior period items.

The reporting is relevant only for assessees following a mercantile system of accounting, as the cash system recognizes transactions only on payment or receipt basis.

Practical Issues in Clause 26 and Clause 27 Reporting

Auditors often face challenges while reporting under these clauses, some of which include:

Reconciliation of statutory liabilities with general ledger balances, especially in large organizations where multiple ledgers are maintained.
Determining whether deferred sales tax or GST liability under incentive schemes constitutes actual payment.
Identifying the correct due date for filing return under section 139(1) in case of extended deadlines.
Differentiating between prior period items and current year crystallizations, which often requires professional judgment.
Deciding whether GST ITC needs to be reported under clause 27(a) in the absence of amendment in Form 3CD.

These challenges necessitate a robust audit approach, detailed documentation, and reliance on management representations where necessary.

Reporting under Clause 28 and Clause 29

Form 3CD is the backbone of tax audit reporting under section 44AB of the Income-tax Act, 1961. Each clause is designed to capture specific details about transactions that may have a direct or indirect impact on the computation of taxable income. While clause 26 and clause 27 deal with statutory liabilities and indirect tax credits, clauses 28 and 29 cover transactions involving shares issued or received without adequate consideration.

These provisions were inserted to plug tax avoidance routes where taxpayers could transfer or issue shares at values different from fair market value. We elaborate on clause 28 and clause 29, their legislative background, reporting requirements, and the practical aspects auditors must consider.

Clause 28 – Receipt of Shares without Adequate Consideration

Background and Scope of Section 56(2)(viia)

Clause 28 of Form 3CD was introduced to capture transactions covered under section 56(2)(viia). This section was in force between 1 June 2010 and 1 April 2017. It taxed the receipt of shares of a closely held company by another closely held company or firm without consideration, or for inadequate consideration, where the difference between consideration and fair market value exceeded a threshold of fifty thousand rupees.

The intent was to prevent taxpayers from transferring shares at artificially low values between related parties to avoid tax or to shift profits. The law required taxation of the difference as income from other sources in the hands of the recipient.

Applicability Timeline

Section 56(2)(viia) was applicable only for a limited period. With effect from assessment year 2018-19, the provision was omitted and replaced by a broader provision in section 56(2)(x). Therefore, clause 28 of Form 3CD has lost its relevance for current reporting years.

Auditor’s Responsibility under Clause 28

For assessment years up to 2017-18, the auditor was required to:

Identify whether the assessee, being a closely held company or firm, had received shares of another closely held company.
Verify whether such shares were received without consideration or for inadequate consideration.
Determine the fair market value of shares in accordance with Rule 11U and Rule 11UA.
Compare the FMV with the consideration paid, and check if the shortfall exceeded fifty thousand rupees.
Report details of such transactions in clause 28.

For all assessment years from 2018-19 onwards, the auditor is required to simply select “No” in the reporting utility since the provision is no longer applicable.

Practical Challenges under Clause 28

During the years of its applicability, clause 28 presented a number of challenges:

Determination of fair market value under Rule 11UA often involved technical calculations, particularly where unquoted equity shares were concerned.
Auditors had to rely on valuation reports and certifications from professionals such as chartered accountants or merchant bankers.
Related party transactions often raised doubts about genuineness and required additional scrutiny.
Inadequate documentation or absence of proper agreements made verification difficult.

Although the clause is not relevant now, its historical importance remains, as many pending assessments for earlier years still involve issues under section 56(2)(viia).

Clause 29 – Issue of Shares at Premium

Legislative Background

Clause 29 was inserted to report compliance with section 56(2)(viib). This provision applies to closely held companies that issue shares at a premium exceeding their fair market value. The excess premium received is taxable as income from other sources in the hands of the issuing company. The rationale is to curb the practice of routing unaccounted money or introducing capital at inflated valuations through private placement of shares.

Applicability of Section 56(2)(viib)

The provision applies when:

A closely held company (that is, a company other than one in which the public are substantially interested) issues shares.
The shares are issued at a consideration that exceeds the fair market value.
The excess premium over the fair market value is taxable as income from other sources.

This section does not apply to:

Shares issued to a venture capital fund or venture capital company.
Certain notified classes of investors.

The provision has wide applicability for startups and private companies raising funds from resident investors.

Determination of Fair Market Value

The fair market value of shares for section 56(2)(viib) is determined in accordance with Rule 11UA. The company has the option to adopt:

The net asset value method based on book value of assets and liabilities, or
The discounted cash flow method, which requires a valuation report from a merchant banker.

The law provides that the fair market value is the higher of the value determined under these methods or the value substantiated by the company to the satisfaction of the assessing officer.

Auditor’s Responsibility under Clause 29

The auditor must carefully examine share issuance transactions and report whether section 56(2)(viib) is attracted. The following steps are generally followed:

Obtain a complete list of shares issued during the year, including face value, premium, date of issue, and names of subscribers.
Verify details of subscribers, including PAN or Aadhaar, to ensure identity and residential status.
Examine consideration received, whether in cash, cheque, or other modes, and verify corresponding bank entries.
Review the valuation report obtained by the company under Rule 11UA.
Compare issue price with fair market value. If the issue price exceeds FMV, the auditor must report details in clause 29.
Obtain management representation regarding justification of share issue price and compliance with statutory requirements.

Importance of Form 61A

Where a closely held company receives share application money or consideration of ten lakh rupees or more from a person during a financial year, such receipts are reportable under statement of financial transactions in Form 61A. The auditor should check whether the assessee has complied with this reporting obligation.

Judicial Perspective on Section 56(2)(viib)

Courts and tribunals have examined the application of section 56(2)(viib) in several cases. Important aspects highlighted in rulings include:

The assessing officer has limited scope to challenge a valuation report if it is prepared by a qualified merchant banker under the prescribed method.
Valuation is inherently subjective, particularly under the discounted cash flow method, and minor deviations cannot be ground for rejection.
The provision cannot be used to substitute the commercial wisdom of investors or the company’s decision to issue shares at a premium.
Exemptions granted to venture capital investments are to be construed liberally to promote funding of innovative businesses.

These judicial interpretations guide auditors in exercising judgment while reporting under clause 29.

Practical Challenges in Clause 29 Reporting

Auditors often face complexities in reporting under clause 29 due to the following:

Determining whether a company qualifies as a closely held company.
Verification of valuation reports, especially when based on projections under the discounted cash flow method.
Assessing whether consideration received in kind, such as property or securities, should be taken into account.
Ensuring completeness of details regarding investors, including foreign shareholders in case of partial applicability.
Addressing cases where shares are issued to related parties at different premiums.

These challenges require careful documentation and professional skepticism during the audit.

Key Differences Between Clause 28 and Clause 29

Although both clauses deal with share transactions, their scope and applicability differ significantly:

Clause 28 applied to receipt of shares by a closely held company or firm, whereas clause 29 applies to issuance of shares by a closely held company.
Clause 28 was based on section 56(2)(viia), which is no longer applicable. Clause 29 continues to apply under section 56(2)(viib).
Clause 28 taxed the recipient of shares, while clause 29 taxes the issuer of shares.
Valuation under clause 28 was primarily from the perspective of the recipient, whereas under clause 29 it is based on the issuer’s valuation report.

Understanding these differences is essential for proper audit reporting.

Documentation Required for Clause 29 Reporting

For accurate reporting under clause 29, the auditor must collect and verify several documents, including:

Share allotment register and minutes of board meetings authorizing share issues.
Shareholders’ agreement or private placement offer letter.
Copies of share certificates issued to investors.
Proof of receipt of consideration, such as bank statements.
Valuation report from a merchant banker or chartered accountant, as per prescribed rules.
Management representation regarding compliance with section 56(2)(viib).

Proper documentation not only supports the audit report but also protects the auditor in case of future disputes.

Clause 29A – Forfeiture of Advance on Capital Asset

Legislative Background

Section 56(2)(ix) was introduced to address situations where an assessee receives an advance or earnest money in relation to the transfer of a capital asset, but such transaction does not materialize, and the advance is forfeited. Before this provision, such amounts forfeited were generally treated as capital receipts and not taxable in the hands of the recipient.

To plug this gap, the law was amended so that any such forfeiture is taxed as income from other sources in the year of forfeiture. Clause 29A of Form 3CD requires the auditor to report whether the assessee has forfeited any advance received in relation to transfer of a capital asset, and if so, details of such forfeiture.

Applicability of Section 56(2)(ix)

The provision applies when:

An assessee receives any sum of money as an advance or otherwise in the course of negotiations for transfer of a capital asset.
The transaction of transfer does not take place.
The sum received is retained by the assessee by way of forfeiture.

The entire amount forfeited becomes taxable as income from other sources in the year of forfeiture, irrespective of its original intention or treatment in books of accounts.

Auditor’s Responsibility under Clause 29A

The auditor is required to:

Obtain details of advances or earnest money received in connection with negotiations for transfer of capital assets.
Verify whether such transactions were completed or aborted.
Examine whether any amount received has been forfeited during the year.
Ensure that the forfeited amount has been credited to the profit and loss account or separately disclosed as income.
Report details of such forfeiture, including name of the party, amount forfeited, date of agreement, and date of forfeiture.

The auditor should also obtain a management representation letter confirming that all such transactions have been disclosed.

Documentation for Clause 29A

The following documents are generally relevant:

Agreement to sell or memorandum of understanding in relation to the proposed transfer.
Receipts or proof of money received as advance.
Correspondence showing termination or cancellation of the transaction.
Entry in books of accounts recognizing forfeiture of advance.
Party confirmation, if available, to substantiate forfeiture.

Proper documentation helps ensure that the reporting is accurate and defensible.

Practical Challenges in Clause 29A

Auditors may face difficulties in identifying forfeited advances where:

Agreements are oral or not properly documented.
Advances are adjusted against other transactions between the parties.
Disputes are ongoing regarding whether the advance is forfeited or refundable.
The assessee has accounted for forfeiture in capital reserves instead of income.

In such cases, professional judgment, coupled with written representation from management, becomes crucial.

Judicial Interpretations on Forfeiture

Several rulings have provided clarity on the taxation of forfeited advances:

Courts have held that once section 56(2)(ix) applies, forfeited advances cannot be treated as capital receipts. They are taxable as income from other sources.
Disputed forfeitures, where litigation is pending, may not trigger taxation until resolution.
If forfeiture occurs in relation to stock-in-trade rather than a capital asset, section 56(2)(ix) does not apply, and such amounts may be treated as business income.

These principles guide both taxpayers and auditors in applying the law correctly.

Clause 29B – Gifts and Deemed Income

Legislative Background

Section 56(2)(x) was introduced to consolidate earlier provisions that taxed gifts or property received without consideration or for inadequate consideration. The provision applies to all persons and entities, unlike earlier sections which were restricted to individuals, HUFs, or closely held companies.

The intent is to tax unaccounted transfers of money or property camouflaged as gifts. However, the law carves out specific exemptions for genuine transactions, such as gifts from relatives, on the occasion of marriage, or under a will. Clause 29B of Form 3CD requires auditors to report whether the assessee has received any such income chargeable under section 56(2)(x).

Applicability of Section 56(2)(x)

Section 56(2)(x) applies where any person receives:

Money without consideration exceeding fifty thousand rupees in aggregate during the year.
Immovable property without consideration where the stamp duty value exceeds fifty thousand rupees.
Immovable property for inadequate consideration where the difference between stamp duty value and consideration exceeds the higher of fifty thousand rupees or ten percent of consideration.
Specified movable properties (shares, securities, jewellery, bullion, etc.) without consideration exceeding fifty thousand rupees.
Specified movable properties for inadequate consideration where the difference between fair market value and consideration exceeds fifty thousand rupees.

The entire value or difference, as applicable, is taxable as income from other sources in the hands of the recipient.

Exemptions under Section 56(2)(x)

The provision does not apply where property is received:

From a relative, as defined under the Act.
On the occasion of an individual’s marriage.
Under a will or by inheritance.
In contemplation of the death of the donor.
From specified local authorities or charitable institutions.
By certain notified trusts or educational institutions.

Auditors must verify whether the assessee’s claim for exemption is backed by proper evidence and documentation.

Auditor’s Responsibility under Clause 29B

The auditor should:

Scrutinize bank accounts, books of accounts, and other records for any receipts of money or property without consideration or for inadequate consideration.
Verify purchase deeds, gift deeds, or transfer agreements relating to immovable and movable properties.
Determine fair market value or stamp duty value in accordance with Rule 11U and Rule 11UA.
Cross-check whether the total receipts exceed the specified threshold.
Report such receipts in clause 29B, with details of nature of property, amount, parties involved, and applicable exemption, if any.

Documentation for Clause 29B

The following records are essential:

Gift deeds or property transfer documents.
Stamp duty valuation certificates for immovable property.
Valuation reports for unquoted shares or other specified movable property.
Relationship proofs in case of gifts from relatives.
Marriage invitations or death certificates in case of exempt occasions.
Confirmations from donors or transferors, wherever possible.

These documents provide the foundation for accurate audit reporting.

Practical Challenges in Clause 29B

Reporting under clause 29B is often complicated by:

Difficulty in identifying non-business receipts in accounts, especially where mixed bank accounts are used.
Valuation complexities for unquoted shares or unique assets like art and collectibles.
Determining genuineness of claimed exemptions, particularly for gifts from relatives or under wills.
Cases where property values are disputed with stamp duty authorities.
Transactions structured through multiple small amounts to avoid threshold reporting.

Auditors must exercise professional skepticism and rely on management representations along with documentary evidence.

Judicial Interpretations on Gifts and Deemed Income

Case law has shaped the application of section 56(2)(x) and its predecessors:

Courts have upheld that the deeming provisions are to be strictly applied and exemptions must be clearly proven by the assessee.
It has been clarified that marriage exemption is available only for the individual’s own marriage and not for children or relatives.
In matters involving valuation disputes, courts have accepted that prescribed valuation rules are binding, even if they deviate from actual market trends.
Exemptions for gifts from relatives are interpreted liberally, but the relationship must fall within the specific definition provided under the Act.

These rulings provide important guidance for auditors while evaluating transactions.

Interaction between Clause 29A and Clause 29B

Though clauses 29A and 29B address different provisions, they share the common theme of taxing receipts that were earlier considered capital in nature or outside the tax ambit. Key differences include:

Clause 29A deals specifically with forfeiture of advances on capital assets, whereas clause 29B covers a wide range of receipts including money, immovable property, and specified movable properties.
Clause 29A applies to the person who retains an advance, while clause 29B applies to the recipient of money or property.
Clause 29A has no exemptions, while clause 29B provides multiple exemptions for genuine transfers.

Understanding this distinction helps auditors in ensuring accurate and complete reporting.

Conclusion

Clauses 26 to 29B of Form 3CD represent some of the most significant reporting requirements in a tax audit, as they touch upon provisions designed to ensure tax compliance and prevent revenue leakage through timing differences, disguised receipts, or unexplained transfers. Each clause has its own unique scope and practical challenges, but together they reflect the legislature’s intent to align accounting practices with tax policy.

Clause 26 enforces discipline by ensuring that deductions for statutory liabilities are available only on actual payment, thereby aligning fiscal incentives with timely compliance. It draws a distinction between liabilities carried forward from earlier years and those incurred during the current year, while also incorporating guidance from judicial pronouncements and CBDT circulars.

Clause 27 focuses on reconciliation between statutory credits and financial statements, while also highlighting the importance of prior period adjustments. Though GST input credits are not yet formally included within the clause, auditors are expected to maintain a reconciliatory approach, ensuring transparency in treatment of indirect tax credits.

Clause 28, while no longer relevant post 2017, stands as a reminder of earlier provisions designed to tax share transfers at inadequate consideration. Clause 29 continues this theme by dealing with issue of shares at a premium in closely held companies, requiring robust valuation support and management disclosures. The auditor’s role here extends beyond mere verification to assessing whether valuation methods and compliance with prescribed rules have been properly followed.

Clause 29A ensures that forfeiture of advances in relation to capital assets, earlier considered a capital receipt, is now appropriately taxed as income from other sources. This prevents taxpayers from using forfeiture as a loophole to avoid tax. Clause 29B, with its wide scope, ensures that gifts and deemed income received without adequate consideration are taxed, unless they fall within specified exemptions. By requiring detailed reporting of such transactions, it strengthens the transparency and accountability of financial reporting.

Together, these clauses demand meticulous verification, reconciliation, and documentation by auditors. They also require auditors to apply professional skepticism in evaluating transactions, as the boundaries between genuine business dealings and arrangements intended to avoid tax can sometimes be thin. Judicial precedents and CBDT guidance provide clarity in ambiguous situations, but ultimately, accurate disclosure and fair reporting remain at the heart of these clauses.

The essence of clauses 26 to 29B lies in striking a balance between legitimate business practices and the prevention of tax abuse. They underscore the need for taxpayers to maintain proper records, make timely payments, secure valuation reports, and substantiate exemptions. For auditors, they highlight the responsibility not just of verifying figures, but of understanding the broader implications of tax law, and ensuring that compliance is not just technical but also true to the intent of legislation.