The Income-tax Act, 1961 mandates that certain categories of assessees must undergo a tax audit under section 44AB. This audit is required when a business or profession crosses the prescribed turnover or gross receipts threshold, or when specific provisions relating to presumptive taxation apply. The purpose of this audit is not only to verify the accuracy of the accounts but also to ensure that disallowances, inadmissible expenses, and specific reporting requirements are properly disclosed.
The Chartered Accountant conducting the tax audit is responsible for furnishing the audit report in Form 3CA or Form 3CB, along with the detailed particulars in Form 3CD. Form 3CD is a statement of particulars that requires reporting of various items, such as compliance with sections 36, 40, 40A, and 43B, and also requires the auditor to scrutinize payments, deductions, and contributions made by the assessee.
Clause 20 of Form 3CD is particularly focused on employee-related expenses, such as bonus, commission, and contributions to employee welfare funds. These expenses are allowable as deductions only under specified conditions. The tax auditor must therefore verify and report the relevant details, ensuring that payments meet the requirements of the Act and are not merely a mechanism to divert profits in a disguised manner.
Overview of Part B of Form 3CD
Form 3CD is divided into different parts. Part A relates to basic details of the assessee, while Part B requires reporting of various items linked with the profit and loss account, deductions, and disallowances. Clause 20 falls under Part B and requires the auditor to provide information relating to two major categories:
- Bonus or commission paid to employees under section 36(1)(ii).
- Contributions received from employees towards provident fund, employees’ state insurance, or other welfare funds covered by section 36(1)(va).
The reporting under this clause requires detailed verification of contracts, terms of employment, contribution records, and the timelines of payments to ensure compliance with statutory provisions.
Clause 20.1 Bonus or Commission to Employees [Section 36(1)(ii)]
Section 36(1)(ii) allows deduction for any sum paid to an employee as bonus or commission for services rendered, provided such payment is not in lieu of profit or dividend. The intent is to ensure that genuine payments made to employees for their contribution to the business are deductible, while disguised distribution of profits in the form of commission or bonus is not deductible.
Conditions for Allowability
For a payment to qualify as deductible under section 36(1)(ii), the following conditions must be met:
- The payment should be made to an employee, not to a shareholder in their capacity as a shareholder.
- The payment should be linked to services rendered by the employee.
- It should not represent distribution of profits or dividends in another form.
- The payment must be in accordance with the terms of employment or contractual obligation.
If these conditions are not satisfied, the deduction can be disallowed, and the auditor must report the same in Clause 20 of Form 3CD.
Disguised Dividend or Profit Distribution
In some cases, companies attempt to reduce taxable income by making payments in the form of commission or bonus to their shareholder-employees. If the payment is not in line with the services rendered and is instead linked to profit-sharing, the deduction is not permissible. For example, if a shareholder-director receives a commission equivalent to a fixed percentage of company profits without being linked to any specific services, such payment may be treated as a disguised distribution of profits.
Judicial precedents have clarified that payments made in such a manner do not qualify for deduction under section 36(1)(ii). The auditor must be vigilant to identify such cases during audit procedures.
Role of the Auditor
The auditor is not required to give an opinion on the allowability of the payment under this clause. The primary responsibility is to report the particulars accurately. However, in order to report correctly, the auditor must:
- Obtain a schedule from the assessee containing details of bonus and commission paid or payable to employees.
- Verify these payments against the terms of employment or contractual agreements.
- Examine whether such payments are linked to profits or represent disguised dividends.
- Report cases where the payments are not in line with employment terms or appear to be linked to profit-sharing.
By adopting this approach, the auditor ensures that reporting under Clause 20.1 remains transparent and in accordance with the requirements of the Income-tax Act and the ICAI guidance note.
Interaction with Section 43B
Even if the payment qualifies as a deductible expense under section 36(1)(ii), it must also meet the requirements of section 43B. This section allows deduction only on actual payment and within the due date of filing the return of income under section 139(1). Therefore, if a company provides for bonus or commission in its accounts but fails to pay it within the prescribed timeline, the deduction will not be allowed in the relevant year.
For reporting purposes, the details of compliance with section 43B are separately disclosed under Clause 26 of Form 3CD. Nevertheless, the auditor must ensure that the payments reported under Clause 20.1 are checked for compliance with section 43B as well.
Practical Example
Consider a company that pays its senior manager a fixed commission of two percent of sales achieved during the year. This is clearly linked to services rendered, and the deduction will be admissible under section 36(1)(ii), subject to compliance with section 43B. However, if the same company pays its director a commission equivalent to ten percent of company profits without linking it to any service or contractual obligation, such payment would be treated as disguised dividend and disallowed. The auditor must report these details in Clause 20.1.
Clause 20.2 Employee Contributions to Funds [Section 36(1)(va)]
Section 36(1)(va) deals with the treatment of employee contributions to welfare funds like provident fund, employees’ state insurance, or other similar funds. The law distinguishes between contributions made by the employer and contributions collected from employees. While employer contributions are deductible under section 36(1)(iv), employee contributions are governed by section 36(1)(va).
Nature of Employee Contributions
When an employer collects contributions from employees’ salaries towards provident fund, ESI, or other welfare funds, these amounts represent money held in trust by the employer. Since these are employees’ money, the employer has a statutory obligation to deposit them within the due dates prescribed under the relevant labor laws.
If the employer fails to deposit the contributions within the due date, the deduction is not allowed. This rule applies strictly because the employer is merely a custodian of employee contributions.
Reporting Requirements under Clause 20.2
The auditor is required to provide details of employee contributions received and verify whether they were deposited into the respective funds within the due dates prescribed under the relevant laws. The following steps are generally taken:
- Obtain schedules of employee contributions collected and deposited.
- Verify challans or payment receipts confirming the deposits.
- Check compliance with the statutory due dates prescribed under the PF Act, ESI Act, or other relevant laws.
- Report cases of delayed payment or non-payment.
The auditor must also distinguish employee contributions from employer contributions, as the latter is reported under a different clause of Form 3CD.
Effect of Delayed Payments
If the employer fails to deposit employee contributions within the prescribed due date under the respective welfare laws, the deduction will not be allowed even if the amount is paid before the due date of filing the income tax return. This distinction between employer and employee contributions has been the subject of several litigations, but the law is now clear that delayed employee contributions are not deductible.
For example, if employee provident fund contributions for the month of April are required to be deposited by the 15th of May, but the employer deposits them in June, the deduction will not be allowed. The auditor must ensure that such cases are properly reported in Clause 20.2.
Documentation and Verification
To ensure compliance with reporting requirements, the auditor should collect:
- Monthly records of employee contributions deducted from salaries.
- Bank statements and challans evidencing the actual deposit of contributions.
- Statutory due dates for each fund as per applicable laws.
The reconciliation of these documents will help identify cases of late deposit or non-deposit. The auditor must report such cases clearly in Clause 20.2 of Form 3CD.
Practical Illustration
Suppose an assessee deducts provident fund contributions from employees’ salaries every month. For the month of July, the contributions are deducted on 31st July, and the due date for deposit is 15th August. If the employer deposits the contributions on 12th August, the deduction is admissible. However, if the deposit is made on 25th August, the deduction is not allowed under section 36(1)(va). The auditor must scrutinize such instances carefully and report them.
Introduction to Clause 21
Form 3CD under the Income-tax Act requires auditors to disclose a wide range of information relating to business expenses, deductions, and disallowances. Clause 21 of Part B is one of the most detailed clauses, demanding reporting of several categories of expenditure that may be inadmissible under the Act. The intention is to ensure that items such as capital expenditure, personal expenditure, contingent liabilities, and disallowances under specific provisions are disclosed transparently.
The auditor’s role under this clause is primarily to gather information, verify supporting evidence, and report in the prescribed format. While the tax auditor is not expected to make legal conclusions, they must perform sufficient verification to ensure that all relevant transactions are properly disclosed.
Clause 21 requires disclosure across multiple heads, including disallowances under sections 40, 40A, 36(1)(iii), and 14A. Each category carries different implications, and the auditor must carefully understand the scope before completing the reporting.
Clause 21.1 Capital, Personal, and Advertisement Expenditure
Capital Expenditure
Capital expenditure refers to outlays incurred for acquiring or improving fixed assets rather than for day-to-day business operations. Since such expenditure results in creation of an asset with enduring benefit, it is not allowed as a deduction under normal business expenditure. Instead, depreciation is allowed as per section 32.
The auditor must therefore identify items debited to the profit and loss account that represent capital expenditure. Common examples include purchase of machinery, building improvements, or major software development expenses. Where such items are incorrectly classified as revenue expenditure, they must be reported in Clause 21.1.
Personal Expenditure
Personal expenses of proprietors, partners, or directors debited to the profit and loss account are not deductible under the Income-tax Act. These include household expenses, personal travel, personal insurance, or school fees paid on behalf of family members. The auditor must review the accounts carefully to identify any such expenses that have been booked in the business accounts and report them separately.
Advertisement Expenditure
While genuine advertisement expenses incurred wholly for business purposes are deductible, the law disallows certain types. For example, expenses incurred on advertisement in a souvenir or brochure published by a political party are not admissible. The auditor should review advertisement and sales promotion accounts to identify such disallowable items and report them in this clause.
Clause 21.2 Disallowance under Section 40(a) – Non-deduction of TDS
Scope of Section 40(a)
Section 40(a) disallows certain payments when tax is deductible at source but has either not been deducted or has not been deposited within the prescribed time. The disallowance applies to payments such as interest, commission, brokerage, rent, fees for professional services, and payments to non-residents.
Auditor’s Responsibilities
The auditor must verify whether tax has been deducted wherever applicable, whether it has been deposited into the government account, and whether returns in Form 24Q, 26Q, or 27Q have been filed.
If tax has not been deducted or deposited, the corresponding expenditure must be reported under Clause 21.2. However, if the assessee furnishes a certificate in Form 26A from another Chartered Accountant confirming that the recipient has declared the income in their return and paid taxes, then the disallowance is not attracted. The auditor must verify the presence of such certificates before excluding the item.
Practical Illustration
Consider a company paying professional fees of 5,00,000 to a consultant but failing to deduct tax under section 194J. Unless Form 26A is obtained confirming that the consultant has offered this income to tax, the entire amount is disallowed under section 40(a). The auditor must report this transaction under Clause 21.2.
Clause 21.3 Disallowance under Section 40(b) and 40(ba) – Payments to Partners or Members
Scope of Section 40(b)
In the case of a partnership firm, remuneration, interest, salary, commission, or bonus paid to partners is subject to strict limits. The Income-tax Act specifies that such payments are allowed only if authorized by the partnership deed and subject to certain ceilings.
The auditor must examine the partnership deed and verify that:
- Interest is not more than 12 percent simple interest per annum.
- Remuneration is within the prescribed limits based on book profits.
Any excess or unauthorized payment must be reported as disallowance.
Scope of Section 40(ba)
For association of persons or body of individuals, similar provisions apply with respect to payments to members. These payments must also be reported if inadmissible.
Clause 21.4 Disallowance under Section 40A(3) – Cash Payments
Limits on Cash Payments
Section 40A(3) disallows any expenditure where payment exceeding 10,000 is made to a single person in a day otherwise than by account payee cheque, draft, or electronic mode. In the case of payments for goods carriage business, the threshold is 35,000.
Exceptions under Rule 6DD
Certain exceptions are provided under Rule 6DD, such as payments made in villages without banking facilities, payments to government agencies, or in cases of business exigencies. The auditor must verify whether the assessee has correctly applied these exceptions.
Auditor’s Procedures
The auditor should scrutinize cash book entries, vouchers, and supporting invoices to identify payments exceeding the threshold. Where no exception applies, such payments must be reported in Clause 21.4.
Clause 21.5 Disallowance of Provisions for Gratuity – Section 40A(7)
Treatment of Gratuity
The law disallows provisions for gratuity unless the employer has made actual payment during the year or contributed to an approved gratuity fund. A mere provision in the books without corresponding payment is not deductible.
Auditor’s Role
The auditor must review the gratuity provision account, the trust deed of gratuity fund if any, and approval orders issued by the Commissioner of Income-tax. Only provisions made towards an approved gratuity fund are admissible. All other provisions must be reported under Clause 21.5.
Clause 21.6 Payments Disallowed under Section 40A(9)
Nature of Payments
Section 40A(9) disallows payments made by an employer towards unapproved funds, trusts, or societies created for employee welfare, unless specifically allowed under section 36(1)(iv) or section 36(1)(v). Contributions made to unrecognized funds or schemes are therefore inadmissible.
Verification by Auditor
The auditor must examine contributions made by the employer to various funds, confirm whether they are approved by the Commissioner of Income-tax, and report inadmissible contributions separately in Clause 21.6.
Clause 21.7 Contingent Liabilities
Definition and Treatment
A contingent liability is an obligation dependent on future events and not certain as on the balance sheet date. Since contingent liabilities do not represent actual expenditure or accrued obligations, they are not deductible.
If any contingent liability is charged to the profit and loss account, it must be reported under Clause 21.7. Common examples include provisions for disputed claims or guarantees given.
Auditor’s Verification
The auditor must review the notes to accounts, provisions made in the books, and management explanations to determine whether contingent items have been charged to profit and loss. If such items are found, they must be reported in this clause.
Clause 21.8 Expenditure Disallowed under Section 14A
Scope of Section 14A
Section 14A disallows expenditure incurred in relation to income that does not form part of total income, such as exempt dividend income or agricultural income. The law requires the assessee to identify and disallow such expenditure.
Where the assessing officer is not satisfied with the correctness of the claim, disallowance may be computed using Rule 8D.
Auditor’s Duties
The auditor should obtain details of exempt income and the basis of expenditure allocation submitted by management. Though the auditor is not expected to compute disallowance independently, they must verify that reasonable steps have been taken and report the particulars.
Clause 21.9 Disallowance under Proviso to Section 36(1)(iii) – Interest on Borrowings for Capital Assets
Scope of the Proviso
The provision to section 36(1)(iii) disallows deduction for interest on borrowings used for acquisition of capital assets until the date such asset is first put to use. The intention is to prevent claiming deduction for interest on assets that are not yet productive.
Auditor’s Verification
The auditor must review loan agreements, asset acquisition details, and capitalization records to identify interest that relates to pre-usage periods. Such interest is required to be capitalized under Accounting Standard 16 or Ind AS 23 and not charged as revenue expenditure. The auditor must report inadmissible interest separately in Clause 21.9.
Clause 20 Advanced Issues
Bonus and Commission Payments Linked with Profit
One of the recurring concerns under section 36(1)(ii) is whether bonus or commission paid to employees is genuinely in connection with services rendered or whether it is a disguised distribution of profits. Payments structured as a percentage of profits often attract scrutiny. Judicial precedents emphasize that if such payments are made to shareholder-employees without a direct link to services, they may be regarded as appropriation of profit.
Auditors must therefore analyze the terms of employment, resolutions of the board or partners, and actual service rendered. Merely citing that commission is linked to company performance is not sufficient; it must be demonstrated that services were integral to business operations.
Distinction Between Employee and Non-employee Payments
Payments to managing directors or whole-time directors sometimes blur the line between employer-employee relationship and contractual relationship. If remuneration is paid under a contract of service, it qualifies under employee bonus or commission. However, if payments are made under a contract for service, they may fall outside the ambit of section 36(1)(ii).
This distinction has implications not only for disallowance but also for reporting under Clause 20. The auditor should review employment agreements, board minutes, and payment structures to arrive at a clear classification.
Employee Contributions to Provident Fund and ESI
Section 36(1)(va) requires that employee contributions deducted from salaries must be deposited with the respective funds before the due date under the relevant law. Courts have consistently distinguished between employee contributions and employer contributions. Delayed deposits of employee contributions have been disallowed, regardless of whether they were deposited before the due date of filing return under section 139(1).
Auditors must therefore obtain reconciliation of deductions made and deposits with statutory authorities, along with challans and electronic filings. Where delays exist, they must be reported in Clause 20.2, even if management argues that judicial interpretations differ.
Clause 21 Advanced Issues
Capital Expenditure Mistaken as Revenue
Businesses often classify repair and maintenance expenses as revenue even though they result in substantial improvement in the asset. For example, overhauling factory machinery or renovating office premises may create enduring benefits. Auditors must critically examine repair bills, work contracts, and supporting vouchers to assess whether they are revenue or capital.
If such items are wrongly debited to a profit and loss account, the amounts must be reported under Clause 21.1. Failure to identify such classification errors can materially impact the computation of taxable income.
Disallowances under Section 40(a) – Practical Challenges
The provisions of section 40(a) present multiple challenges for auditors. Firstly, businesses often make composite payments without segregating the element on which tax was deductible. For instance, a contract for supply and installation may have both goods and service elements. If tax is not deducted correctly, disallowance may arise.
Secondly, obtaining Form 26A from recipients to avoid disallowance involves practical delays. Auditors must ensure that such certificates are genuine and supported by recipient returns. This requires reconciliation with TRACES data and review of TDS filings.
Finally, for payments to non-residents, complexities of double taxation avoidance agreements, permanent establishment rules, and tax treaties must be considered. The auditor is expected to verify whether tax was correctly withheld and whether the assessee relied on treaty provisions.
Remuneration to Partners and Interest Restrictions
Section 40(b) permits interest and remuneration to partners only if authorized by the partnership deed and within specified limits. Problems often arise when the partnership deed is silent on remuneration or when retrospective amendments are made. Judicial precedents clarify that retrospective changes in the partnership deed cannot validate past payments.
Auditors must check the original deed and amendments filed with registrar of firms, and verify whether computation of book profits has been correctly carried out for remuneration ceilings. Incorrect computation or excessive payment must be reported in Clause 21.3.
Cash Payments and Rule 6DD Exceptions
Although section 40A(3) disallows cash payments above prescribed limits, genuine business exigencies may still require cash settlements. Rule 6DD lists exceptions such as payments in rural areas, payments to government institutions, or situations where banking channels are not available.
Auditors should examine whether claimed exceptions are substantiated with adequate evidence such as location of supplier, absence of banking facilities, or urgent business circumstances. Unsupported claims cannot be accepted. Each violation must be reported under Clause 21.4, even if management insists it was unavoidable.
Gratuity and Unapproved Funds
Section 40A(7) disallows provisions for gratuity unless supported by actual payment or contribution to an approved fund. Similarly, section 40A(9) disallows employer contributions to unapproved funds or trusts. Many businesses create welfare schemes or group insurance arrangements that are not formally approved. These need to be carefully scrutinized.
The auditor should obtain trust deeds, approval orders, and confirmation from management on the status of funds. In absence of approval, contributions must be reported as disallowable under Clause 21.5 or 21.6.
Contingent Liabilities and Provisioning Practices
A frequent area of misreporting is creation of provisions for disputed liabilities, claims under litigation, or guarantees. If such provisions are charged to profit and loss account, they represent contingent liabilities and are inadmissible.
Auditors should compare current year provisions with prior year disclosures, examine legal correspondence, and verify whether liabilities have crystallized. Only crystallized liabilities are deductible. Misclassified contingent provisions must be highlighted under Clause 21.7.
Section 14A and Expenditure on Exempt Income
The disallowance under section 14A remains contentious. Businesses with substantial investments generating exempt dividend income are expected to identify expenditure incurred in relation to such income. Many assessees argue that no expenditure was incurred. However, if borrowings are used or management time is devoted, an allocation must be made.
Rule 8D provides a formula when the assessing officer is not satisfied with the assessee’s claim. Auditors must obtain working of management, examine borrowings, investment policies, and administrative costs. They must report the particulars of expenditure considered by management, even though final computation may be subject to assessment.
Interest Disallowance on Capital Assets
Section 36(1)(iii) allows deduction for interest on borrowings used for business, but the proviso disallows such interest till the asset is put to use. Many businesses claim deduction for interest on loans taken for construction of buildings or acquisition of machinery even before commencement of operations.
Auditors must review capitalization of interest, project cost statements, and fixed asset register. If any interest is wrongly debited to a profit and loss account, it must be reported under Clause 21.9.
Audit Procedures and Documentation
Information Gathering
The starting point for audit under Clauses 20 and 21 is to obtain detailed schedules of payments, provisions, and deductions from management. These include:
- Employee bonus and commission statements.
- PF and ESI challans.
- TDS deduction and payment records.
- Details of partner remuneration and interest.
- Cash book and vouchers for payments above threshold.
- Contribution to gratuity and welfare funds.
- Investments and exempt income details.
- Loan agreements and interest computations.
Verification Techniques
Auditors must reconcile these details with statutory returns such as TDS statements, provident fund returns, and income-tax filings. Third-party confirmations, legal documents, and supporting invoices must be checked. Analytical review procedures can also help identify unusual or high-value items that warrant closer scrutiny.
Reliance on Management Representation
Since many disallowance-related items involve interpretation, auditors often rely on written management representation. For example, in relation to section 14A or contingent liabilities, management may provide a written statement of the basis of computation. While reliance on such representation is permitted, auditors must also apply professional skepticism and ensure documentation is adequate.
Reporting in Form 3CD
The ultimate responsibility is to report in the specified format of Form 3CD. Auditors must ensure that particulars are filled accurately, amounts are cross-referenced, and notes are added where necessary. Reporting does not mean certifying allowability or disallowability; it is a disclosure exercise enabling the assessing officer to take a view.
Conclusion
The reporting obligations under Clause 20 and Clause 21 of Form 3CD form the backbone of the tax audit process, ensuring that employee-related deductions, statutory contributions, capital or personal expenses, and specific disallowances under the Income-tax Act are transparently disclosed. These clauses require auditors to strike a careful balance between factual reporting and professional judgment. While the tax auditor is not expected to provide a conclusive opinion on the allowability of expenses, they are responsible for verifying the details, reconciling them with statutory records, and presenting accurate particulars for assessment purposes.
Clause 20 primarily addresses payments to employees, including bonus, commission, and contributions to provident fund, ESI, and other funds. Here, the auditor’s role extends beyond mere verification of payments to ensuring that these outflows are genuinely linked to services rendered and that statutory deadlines for deposit are adhered to. The distinction between permissible deductions and disguised distribution of profits remains an area requiring sharp professional scrutiny.
Clause 21 widens the scope of review, requiring auditors to examine disallowances under a series of provisions including section 40(a) for TDS defaults, section 40(b) for partner remuneration, section 40A for cash payments and welfare fund contributions, section 14A for expenditure relating to exempt income, and section 36(1)(iii) for interest on borrowings for capital assets. In each of these, the auditor is required to carefully review supporting evidence, statutory approvals, and management workings to ensure that the details reported are complete and reliable.
Practical challenges such as delays in deposit of employee contributions, non-availability of Form 26A, classification disputes between capital and revenue expenditure, and claims of exemptions under Rule 6DD demand a robust audit methodology. Professional skepticism, adequate documentation, and reliance on management representations, wherever unavoidable, remain critical safeguards in meeting the auditor’s responsibility.
The ICAI’s Guidance Note emphasizes that reporting under Clauses 20 and 21 is primarily disclosure-based, empowering tax authorities to make informed decisions during assessment. The auditor, therefore, acts as a bridge between the assessee and the tax department by ensuring that relevant information is correctly captured in the audit report. By adhering to statutory requirements, established case law, and best practices in auditing, professionals can ensure that the tax audit exercise achieves its objective of enhancing compliance, transparency, and reliability in the computation of taxable income.