section 40a l expenses or payments not deductible

382. Disallowance of expenditure for which payment exceeding Rs. 2,500¹ is made otherwise than by crossed cheque/bank draft under sub-section (3), read with rule 6DD of the Income-tax Rules - Scope and operation of the sub-section explained

clarification 1

1. The Ministry of Finance have received enquiries from various trade associations and members of the public about the operation of the new provision in section 40A(3) for the disallowance of expenditure in business and professions for which a payment exceeding Rs. 2,500¹ is made otherwise than by a crossed cheque or bank draft.

2. The above provision applies to payments made on or after April 1, 1969. Certain categories of payments have been excluded from its operation. These exclusions have already been notified by the Central Board of Direct Taxes in the Gazette of India, Extraordinary, dated 14-2-1969² and the Gazette of India, Extraordinary, dated 25-3-1969. Broadly, the following categories of payments have been excluded from the operation of the above provisions :

u Payments which under contracts entered into before April 1, 1969, have to be made in cash

u Payments by book adjustment by the taxpayer in the account of the payee against money due to the taxpayer for any goods supplied or services rendered by him to the payee

u Payments made in villages and towns having no banking facilities, to persons ordinarily residing or carrying on business or profession in any such village or town

u Payments made to cultivators, growers or producers for purchase of agricultural or forest produce, animal husbandry products including hides and skins, products of dairy or poultry farming, products of horticulture or epiculture, ³[fish or fish products] and products of any cottage industry run without the aid of power

u Payments made to the Reserve Bank of India, State Bank of India, other banking institutions, including co-operative banks and land mortgage banks, primary credit societies, including agricultural credit societies, Life Insurance Corporation, Unit Trust of India and specified financial institution

u Certain categories of payments made through the banking system, e.g., letters of credit, mail or telegraphic transfers, book adjustments and bills of exchange made payable only to a bank

u Payments of terminal benefits, e.g., gratuity, retrenchment compensation, etc., to low-paid employees or to members of their families

u A residuary exception is also provided in respect of payments which could not be made by crossed bank cheque or draft due to exceptional and unavoidable circumstances, provided the taxpayer furnishes evidence as to the genuineness of the payment and the identity of the payee.

3. The points on which enquiries have been made, and clarifications in the matter are given below :

Question 1 : Does the requirement of making payments over Rs. 2,500 by cheque or draft apply also to payments made for purchase of goods for the business?

Answer : Yes, the provisions apply to all categories of expenditure involving payments for goods or services, which is deductible in computing the taxable income.

Question 2 : Does the requirement apply also to loan transactions?

Answer : No, because advancing of loans or repayment the principal amount of the loan do not constitute expenditure deductible in computing the taxable income. However, interest payments in amounts exceeding Rs. 2,500 at a time are required to be made by crossed bank cheques or drafts, as interest is a deductible expenditure.

Question 3 : Does the requirement apply to payments made by commission agents (arhatias) for goods received by them for sale on commission or on consignment basis ?

Answer : No, this is because such a payment is not an expenditure deductible in computing the taxable income of the commission agent (arhatiya). For the same reason, the requirement does not also apply to advance payments made by the commission agent to the party concerned against supply of goods. However, where a commission agent (arhatiya) purchases goods on his own account, and not on commission basis, the requirement will apply in that case.

Question 4: Does the requirement apply to payments made for goods purchased on credit?

Answer : Yes, if the payment is made in an amount exceeding Rs. 2,500 at a time.

Question 5: What categories of hundi payments are excluded from the operation of the requirement in section 40A(3)?

Answer : Hundi transactions entered into in connection with the advancing of loans or the repaying of loans are outside the scope of the provisions because such transactions do not constitute expenditure deductible in computing the taxable income—vide answer 2 above.

Payments for goods or services made by a bill of exchange (hundi) where the hundi is made payable only to a bank, have been specifically excluded from the operation of section 40A(3) under the Notification in the Gazette of India, Extraordinary, dated 14-2-1969.

Question 6 : Are payments made to the grower or producer of agricultural products excluded from the operation of section 40A(3) even where these have been subjected to some processing by him?

Answer : Yes, payments made to the grower or producer of agricultural or forest produce, produce of animal husbandry, dairy or poultry farming, etc., have been specifically excluded from the requirement in section 40A(3) by the Gazette Notification, dated 14-2-1969, read with the corrigenda published in the Gazette of March 25,1969.

Thus, payments made to a grower or producer of kapas ginned by him or to a grower of paddy which has been converted by him into rice, are excluded from this provision.

Question 7 : Are payments, made in towns having banking facilities, for purchase of goods from villager whose village does not have banking facilities, excluded from the requirement in section 40A(3)?

Answer : No, because in such a case, the payment is made in a town having banking facilities. If the payment is made to the villager in the village in which he is residing and where there are no banking facilities, the requirement in section 40A(3) will not apply.

Press Note : Dated 2-5-1969, issued by Ministry of Finance.

clarification 2

A further relaxation has been made in the provision in the Income-tax Rules requiring payments for business expenses exceeding Rs. 2,500¹ to be made by crossed cheques or drafts.

The relaxation cover payments in cash in excess of Rs. 2,500¹ made with a view to avoid difficulty to the payee or where it was not practicable to pay in cheque or draft [rule 6DD(j)]². The availability of this benefit depends upon the nature of transaction as well as the need for its expeditious settlement. The assessee making such payments is, however, required to satisfy the Income-tax Officer about the genuineness of the payment and the identity of the payee.

Background -The Income-tax Act contains a provision in section 40A(3) which requires that payments for business expenditure in amounts exceedingRs. 2,500¹ should be made by crossed bank cheque or draft in order to qualify for deduction in computing the taxable profits. With a view to avoiding genuine hardship to taxpayers, particularly in the rural areas, certain exceptions were notified under rule 6DD by virtue of which payment in a sum exceeding Rs. 2,500¹ may be made otherwise than by a crossed cheque drawn on a bank or a crossed bank draft in certain circumstances.

These exceptions cover, inter alia, payments made for purchases of agricultural or forest produce, cottage industry products, etc., from the producers of such products; payments made in villages or towns having no banking facility to any person carrying on business or profession in any such village or town; payments made through the banking system, that is, in the form of letter of credit arrangements, telegraphic transfers, adjustments in accounts, or bills of exchange made payable only to a bank; and payments by way of gratuity, retrenchment compensation or other terminal benefits to low-paid employees of the business or profession.

There is also a residuary exception under clause (j) of rule 6DD which provides that the provision for the disallowance of the expenditure might not be applied if the assessee (i) establishes that the payment could not be made by crossed bank cheque or draft due to exceptional or unavoidable circumstances, and (ii) also furnishes evidence to the satisfaction of the Income-tax Officer as to the genuineness of the payment and the identity of the payee.

After considering representations from various quarters that the existing exceptions were not helpful in preventing disallowance of substantial payments for purchases of commodities on the ground that these were made in cash in amounts exceeding Rs. 2,500, the Central Board of Direct Taxes have now liberalised this residuary clause (j) of rule 6DD so as to avoid disallowance of such payments in genuine cases.

Press Note : Dated 19-11-1970, issued by Ministry of Finance.

clarification 3

1. The Board had occasion to deal with several representations from various chambers of commerce, trade associations and businessmen regarding the scope of provisions of section 40A(3) and rule 6DD. Since many of the points raised therein are of an important nature, the clarifications given thereon are summarised below.

2. The provisions of section 40A(3) would apply in computing the income under the heads “Profits and gains of business or profession” and “Income from other sources” as per section 58(2). All payments in excess of Rs. 2,500 at one time whether for goods or services obtained for cash or credit, which are deductible in computing the income, have to be made by crossed cheque or bank draft. Thus, the price of goods purchased for resale or use in manufacturing process or payments for services will be covered by the provisions of section 40A(3). However, the section will not apply to repayment of loans or payment towards the purchase price of capital assets such as plant and machinery not for resale.

3. A large portion of trade in agricultural commodities is channelled through the institution of “arhatias”. While the payments made to the cultivators or growers of agricultural produce are specifically excluded from the purview of section 40A(3) by clause (f) of rule 6DD, the payments made to the “arhatiya” for purchases made from him are not so exempted. It is contended that the “arhatiy” is not in a position to pay the cultivators in cash until the cheques are encashed and this procedure involves severe hardship. However, this difficulty can be met by obtaining the advances from the purchasers, which should of course conform to requirements of section 40A(3). The extension of the exemption to the purchases would defeat the objective of the provisions.

4. So far as payments made to the railways on account of freight charges or for booking of wagons, and payment of sales tax, excise duty, are concerned, clause (b) of rule 6DD specifically exempts such payments from the purview of section 40A(3) if, under the rules framed by the Government, these are required to be made in legal tender.

Circular : No 34 [F. No. 13A/92/69-IT(A-II)], dated 5-3-1970.

clarification 4

Section 40A(3) requires that if any payment in a sum exceeding Rs. 2,500¹ in respect of an expenditure incurred after March 31, 1969 is made otherwise than by a crossed cheque drawn on a bank or by a crossed bank draft, such expenditure shall not be allowed as a deduction. It has now been represented to the Board that the entries in bank pass book do not specifically indicate whether the payment made is by a bearer or crossed cheque. The cheques after their encashment are retained by the bank and cannot be produced before the assessing authorities to prove that the payments have been made by crossed cheques.

2. The difficulty pointed out has been considered by the Board in consultation with the Department of Banking and it has been decided that the banks may now return the paid cheques to their constituents after obtaining a formal undertaking from them to the effect that they shall retain the returned paid cheques for a period of eight years and produce them before the Income-tax Officer whenever called upon to do so.

Circular : No 33 [F. No. 9/50/69-IT (A-II) ], dated 29-12-1969.

383. Date specified for the purposes of disallowance under sub-section (3)

In pursuance of sub-section (3) of section 40A of the Income-tax Act, 1961 (43 of 1961), the Central Government specifies the 31st day of March, 1969 as the date for the purposes of that section.

Notification : SO 623, dated 14-2-1969.

384. Payment made during the period when cheque clearing operations by banks suspended - Whether covered under sub-section (3)

clarification 1

1. Representations have been received from the members of public, chambers of commerce, etc., pointing out the hardship resulting from the operation of the provisions of section 40A(3) in view of the difficulties in clearance of cheques issued on banks.

2. Sub-section (3) of section 40A provides for the disallowance of expenditure incurred in business or profession for which payment is made in an amount exceeding Rs. 2,500¹ otherwise than by a crossed cheque drawn on a bank or a crossed bank draft.

3. Under clause (j) of rule 6DD the provision in section 40A(3) will not be applied by the Income-tax Officer where he is satisfied that the payment could not be made by crossed bank cheque or draft due to “exceptional or unavoidable circumstances” and the assessee furnishes evidence as to the genuineness of the payment and the identity of the payee. The hold-up in cheque clearing operations in the banks or any other similar circumstances which is likely to cause reasonable apprehension in the mind of the payee that the crossed cheque/bank draft will not be cleared expeditiously would constitute “exceptional or unavoidable circumstances” within the meaning of clause (j) of rule 6DD. Accordingly, any payment for business expenditure made during the period when the cheque clearing operations are suspended or other similar circumstance as aforesaid exists, will not be covered by the provisions of section 40A(3) provided the assessee furnishes evidence to the satisfaction of the Income-tax Officer as to the genuineness of the payment and the identity of the payee.

Circular : No. 250 [F. No. 206/1/79-IT(A-II)], dated 11-1-1979.

clarification 2

Under clause (j) of rule 6DD, the provisions in section 40A(3) will not be applied by the Income-tax Officer where he is satisfied that the payment could not be made by crossed bank cheque or draft due to exceptional or unavoidable circumstances and the assessee furnishes evidence as to the genuineness of the payment and the identity of the payee. The suspension of cheque clearing and banking operations consequential to the strike of bank employees will constitute “exceptional or unavoidable circumstances.” Accordingly, payments for business expenditure made during this period, and until clearance of cheques is resumed, will be excepted from the operation of section 40A(3), subject to the other requirements that the payment is genuine and the identity of the payee is also established to the satisfaction of the Income-tax Officer. You may inform all your members, accordingly.

Letter : F. No. 142 (14)/70-TPL, dated 28-9-1970.

385. Whether the word “expenditure” in sub-section (3) covers payments made in advancing loan and returning principal amount

The word “expenditure” in section 40A(3) covers expenditure of all categories including that on purchase of goods and merchandise as also payment for services. Under the provisions of rule 6DD, notified on February 14, 1969, no disallowance under section 40A(3) shall be made where any payment is made for the purchase of agricultural produce in a sum exceeding Rs. 2,500 otherwise than by a crossed bank cheque drawn on a bank or by a crossed bank draft if the payment is made to the cultivator or grower of such produce. Payments to middlemen for the purchase of agricultural produce do not as such come under the exceptions enumerated in rule 6DD. However, payments made in a town or village having no banking facilities to any person residing in or carrying on any business or profession in any such village or town, are also exempted from the purview of section 40A(3). In this connection, reference is also invited to the residuary exception in clause (j) of the new rule 6DD.

2. The payments made in advancing loans and returning the principal amount of borrowed moneys are not covered by these provisions of section 40A(3), as these do not constitute expenditure.

Letter : F. No. 1(22)/69-TPL(Pt.), dated 18-4-1969.

386. Circumstances when Income-tax Officer can relax requirement of making payments in excess of Rs. 2,500¹ by crossed cheques under clause (j)² of rule 6DD

1. Clause (j) of rule 6DD provides that no disallowance under section 40A(3) shall be made where the assessee satisfies the Income-tax Officer that the payment could not be made by way of a crossed cheque drawn on a bank or by a crossed bank draft—

a. due to exceptional or unavoidable circumstances; or

b. because payment in the manner aforesaid was not practicable, or would have caused genuine difficulty to the payee, having regard to the nature of the transaction and the necessity for expeditious settlement thereof,

and also furnishes evidence to the satisfaction of the Income-tax Officer as to the genuineness of the payment and the identity of the payee.

2. It would be seen that where payment of a sum exceeding Rs. 2,500 is made, otherwise than by a crossed cheque/draft, the assessee besides furnishing evidence as to the genuineness of the payment and the identity of the payee, is required to satisfy the Income-tax Officer that his case falls under any one of the circumstances mentioned in (a) and (b) above, if he claims that no disallowance should be made under section 40A(3).

3. Various representations have been received by the Board regarding the difficulties that are being experienced by the taxpayers due to lack of uniformity in the interpretation of the provisions of rule 6DD(j) by the Income-tax Officers. The Board have considered these representations and have decided to lay down certain guidelines to ensure uniformity of approach among the Income-tax Officers in this behalf.

4. All the circumstances in which the conditions laid down in rule 6DD(j) would be applicable cannot be spelt out. However, some of them which would seem to meet the requirements of the said rule are :

a. the purchaser is new to the seller, or

b. the transactions are made at a place where either the purchaser or the seller does not have a bank account; or

c. the transactions and payments are made on a bank holiday; or

d. the seller is refusing to accept the payment by way of crossed cheque/draft and the purchaser’s business interest would suffer due to non-availability of goods otherwise than from this particular seller; or

e. the seller, acting as a commission agent, is required to pay cash in turn to persons from whom he has purchased the goods; or

f. specific discount is given by the seller for payment to be made by way of cash.

5. It can be said that it would, generally, satisfy the requirements of rule 6DD(j), if a letter to the above effect is produced in respect of each transaction falling within the categories listed above from the seller giving full particulars of his address, sales tax number/permanent account number, if any, for the purposes of proper identification to enable the Income-tax Officer to satisfy himself about the genuineness of the transaction. The Income-tax Officer will, however, record his satisfaction before allowing the benefit of rule 6DD(j).

6. It is further clarified that the above circumstances are not exhaustive but illustrative. There could be cases other than those falling within the above categories which would also meet the requirements of rule 6DD(j).

Circular : No. 220 [F. No. 206/17/76-IT (A-II)], dated 31-5-1977.

JUDICIAL ANALYSIS

Explained in - The abovesaid circular was explained in CIT v. Avtar Singh & Sons [1992] 194 ITR 80 (Punj. & Har.) with the following observations :

“The said circular was noticed and considered in Navsari Waste Cotton Products v. CIT [1987] 163 ITR 378 (Guj.), where it was held that it would appear from clauses (i) to (v) of paragraph 4 of the said circular that if the identity of the seller is known, it would be possible for the Department to cross-check if the payment in question was actually made in cash to the seller from whom goods were purchased and the requirements of rule 6DD(j) would stand satisfied if a letter is produced from the seller in respect of each transaction falling within the categories illustrated in paragraph 4 giving full particulars of his address, sales tax registration number, if any, for the purposes of proper identification to enable the Income-tax Officer to satisfy himself about the genuineness of the transaction. It was further added that the circumstances indicated in paragraph 4 of the circular were merely illustrative and not exhaustive, but the underlying idea was that if the seller’s identity can be established, it would be possible for the Income-tax Officer to cross-check whether the transaction had, in fact, taken place as stated and was of a genuine nature.

A similar view is expressed by the High Court of Calcutta in Girdharilal Goenka v. CIT [1989] 179 ITR 122, where it was observed that (at p. 128):‘The circular of the Board is not exhaustive, it is only illustrative and the Assessing Officer has to take into account the surrounding circumstances, considerations of business expediency and the facts of each particular case in exercising his discretion either in favour or against the assessee’. It was also held that the Income-tax Officer should take a practical approach to the problem and strike a balance between the direction of law and hardship to the assessee.” (p. 83)

Explained in - The above circular was explained in Navsari Waste Cotton Products v. CIT [1987] 163 ITR 378 (Guj.) with the following observations :

“. . . The cases indicated in paragraph 4 are merely illustrative and not exhaustive but the underlying idea is that if the seller’s identity can be established, it would be possible for the Income-tax Officer to cross-check whether the transaction in fact had taken place as stated and was of a genuine nature. Even though this circular came to be issued in May, 1977, the assessee is justified in pressing it into aid as the circular merely indicates the circumstances in which rule 6DD(j) would be attracted.” (p. 380)

Explained in - The abovesaid circular was commented upon Girdharilal Goenka v. CIT [1989] 179 ITR 122 (Cal.) with the following observations :

“. . . The circular of the Board is not exhaustive but only illustrative. The Income-tax Officer has to take a pragmatic view of the matter. The Income-tax Officer should take a practical approach to problems and strike a balance between the direction of law and hardship to the assessee. He should not enmesh himself in technicalities. After all, the object is not to deprive the assessee of the deduction which he is otherwise entitled to claim. Where the amount was paid in cash or received in cash, the Assessing Officer has to find out whether the transaction is genuine or not and if he finds that the transaction is genuine, he should allow the deduction. The circular of the Board is not exhaustive; it is only illustrative and the Assessing Officer has to take into account the surrounding circumstances, considerations of business expediency and the facts of each particular case in exercising his discretion either in favour or against the assessee. There may be an oral agreement between the assessee and the seller for payment in cash. A seller may not be willing to accept cheques; cash payment may be made at the request of the payee who is also an assessee and a certificate to that effect filed; absence of banking facilities in places where cash payments are made. All such cases would come within the purview of exceptional or unavoidable circumstances.” (p. 128)

Explained in - In CIT v. Trinity Traders [1987] 163 ITR 381 (Guj.), the above circular was referred to with the following observations :

“The circular makes it clear that these are merely illustrative instances of cases in which rule 6DD(j) would be applicable. The circular also points out that the requirements of rule 6DD(j) can be satisfied if a letter to the above effect is produced in respect of each transaction falling within the categories listed above from the seller giving full particulars of his address, sales-tax number/permanent account number, if any, for the purposes of proper identification to enable the Income-tax Officer to satisfy himself about the genuineness of the transaction . . . .” (p. 384)

Explained in - The abovesaid circular was commented upon in Badrilal Phool Chand Rodawat v. CIT [1987] 167 ITR 404 (Raj.) with the following observations :

“It is no doubt true that the said circular was not available at the time when the Income-tax Officer passed the assessment order and the Appellate Assistant Commissioner considered the appeal of the assessee. The guidelines contained in the said circular can, in our opinion, be taken into account for the purpose of considering as to whether the payments in question can be regarded as falling within the ambit of rule 6DD(j) of the Rules.” (p. 410)

Explained in - The above circular was referred to in Venkata Satyanarayana Timber Depot v. CIT [1987] 165 ITR 253 (AP) with the following observations :

“. . . On the merits, we are satisfied that the assessee is entitled to exemption for the payments in view of rule 6DD(j) read with clause 4(ii) of Circular No. 220, dated May 31, 1977 of the Central Board of Direct Taxes....” (p. 254)

Explained in - In Rajarajeswari Weaving Mills v. ITO [1978] 113 ITR 405 (Ker.), the above circular was referred to with the following observations :

“. . . We do not wish to get enmeshed in the intricacies as to the exact scope and purview of a circular under section 119 of the Income-tax Act, and as to whether, and, if so, to what extent, such a circular can fetter the judicial or quasi-judicial discretion of authorities functioning under the Act. In this particular case, the circular that we have noticed earlier is dated May 31, 1977, and the order of the Commissioner with respect to which the question has arisen in these appeals is dated June 21, 1976. It is obvious, therefore, that the circular in question can have no application to these cases. We are not impressed by the argument of the assessee that the circular is only clarificatory or declaratory.” (pp. 409-410)

See also CIT v. Union Agencies [1987] 166 ITR 529 (Delhi).

relied on in - The above circular was relied on in Ingenieurs & Agents v. ITO [1984] Taxation 72(6A) - II (All. - Trib.), for disallowing the assessee’s claim for deduction.

applied in - The above circular was referred to and applied in Tatikonda Subba Rao v. ITO [1987] 28 TTJ (Hyd.) 146, 150.

Explained in - The above circular was explained in S. Venkata Subba Rao v. CIT [1988] 173 ITR 340 (AP), with the following observations :

“Mr. Y. Ratnakar relied upon a circular issued by the Central Board of Direct Taxes, being Circular No. 220, dated May 31, 1997 ([1997] 108 ITR (St.) 8). We have perused the said circular. It only elaborates and illustrates—though not exhaustively—the circumstances in which it is not practicable to comply with the requirements of section 40A(3). The circular nowhere says that it is not necessary for a person claiming the benefit of rule 6DD(j) to establish the genuineness of the payment and the identity of the payee. On the contrary, the said requirement is repeatedly reiterated. We are, therefore, of the opinion that the said circular cannot in any manner advance the case of the assessee.” (p. 345)

Explained in - The above circular was explained in Paul Bros. v. CIT [1990] 186 ITR 356 (Gauhati), with the following observations :

“Pursuant to the provision in sub-section (3) of section 40A, rule 6DD was promulgated and Circular No. 220 was issued by the Central Board of Direct Taxes on May 31, 1977. Section 40A, rule 6DD and the Circular No. 220 recite that after March 31, 1969, any payments on account of expenditure of more than Rs. 2,500 will have to be made by a crossed cheque or by a crossed bank draft unless exempted by the revenue authorities. . . .

The Indian Parliament incorporated the above provisions to check evasion of taxes. Even in genuine cases where payments are shown to have been made in cash, the assessee is put to the necessity to prove that in the area of business, banking facilities are not adequate. Therefore, impelled by genuine difficulty, the assessee had to make payment in cash. The same idea is writ large in the Rules. The assessee will have to show that there was no way left for the assessee except to pay in cash. In the nature of things whether in the statute, rules or circulars, all the contingencies cannot be enumerated exhaustively. Parliament referred to the inadequacy of facilities in section 40A. The rule-making authorities illustrated some of the circumstances in the Rules. The Revenue supplemented the further circumstances when exemption can be claimed and allowed. (pp. 357-358)

applied in - The above circular was applied in Dhorajia Construction Co. v. ITO [1991] 92 CTR (Trib.) (Ahd.) 51, with the following observations :

“. . . In the paper book we find that the three sub-contractors appear to have agreed to take up the work from the assessee-firm on the clear understanding that payments to them, as and when needed, shall have to be made in cash as they would be requiring cash for payment to the labourers who were executing the work on site. The site of the work was admittedly at about 12 Km. away from the place where bank facilities were available to the parties. Looking to the nature of the business of the assessee-firm, the insistence of the sub-contractors who received payments in cash in order to enable them to pay cash to the labourers on site, the provisions of r. 6DD(j) read with the Circular of the Board applies for the benefit of the assessee-firm. . . .” (p. 62)

relied on in - The above circular was relied on in ITO v. New Card Board Industries [1992] Tax LR 80 (Cal. - Trib.), and the Tribunal remitted the matter to the Assessing Officer for examining the documents produced for the first time by the assessee before the Tribunal.

relied on in - The above circular was relied on in CIT v. Meghdoot Sales [1993] 200 ITR 490 (Delhi), with the following observations :

“In our opinion, the answer to the said question which has been referred is self-evident. The Income-tax Tribunal has found as a fact that cash payments were made only under exceptional and unavoidable circumstances. This conclusion has been arrived at by the Tribunal after examining the entire material which was placed before it. It has further observed that the genuineness of the transaction was not in dispute. This being so, on the facts found by the Tribunal, the case not only fell within the provisions of rule 6DD(j), but the assessee was also entitled to claim the benefit of Circular No. 220, dated May 31, 1997, issued by the Central Board of Direct Taxes. In the said circular, it is, inter alia, stated that, if a seller refuses to accept payment by way of crossed cheque or crossed draft and the purchaser’s business interest would suffer due to non-availability of goods otherwise than from the particular seller, then even if the payment is made by cash, the same would be allowable as a deduction.” (pp. 492-493)

relied on in - The above circular was relied on in Drill Rock Engg. Co. (P.) Ltd. v. ITO [1993] 45 ITD 149 (Hyd. - Trib.) with the following observations :

“. . . Looking into the wording of section 40A(3) as well as rule 6DD(j) and also Board’s Circular No. 220 issued in 1977 one of the primary requirements of section 40A(3) is that the identity of the payee should be established before the ITO. The section is specifically enacted in order to curb the transactions in black money. However, the appellant before us failed to comply with the requirements of the above provisions as well as the Board’s circular. Hence for these reasons also the amount of secret commission is to be disallowed.” (p. 199)

Explained in - The above circular was explained in ITO v. Patidar Ginning & Pressing Co. Ltd. [1994] 51 ITD 7 (Ahd. - Trib.), with the following observations :

“6.1 In Circular No. 220 dated 31-5-1977, it has been clarified that it would generally satisfy the requirements of rule 6DD(j) if a latter explaining the exceptional and unavoidable circumstances such as mentioned in para 4 of the said circular is produced in respect of each transaction falling within the categories listed in para 4 of the said circular from the seller giving full particulars of his address, sales-tax number, permanent account number, if any, for the purpose of proper identification to enable the ITO to satisfy himself about the genuineness of the transaction. One of the illustration of exceptional circumstance given in para 4 of the said circular is that if the seller is refusing to accept payment by way of crossed cheque/draft and the purchasers business interest would suffer due to non-availability of goods otherwise than from this particular seller. The other illustration is that the seller, acting as a commission agent, is required to pay cash in turn to persons from whom he had purchased the goods. Few more instances of exceptional circumstances have been given in the said circular. The Hon’ble Gujarat High Court in the case of Navsari Waste Cotton Products v. CIT [1987] 163 ITR 378 has held that the said circular merely indicate the circumstances in which rule 6DD(j) would be attracted. The underlying idea is that if the seller’s identity can be established, it would be possible for the ITO to cross-check whether the transactions in fact had taken place as stated and was of a genuine nature. The instances given in the said circular are merely illustrative and not exhaustive. . . .” (pp. 13-14)

applied in - The above circular was referred to and applied in Avon Sales Corporation v. ITO 1994 Tax LR 79 (ITAC - Delhi), with the following observations :

“. . . The CBDT vide Circular No. 220 have issued instructions that where the payee had insisted for cash payment and a certificate from them is furnished giving the income-tax number and sales-tax numbers, etc., disallowance u/s 40A(3) should not be made. In this case substantial payments to M/s. Avon Sales Corporation had been made by cross-cheques or bank drafts. Only two payments of Rs. 2,600 and Rs. 4,000 had been made by cash on the party having insisted for cash payment. These payments, in our view, are covered under rule 6DD(j) read with Circular No. 220 of CBDT. The disallowance of Rs. 6,600 is accordingly deleted.” (p. 90)

EXPLAINED IN - Janambhumi v. CIT [1998] 99 Taxman 451/225 ITR 517 (Gau.) with the following observations :

“The circular itself indicates that these are not the only circumstances which can be said to be exceptional and unavoidable. There may be some other exceptional and unavoidable circumstances which may not be put in writing. The Commissioner (Appeals) upheld the order of the ITO on the ground that the assessee failed to establish exceptional and unavoidable circumstances under which payment had to be made in cash exceedingRs. 2,500. While considering the exceptional circumstances the business exigencies, convenience and security should also be looked into.”

EXPLAINED IN - CIT v. G.S. Auto Industries (P.) Ltd. [1998] 144 CTR (Punj. & Har.) 464 with the following observations :

“It would appear from the perusal of the Board’s circular referred to above that the seller’s refusal to accept the payment by crossed cheque or draft may permit the assessee to make payment in cash. But, at the same time, it should also be shown that the assessee’s business interest would have suffered due to non-availability of goods otherwise than from that particular seller. Sub-clause (iv) of clause 4 of the circular requires the fulfilment of both the conditions as aforesaid. In this light, the factum of insistence by the recipients may not alone be sufficient to attract clause 4(iv) of the circular.”

EXPLAINED IN - Shri Mahabir Industries v. CIT [1996] 220 ITR 459 (Gau.) with the following observations :

“Circular No. 220, dated May 31, 1977, specifies some of the circumstances in which rule 6DD(j) of the Income-tax Rules, 1962, would apply. The circular itself indicates that these are not the only circumstances which can be said to be exceptional and unavoidable. Exceptional and unavoidable circumstances may vary depending on the facts of each case. Merely because the parties have bank accounts and there is a long gap between submission of the bill and making payment, the conclusion cannot be arrived at that the assessee failed to show exceptional and unavoidable circumstances. Before coming to a decision regarding failure to establish exceptional and unavoidable circumstances, the authority must give reasons why it came to such conclusions.”

Explained in - CIT v. G.S. Auto Industries (P.) Ltd. [1999] 106 Taxman 473 (Punj. & Har.) in following words :

“. . . [According to Circular No. 220, the seller’s refusal to accept the payment by crossed cheque or draft] may permit the assessee to make payment in Cash. But, at the same time, it should also be shown that the assessee’s business interest would have suffered due to non-availability of goods otherwise than from that particular seller. Sub-clause (iv) of clause 4 of the Circular requires the fulfilment of both the conditions as aforesaid. In this light, the factum of insistence by the recipients may not alone be sufficient to attract clause 4(iv) of the Circular.” (pp. 475-476)

387. Monetary ceilings prescribed in section 40A(3)/269SS/269T - Raised to Rs. 10,000, Rs. 20,000 and Rs. 20,000, respectively, by Direct Tax Laws (Amendment) Act, 1987 - Clarification regarding effective date of change in monetary ceilings

1. Provisions of sections 40A(3), 269SS and 269T have been amended by Direct Tax Laws (Amendment) Act, 1987 (4 of 1988) and consequently the monetary ceilings prescribed under the aforesaid sections have been raised from Rs. 2,500 to Rs. 10,000, Rs. 10,000 to Rs. 20,000 and Rs. 10,000 to Rs. 20,000, respectively. As per provisions of section 1(2) of the Direct Tax Laws (Amendment) Act, these changes have been made effective from 1-4-1989.

2. Board has received a number of representations regarding the date of applicability of the abovementioned amended sections of the Income-tax Act. It is hereby clarified that the amended provisions of sections 269SS and 269T will apply to payments or repayments made on or after 1-4-1989. In respect of disallowance of payments made under section 40A(3), the amendment will apply to payments made in the previous year relevant to the assessment year 1989-90 and subsequent years.

Circular : No. 522, dated 18-8-1988.

388. Provision for estimated service gratuity payable to its employees -Deduction under section 37(1) and section 40A(7) after its insertion by the Finance Act, 1975, with effect from 1-4-1973

clarification 1

In the Board’s Circular No. 47, dated 21-9-1970 [Clarification 2]. It was stated that provisions made by an assessee in his accounts on a scientific basis in respect of estimated service gratuity payable to employees would be admissible as deduction under section 37(1). The matter was re-examined by the Board in 1974 and the earlier instructions were withdrawn by the Board’s Circular No. 146 dated 26-9-1974 [Clarification 2]. Some of the High Courts have recently taken a view that a provision made by an assessee in his accounts in respect of estimated service gratuity payable to employees will be deductible in computing the taxable income in cases where the provision has been made on a scientific basis in the form of actuarial valuation. In order to remove uncertainty, in the matter, the Finance Act, 1975 has inserted a new sub-section (7) in section 40A which provides that no deduction will be allowed in the computation of taxable profits in respect of mere “provisions” made by employers in their books of account for payment of gratuity to their employees on their retirement or on termination of their employment for any reason. The amendment will not, however, affect provisions made for the purpose of payment of sums by way of contribution towards approved gratuity funds that have become payable during the previous year, or for the purpose of making any payment on account of gratuity to employees where such gratuity has become payable during the previous year and such provisions will continue to be eligible for deduction as hitherto.

Circular : No. 169 (para 27), dated 23-6-1975.

JUDICIAL ANALYSIS

Commented upon - The above circular was commented upon in CIT v. Chackolas Spg. & Wvg. Mills Ltd. [1989] 178 ITR 603 (Ker.) with the following observations :

“The circular issued by the Central Board of Direct Taxes, as also the Notes on Clauses referred to above, clearly indicate that what is contemplated by section 40A(7)(b)(i) of the Act, is a definite or clear provision by the assessee for the purpose of payment of a sum, by way of any contribution towards an approved gratuity fund. It is not sufficient if a ‘mere reserve’ or ‘mere provision’, without anything more, is made. In this case, there is no dispute that the assessee had made provision, which was clearly one made for payment to an approved gratuity fund. . . .” (p. 609)

clarification 2

1. Attention is invited to the Board’s Circular No. 47 [F. No. 9/100/69-IT(A-II), dated September 21, 1970] [Clarification 3] on the above subject. In this circular, the Board had considered the question as to whether provision made by an assessee in its accounts for estimated service gratuity payable to its employees could be allowed as a deduction even though no approved gratuity fund under the provisions of the Income-tax Act had been set up. At the relevant time when this circular was issued, the Supreme Court’s decision in the case of Metal Box Co. of India Ltd v. Their Workmen [1969] 73 ITR 53 was available and taking note of certain observations in this particular decision of the Supreme Court, it was felt that provision of gratuity on a scientific basis (in the form of actuarial valuation carried out every year) could be considered to represent a real liability of the employer to the employees. Accordingly, the Board decided that such provision would not be a contingent liability and may be treated as admissible deduction under section 37(1).

2. The decision of the Board has been re-examined in the light of the unreported judgment of the Supreme Court in the case of Bombay Dyeing & Manufacturing Co. Ltd. v. CWT [since reported in [1974] 93 ITR 603]. In this judgment, their Lordships have confirmed their own views in Standard Mills Co. Ltd. v. CWT [1967] 63 ITR 470 and have observed that the decision in Metal Box Co.’s case (supra) was rendered under a different Act and in a different context.

3. In view of the later pronouncement of the Supreme Court in the case of Bombay Dyeing and Manufacturing Co. Ltd. (supra) and on the clear provisions of law contained in section 36(1)(v) under which any sum paid by an employer by way of contribution towards an approved gratuity fund created by him for the exclusive benefit of its employees under an irrevocable trust alone was admissible, any allowance of such liability towards an unapproved gratuity fund under section 37(1) does not arise. In view of this, the earlier instructions of the Board referred to above, stand withdrawn with immediate effect.

4. All pending assessments may be completed in the light of the present instruc-tions.

Circular : No. 146 [F. No. 228/2/73-IT(A-II)], dated 26-9-1974.¹

Judicial analysis

explained in - In CBDT v. Chloride India Ltd. [1997] 225 ITR 129 (Cal.), it was held that circular of the Central Board of Direct Taxes dated September 26, 1974, providing that any allowance of gratuity liability towards an unapproved gratuity fund under section 37(1) of the Income-tax Act, 1961, shall not be made, is in direct conflict with the law laid down by the Supreme Court in Metal Box Co. of India Ltd. v. Their Workmen [1969] 73 ITR 53. The circular, therefore, has to be ingored in making assessments for the assessment year 1972-73; for the assessment year 1973-74 onwards the law applicable would be in accordance with section 40A(7) of the Income-tax Act, 1961, as declared by the Supreme Court in Shree Sajjan Mills Ltd. v. CIT [1985] 156 ITR 585 (SC).

clarification 3

A question has arisen whether the provision made by an assessee in its accounts on account of the estimated service gratuity payable to the employees can be allowed as a deduction when no gratuity fund has been set up under Part C of the Fourth Schedule to the Income-tax Act.

The Board have decided that following the decision of the Supreme Court in the case of Metal Box Co. of India Ltd. v. Their Workmen [1969] 73 ITR 53, the provision of gratuity on a scientific basis (in the form of an actuarial valuation carried out every year) can be considered to represent a real liability of the employer to the employees. The Supreme Court, in the case of Garment Cleaning Works v. Workmen AIR 1962 SC 673, decided that the employer would be required to pay gratuity even to an employee who has been dismissed on account of misconduct. The Board have, therefore, come to the conclusion that the liability so ascertained cannot be considered as a contingent liability. Such provision of gratuity may be treated as an admissible deduction under section 37(1).

Circular : No. 47 [F. No. 9/100/69-IT(A-II)], dated 21-9-1970¹

clarification 4

I am directed to refer to your letter dated 25-1-1971, on the above subject and to say if an assessee decided to start making a provision on gratuity from the current year, then the provision made in respect of the current year only will be allowable as deduction under section 37. The liability for paying gratuity in respect of earlier years will not be allowed as deduction in computing the income for the current year. In the year when the gratuity is actually paid to the employee, the portion of gratuity which is not covered by the annual provisions made in respect of those employees on the basis of actuarial valuation and allowed as deduction in the computation of income, the employer will be allowed as deduction in the year in which the gratuity is paid to the employee.

This will, of course, necessitate maintenance of two sets of accounts for the employee—

i. gratuity payable to him for the period during which the provision for gratuity was not allowed as deduction in computing the income of the employer; and

ii. gratuity payable to the employee on the basis of actuarial valuation made from year to year, debited to the profit and loss account and allowed as deduction in the computation of income of the employer.

In the year in which the employee is paid the gratuity, only the first amount will be allowed as deduction, the second having been allowed in the earlier years when provisions were made.

Letter : F. No. 204/10/71-IT(A-II), dated 17-4-1971.

clarification 5

I am directed to refer to your letter dated 31-5-1971 [Annex] on the above subject and to say that the provision has to be made in respect of gratuity payable to each employee and it has to be decided by taking into account several factors such as length of service, salary progressions and the like which would be lost sight of in making an overall provision for the company as a whole and that would not reflect the correct provision for gratuity.

Letter : F. No. 204/10/71-IT(A-II), dated 17-8-1971.

ANNEX - LETTER, DATED 31-5-1971 REFERRED TO IN CLARIFICATION

With reference to your Circular No. 47, dated 21-9-1970 on the above subject, our clients are raising a doubt as to actuarial valuation of gratuity liability.

It appears that actuarial valuation can be made only in respect of general gratuity liability of the company, covering all the employees entitled to gratuity and not in respect of a particular employee of the company.

It appears from your circular that the actuarial valuation for the gratuity liability should be obtained in respect of each and every employee and record is to be maintained by the company, in respect of this particular valuation for each year.

Under the circumstances, we request you to kindly clarify the point and confirm that actuarial valuation of general gratuity liability of the company covering all the employees will suffice.

389. Provision made for the purposes of payment of contribution towards approved gratuity fund - Deduction therefor in terms of sub-section (7)(b) - Conditions to be complied with for securing approval of fund

In order that a gratuity fund may receive approval the trustees of the fund should satisfy certain conditions mentioned in Part C of the Fourth Schedule to the Income-tax Act and the rules mentioned thereunder. They are briefly given below :

1. The application for approval of the fund is to be made by the trustees accompanied by a copy of the instrument under which it is established together with two copies of the rules of the fund. The trust deed should be on an appropriate stamp paper and the application should bear court-fee stamp worth Re. 1.

2. The application should contain, inter alia, the information such as name and address of the employer, his business, profession, address of his principal place of business, classes and number of employees entitled to the gratuity benefits in India and outside India and also place of maintenance of accounts, etc. A verification in the form mentioned below should also be annexed to the application :

“We trustee(s) of the above-named fund do declare that what is stated in the above application is true to the best of our/my information and belief and that the documents sent herewith are the originals or true copies thereof.”

3. The rules of the fund should contain definitions of “employer”, “employee”, “contribution”, “salary”, “trust”, “trustees”, “fund”, etc. These definitions should conform to the provisions of rule 2 of Part A of the Fourth Schedule to the Act and rule 98(a) of the Rules.

It may be mentioned that so far as the definition of “salary” is concerned, it should specifically be made clear that it excludes all other allowances and perquisites except dearness allowance, if the terms of employment so provide.

4. A provision is to be made to the effect that gratuity is for the employees in the trade or undertaking on their retirement at or after a specified age or on their becoming incapacitated prior to such retirement or on termination of their employment after a minimum period of service (to be specified in the rules of the fund) or to the widows, children or dependants of such employees on their death. There should be no provision for payment of gratuity to an employee while he continues to remain in service. It should further be mentioned in the rules that the fund is established for the benefit of the employees employed in India.

5. The fund is to be established under an irrevocable trust in India. The date of such establishment should also be mentioned clearly as per rule (3)(a) of the Fourth Schedule and rule 99 of the Rules. There should be at least two trustees for a fund. If one of the trustees is a company as defined in section 3(1)(i) of the Companies Act, 1956, prior approval of the Commissioner is necessary. All the trustees should be resident in India and any trustee who leaves India permanently should vacate his office.

6. There should be a specific provision that the gratuity benefits are payable only in India and such payments to employees may be made in lump sum or by instalments which may be specified.

7. The rules of the fund should contain a provision for deduction and payment of income-tax and estate duty wherever leviable at the time of payment,of gratuity in accordance with the provisions contained in the Income-tax Act and the Estate Duty Act.

8. Regarding the admission of directors in the case of a limited company to the benefits of the fund, the rules of the fund should contain that such director employee of the company will be admitted to the fund only if he is a wholetime bona fide employee of the company and does not beneficially own shares in the company carrying more than 5 per cent of the total voting power.

9. The ordinary annual contribution by an employer to a fund shall be made on a reasonable basis as may be approved by the Commissioner having regard to the length of service of each employee concerned so, however, that such contribution shall not exeeed 8¹/₃ per cent of the salary of each employee during each year. The amount to be allowed as a deduction on account of initial contribution which an employer may make in respect of the past services of an employee admitted to the benefits of a fund shall not exceed 8¹/₃ per cent of the employee’s salary for each year of his past service with the employer. Provisions in regard to the annual contribution and initial contribution should find a place in the rules of the fund on the lines mentioned above.

10. Another important provision to be incorporated is to the effect that all the moneys belonging to the fund are invested as per rule 101.

11. There should be a rule prohibiting the assignment of, or creation of a charge upon, the beneficial interest of an employee in the fund. If not, there should be a provision to the effect that where an employee assigns or creates a charge upon his beneficial interest in the fund and does not secure the cancellation of the assignment or charge within two months of the date of receipt of a notice from the Income-tax Officer, the consideration received for such assignment or charge shall be deemed to be income received by him in the previous year in which the fact became known to the Income-tax Officer.

12. The employer shall not under any circumstances receive any moneys belonging to the fund or have any lien or charge on the fund. This should be provided in the rules as per the provisions of rule 106.

13. It should also invariably be mentioned that where there is any repugnance between any of the rules of the fund and the provisions of the Act and the Rules, the repugnant rule will be void and that the trustees shall, if so required by the Commissioner of Income-tax, remove the repugnant rule. Similarly there should be a provision to the effect that the trustees’/arbitrator’s decision involving an interpretation of the provisions of the Act and the Rules made thereunder should be communicated to the Commissioner of Income-tax who is having jurisdiction over the fund. The provisions contained in rule 110, namely, no alteration in the rules, constitution, objects or conditions of an approved fund shall be made without the prior approval of the Commissioner, should be incorporated in the rules of the fund.

14. Provision in regard to winding up of the fund is to be indicated. It should also be provided that where the employer’s trade or undertaking is to be wound up or discontinued, the trustees shall, with the prior approval of, and subject to such conditions as may be imposed by, the Commissioner of Income-tax make satisfactory arrangements for the payment of gratuity to the existing beneficiaries. Besides, it should also be provided in the rules that any arrangements for the winding up of the fund or for its amalgamation with another fund shall be subject to the prior approval of, and to such conditions as may be imposed by, the Commissioner of Income-tax.

15. Provisions should also be made that if the fund, for any reasons, ceases to be an approved fund, the trustees shall nevertheless remain liable to tax on any gratuity paid to an employee.

In addition to the above, it is also necessary to state that the administrative expenses incurred by the employer will not be claimed by him as a deduction in his assessment.

16. Nomination form should be as per rule 101A, i.e., in Form No. 40A or in a form as near to it. Such forms also should form part of the rules of the fund which deal with nomination.

Note : The information as to where the employer is assessed together with Permanent Account Number may be mentioned in the covering letter while forwarding the application for approval.

Letter : BC No. T-II/256-Misc. 75-76, dated 15-11-1975, from the Commissioner of Income-tax, Bombay.