Pay your debts to micro or small enterprises or else

With the introduction of amendments to the Income Tax Act, 1961, India’s government has introduced legal changes to encourage the prompt payment of amounts that businesses owe to micro or small enterprises (MSE). This is a positive step as it will provide considerable financial support to Japanese companies, as well as to domestic entities within this category.

Expenses incurred for business purposes are deducted to calculate business income on which tax is to be charged. Under the mercantile system of accounting, expenses are recorded when they become due, not when they are actually paid. However, with the recent amendments to section 43B of the Income Tax Act, this practice has changed. Certain deductible expenses will only be recognised in the year they are actually paid, regardless of when the obligation to pay them arose.

The Finance Act 2023 added a new clause (h) to section 43B that provided that any amount owed by a taxpayer to an MSE beyond the time limit specified in the Micro, Small and Medium Enterprises Development Act, 2006 (MSMED act), will only be deductible in the year it is physically paid, irrespective of when the liability originated. The underlying objective of this amendment is to encourage prompt payment to MSEs by business entities, thereby bolstering the financial stability of those enterprises. This legislative shift applies from the assessment year 2024-25 onward, affecting payments due to MSEs on or after 1 April 2023.

Under section 15 of the MSMED act, buyers of goods or services from an MSE supplier are legally obliged to make payment on or before the date agreed between them. However, that agreed period cannot exceed 45 days from the day of acceptance. In cases where there is no prior agreement between the parties in this regard, the buyer must pay an MSE supplier by the day following the 15th day of acceptance of goods or services.

The day of acceptance of goods or services means the day of delivery or rendering of services. However, if the buyer makes a written objection to the supplier regarding the goods or service within 15 days of the day of delivery, then the day of acceptance means the day the supplier removes the objection.

MSEs are defined by the amounts of their investment in plant and machinery and by their annual turnover. They include entities such as companies, co-operative societies, trusts and bodies constituted under any law. Micro enterprises are those with an investment in plant and machinery not exceeding INR10 million (USD120,000) and an annual turnover of not more than INR50 million. Small enterprises are those where the figures are not more than INR100 million for investment in plant and machinery and an annual turnover not exceeding INR500 million.

There are compliance issues arising from the amendment. The new provision applies only to purchases from suppliers registered as micro or small enterprises. The buyer can obtain a declaration from the supplier regarding its status under the MSMED act or check the supplier’s MSE registration at Udyam Verify. The new provision has no bearing on any advance payment to an MSE, which will continue to be deductible in the year of payment. The provision does not apply to the purchase of capital goods from MSEs.

The provision applies to calculating taxable profits in a regular assessment and does not apply to calculating the minimum alternative tax. If the sum payable to an MSE includes goods and services tax (GST), but the buyer does not claim an input tax credit treating the GST amount as an expense, the purchase cost and the GST will be deductible in the year of actual payment. Where the buyer does claim GST as an input tax credit, only the purchase cost will be deductible in the year of payment.

The payments coming within the ambit of the new provision must be reported by the auditors in their tax audit report.

To conclude, the revised provision in section 43B of the Income Tax Act provides that in the case of purchases from MSEs, a failure to make payment for them within the stipulated 15 or 45-day period as applicable, will result in the deduction of expenses being allowed only in the year of actual payment, and not in the year in which they were incurred. This underscores the importance of making timely payments to MSEs and aligns with broader official efforts to support and sustain these enterprises.

Shahid Khan, is a senior partner direct tax and Reena Khair is a senior partner indirect tax at Kochhar & Co.