Income Tax Act amendment on cards on tax treatment of MSME dues

A change introduced last year in the Income Tax Act to help small businesses receive timely payments might have had the unexpected effect of putting off buyers of their goods and services altogether. According to two people aware of discussions in the government, the Centre may amend the Act again in the full budget for FY25 in July.

What is unclear, though, is the exact change that could be made. One of the two persons cited above said, “It is highly likely that clause H of section 43B may be dropped.” The second person said it was too early to speak about the specific amendments that may be brought out. Both people spoke on condition of anonymity.

In a bid to address liquidity issues of MSMEs (micro, small and medium enterprises), Clause H was added in section 43B of Income Tax Act. Introduced in the Finance Act 2023, the clause says payments to small businesses that are delayed beyond a specified period can be claimed as an expenditure (deduction from taxable income) only in the financial year in which the payments are made, not in the year when the liability to pay arose.

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“However, there is apprehension among small businesses that as an unintended consequence, large procurers would avoid buying from small firms to avoid this provision in the law,” the first person cited above said. “This concern would be addressed in the Finance Bill to be presented as part of the full year budget for FY25.”

Tax expert Ved Jain, who is also a former president of Institute of Chartered Accountants of India (ICAI), strongly pitched for the provision to be dropped. “Income Tax Act should only sparingly be used for larger social objectives, for which there are other laws,” he said.

Jain further explained the implications of the provision on buyers of MSME goods or services. A business that misses a payment deadline faces a jump in its tax liability during a financial year due to denial of the benefit of deduction for the payment liability accrued.

If the deduction is allowed in a subsequent year of payment, the tax liability incurred earlier due to delayed payment does not go away. Besides, it could depress profits in the year that the payment is made. And if income turns out to be negative, in some cases, it could take years for the business to set it off against profits of subsequent years, Jain said.

What counts as timely payment is defined in the Micro, Small and Medium Enterprises Development (MSMED) Act as payment made within 15 days, or within 45 days in case it is backed by a written contract. But in many industries, the payment cycle is longer—three to six months.

The second person quoted above said finance minister Nirmala Sitharaman is privy to the concerns raised by small businesses. In response to a question, Sitharaman told a gathering in Jaipur on 16 April that the finance ministry had in 2022-23 made a thorough review to make sure all central public sector undertakings cleared payments to MSMEs and then maintained the 45-day payment cycle, but the Union finance ministry was not in a position to know about dues to MSMEs from state PSUs or the private sector and, hence, suggestions were sought.

The minister said MSMEs themselves pointed out to the ministry that businesses do not pay within 45 days, and not even within the financial year, but they take fiscal benefits by showing it as expenditure. “MSMEs themselves gave that thought to us,” Sitharaman said, referring to how businesses breach the timeline given in the MSMED Act brazenly.

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The FM said the Income Tax amendment of 2023 was only meant to make sure the benefit is taken in the year when payment is made. Sitharaman also pointed out that small businesses are now putting forth the argument that big businesses are shying away from buying from small businesses, with one group even demanding an ordinance, after the Lok Sabha was prorogued ahead of national polls.

The minister did not say what the government would be doing in the full budget, but the second person quoted above said the intent of the Income Tax provision, as highlighted by Sitharaman, was to encourage timely payments to small businesses, and that the unintended consequences will be addressed in the next Finance Bill, but it was too early to speak about the specific amendments that may be brought out.

In the case of delay in certain payments like taxes and interest payment on loan etc., businesses could still get the benefit of deduction if they manage to make the payment after the financial year but before they file their tax returns. This flexibility is also not available for delayed payments to small businesses.