Section 43B(h) Audit Alert: Are Your MSME Expenses Disallowed?

The tax audit season (October-December) is heating up, and this year, one specific section of the Income Tax Act is giving sleepless nights to business owners, accountants, and tax auditors alike: Section 43B(h).

For decades, Indian businesses have operated on a simple principle: “Buy now, pay later.” If you bought goods worth Rs 5 lakh on credit in March, you booked the expense immediately to reduce your profit and tax liability. It didn’t matter if you actually paid the supplier in June or July. As long as you paid before filing your Income Tax Return (ITR), the law was lenient.

Also Read-Global Diversification: Tax Rules for Foreign Assets (Schedule FA)

That safety net is now gone for payments to Micro and Small Enterprises (MSMEs).

Under the new Section 43B(h), introduced by the Finance Act 2023, the rule is strict and unforgiving: Pay within the time limit defined in the MSMED Act, or pay tax on that expense. This isn’t just a minor compliance tweak; it is a fundamental shift in how you manage your creditors and cash flow.

In this detailed guide, we will look at the world of MSME payments through the eyes of an auditor. We will cover the rules, the hidden traps, the “trader” confusion, and exactly what you need to do to survive this audit season without a massive tax demand.

What is Section 43B(h)? The “Payment Basis” Logic.

To understand the panic, you first need to understand how Section 43B works. Normally, business income is calculated on an “accrual” basis—you claim expenses when the liability arises, not when cash leaves your bank.

However, Section 43B of the Income Tax Act, 1961 overrides this. It lists specific expenses (like PF, GST, Bonus) that are allowed only on actual payment. Until last year, this list did not include payments to vendors. Now, with the addition of clause (h), payments to Micro and Small Enterprises have joined this strict list.

The Core Rule:
Any sum payable by you to a Micro or Small enterprise beyond the time limit specified in Section 15 of the MSMED Act, 2006 shall be allowed as a deduction only in the year you actually pay it.

This means if you miss the deadline, the expense is “disallowed” (added back to your income). You lose the tax shield on that expense for the current year. You will have to pay tax on money you haven’t even earned—essentially paying tax on your unpaid bills.

Who is a “Micro” or “Small” Enterprise? (The Technical Check).

This is the most common area of confusion. Section 43B(h) does not apply to every vendor. It targets the smallest players to ensure they don’t face a cash crunch. You must filter your creditor list based on the “Composite Criteria” of Investment and Turnover.

How to Check the Numbers?

You don’t need to ask for their balance sheet. You simply need their Udyam Registration Certificate.

• Investment Calculation: This is the value of Plant & Machinery minus the cost of Land and Buildings. It is linked to their ITR.
• Turnover Calculation: This excludes “Export Turnover”. So, a company might have Rs 60 Crore total sales, but if Rs 20 Crore is export, their domestic turnover is Rs 40 Crore. They remain a “Small” enterprise, and you must pay them on time!

The “Trader” Exclusion: A Vital Loophole.

There is a massive relief for buyers dealing with pure traders. The Ministry of MSME has clarified (via Office Memorandum 5/2(2)/2021-E/P & G/Policy) that Retail and Wholesale Traders are allowed Udyam registration only for the purpose of Priority Sector Lending from banks.

What this means for you:
If your vendor’s Udyam certificate lists their activity purely as “Trading” (NIC Codes 45, 46, or 47), Section 43B(h) generally does not apply. You can pay them according to your standard business terms without fear of disallowance. However, if they are “Manufacturers” or “Service Providers,” the rule is mandatory.

The Timelines: The 15 vs. 45 Day Rule.

The Income Tax Act sends us to Section 15 of the MSMED Act, 2006 to find the deadlines. This is where many businesses fail because they assume a flat “45-day” credit period exists. It does not.

Situation A: No Written Agreement (The 15-Day Trap).

If you simply buy goods on a verbal order or a standard invoice without a specific signed agreement, the law says you must pay within 15 days of the “Day of Acceptance”.

• Example: Goods delivered on 1st March. No agreement. Payment due by 16th March. If you pay on 20th March, you are legally late (though for tax purposes, if paid within the same year, you are safe—more on this in the scenarios).

Situation B: With Written Agreement (The 45-Day Limit).

If you have a written contract, Purchase Order (PO), or even an email exchange accepting credit terms, you can pay by the agreed date. However, this cannot exceed 45 days.

• Example: You agree to 90 days credit. The law overrides this and caps it at 45 days.
• Example: You agree to 30 days credit. The law respects the 30 days. You cannot claim 45 days if you agreed to 30.

What is the “Day of Acceptance”? (The Objection Clause).

Technically, the clock starts ticking from the “Day of Acceptance”.

• Scenario: You receive goods on 1st April.
• Scenario: The goods are defective. You send a written objection to the supplier on 5th April (within 15 days).
• Result: The clock stops. The new “Day of Acceptance” will be the day the supplier resolves the objection (e.g., replaces the goods). This is a crucial defense for buyers who have genuine disputes.

Real Life Scenarios: Are You Safe?

Let’s apply these rules to “Sharma & Sons,” a manufacturing unit closing its books for the year ending 31st March 2024.

Scenario 1: Paid Late but Within Financial Year (SAFE).

• Vendor: ABC Packaging (Micro Enterprise).
• Bill Date: 1st June 2023.
• Amount: Rs 2,00,000.
• Due Date (45 days): 15th July 2023.
• Actual Payment Date: 20th December 2023.
• Audit Result: Sharma & Sons paid very late (5 months delay). However, the payment was made before 31st March 2024.
• Tax Impact: The expense is ALLOWED in FY 2023-24. Section 43B(h) only disallows amounts outstanding at year-end. (However, interest liability under MSMED Act still applies).

Scenario 2: The Year-End Trap (DISALLOWED).

• Vendor: XYZ Chemicals (Small Enterprise).
• Bill Date: 10th March 2024.
• Amount: Rs 10,00,000.
• Agreement: Yes, 45 days credit.
• Due Date: 24th April 2024 (10th March + 45 days).
• Actual Payment Date: 30th April 2024.
• Audit Result: The payment was pending on 31st March. The law allows you to pay till the “Due Date” (24th April). Sharma & Sons paid on 30th April—missing the deadline by just 6 days.
• Tax Impact: Since the deadline was missed, the entire Rs 10 Lakh is DISALLOWED in FY 2023-24.
• Financial Hit: If Sharma & Sons is in the 30% tax bracket, they will pay Rs 3,12,000 extra tax immediately. They can claim the deduction next year (FY 24-25), but the cash outflow for tax happens now.

Scenario 3: Opening Balance (SAFE).

• Bill Date: 15th January 2023 (Previous Financial Year).
• Status: Still unpaid as of March 2024.
• Audit Result: Section 43B(h) became effective from 1st April 2023. It applies to expenses incurred in the current year or future years. Old opening balances from prior years are generally not hit by this disallowance (though auditors may flag the extreme delay).

Scenario 4: Capital Goods Purchase (LIKELY SAFE).

• Transaction: Bought a machine for Rs 50 Lakh from a Small Enterprise.
• Payment: Delayed by 6 months.
• Audit Result: Section 43B applies to “deductions otherwise allowable”. Buying a machine is a Capital Expenditure, not a revenue expense. You claim “Depreciation,” not the purchase cost.
• Tax Impact: Most experts agree that Depreciation cannot be disallowed under Section 43B(h). However, be warned: the interest penalty for delay will still apply.

Scenario 5: Cheque Issued vs. Cleared.

• Situation: Due date is 31st March. You issue a cheque on 30th March. It clears in the vendor’s bank on 4th April.
• Rule: Under general commercial law, the date of tendering the cheque (if honored) is the date of payment.
• Audit Tip: Ensure the cheque is actually handed over and acknowledged. If you write a cheque and keep it in your drawer, the auditor will treat it as unpaid.

The Double Blow: Interest Penalty (Section 16).

Many business owners think, “It’s okay, I’ll pay the tax now and claim the refund next year.” This is a dangerous mindset because of Section 16 of the MSMED Act.

If you delay payment beyond 15/45 days, you are liable to pay Compound Interest with monthly rests at 3 times the Bank Rate notified by the RBI.

The Calculation of Pain:

• Bill Amount: Rs 10,00,000
• Delay: 6 Months
• Bank Rate (Approx): 6.75%
• Penalty Rate: 3 x 6.75% = 20.25%
• Nature: Compounded Monthly.

The Final Nail: As per Section 23 of the MSMED Act, this interest paid to the vendor is NOT tax-deductible. It is a permanent expense. You cannot claim it in your P&L to reduce tax. It is a dead loss from your net profit.

Tax Audit Reporting: Form 3CD Clause 22.

If your turnover exceeds Rs 1 Crore (or Rs 10 Crore with 95% digital transactions), you undergo a Tax Audit. The auditor has to verify this in Form 3CD.

Clause 22 is the specific area for this reporting. It is split into two parts:

1. Clause 22(a): The auditor must report the amount of interest inadmissible (the penalty interest we discussed above).
2. Clause 22(b): The auditor must report the amount disallowed under Section 43B(h) (the principal bill amount unpaid at year-end and beyond the due date).

What will your Auditor do?

Your auditor cannot just take your word for it. They will:

• Download your Creditors’ Aging Report (e.g., from Tally Prime).
• Ask you to map “MSME Status” for each creditor.
• Verify payments against bank statements.
• Check the “Udyam” portal for random verification.
• If you fail to provide data, they may add a “Qualification” or “Observation” in the audit report, stating that the assessee has not maintained MSME data. This raises a red flag to the Income Tax Department.

Compliance Checklist: Your SOP for Survival.

You cannot change the law, but you can change your process. Here is a practical Standard Operating Procedure (SOP) to implement immediately:

Step 1: Master Data Cleanup.

Don’t wait for March. Send an email or letter to ALL your vendors today.

“Dear Vendor, please update us with your MSME Udyam Registration Certificate and Number. If we do not receive it by [Date], we will assume you are not registered.”

Step 2: Update Your Accounting Software.

If you use Tally, Zoho, or SAP, enable the MSME features.

• Tag vendors as “Micro”, “Small”, or “Medium”.
• Enter their Udyam Number in the statutory details field.
• Set the “Default Credit Period” to 45 days (or 15 days) in the master setup.

Step 3: Create the “45-Day Agreement”.

Since the law allows 45 days only if there is a written agreement, ensure every Purchase Order (PO) has this line printed clearly:

“Payment Terms: 45 Days from date of acceptance of goods/services.”

Without this line, the law defaults to 15 days, making compliance much harder.

Step 4: The Monthly Review.

On the 25th of every month, pull a report of “Bills Due in Next 10 Days”. Prioritize payments to Micro and Small vendors over others. Use your cash flow to clear these “tax-critical” dues first.

Summing Up:

Section 43B(h) is a wake-up call for financial discipline. The government wants to ensure the small fish don’t get eaten by the big fish’s payment delays. While it adds a burden to your accounting team, it also forces a healthy habit of clearing dues.

The cost of ignorance is high—30% tax + 20% penalty interest. Don’t let a simple unpaid bill become a permanent financial scar on your business.

Action Item: Right now, open your accounting software. Export your “Sundry Creditors” list. Sort by amount and days pending. If you see any small vendor pending for 40+ days, cut that cheque today.

Frequently Asked Questions (FAQs) on Section 43B(h) & MSME Payments

Disclaimer: The information provided in this article is based on the Finance Act 2023 and MSMED Act 2006. Tax laws are subject to change and official interpretation. Please consult your Chartered Accountant (CA) or Tax Advisor before filing your Tax Audit Report or Income Tax Return.

C.K. Gupta

Hello, I am C.K. Gupta Founder of Taxgst.in, a seasoned finance professional with a Master of Commerce degree and over 20 years of experience in accounting and finance. My extensive career has been dedicated to mastering the intricacies of financial management, tax consultancy, and strategic planning. Throughout my professional journey, I have honed my skills in financial analysis, tax planning, and compliance, ensuring that all practices adhere to the latest financial regulations. My expertise also extends to auditing, where I focus on maintaining accuracy and integrity in financial reporting. I am passionate about using my knowledge to provide insightful and reliable financial advice, helping businesses optimize their financial strategies and achieve their economic goals. At Taxgst.in, I aim to share valuable insights that assist our readers in navigating the complex world of taxes and finance with ease.