The New Income Tax Act And Disallowable Expenses: What You Need To Know

When it comes to tax audits there is always one question that makes people uncomfortable: which expenses will not be allowed. Businesses usually focus on what they can deduct from their taxes. They do not pay much attention to what gets added back to their taxable income. This can be a problem because it is where most tax demands and penalty notices come from.

The Income-tax Act, 2025 which started on April 2026 has not changed these rules. It has just made them clearer and easier to understand so you can check them before you file your taxes than waiting for an assessing officer to point them out.

Illegal and Prohibited Expenditure

The main rule for disallowing expenses is in Section 34 of the Act. This section says that if you spend money on something that's against the law you cannot claim it as a deduction. This includes things like bribes, illegal payments and expenses related to business activities. However if you make a payment to compensate someone for a loss that is different. Courts have always made a distinction between these two types of payments. Only payments that are meant to punish you for breaking the law are not allowed.

For example lets say a logistics company pays a "facilitation charge" to get its goods cleared through customs faster. It does this outside of the official channels. This would be considered a payment and would not be allowed as a deduction under Section 34.

CSR Expenditure is Not Deductible

Some companies think that because they are required by law to spend money on Corporate Social Responsibility they should be able to claim it as a tax deduction. However this is not the case. The new Act still treats CSR spending as a use of income than a business expense because it is not meant to earn a profit. This has been the rule since 2014. The new Act has not changed it.

There is one exception to this rule. If a company donates money to a fund that's eligible under Section 133 (which used to be Section 80G) it may be able to claim a separate deduction for that donation. However this only applies if the payment is not a mandatory CSR payment that is being routed through an eligible institution to get a double benefit.

Payments That Attract TDS Default

Section 35 of the Act says that if you make a payment to someone and you are required to deduct tax at source but you do not do so or you do not deposit the tax on time you will not be able to claim that payment as a deduction. This applies to payments like interest, royalty, fees for services and commission. If you make a payment to a resident you may be able to claim the deduction if you deduct and deposit the tax before the due date of the return. However if you make a payment to a non-resident the rules are stricter. You may not be able to claim the deduction at all.

This section also limits the amount of remuneration that can be paid to working partners of a firm. It disallows payments to relatives or related parties that are excessive or unreasonable.

The Cash Payment Trap

Section 36 of the Act says that if you make a cash payment of more than Rs10,000 to one person in a single day you will not be able to claim that payment as a deduction. This applies to all cash payments unless they are for the transportation of goods in which case the limit's Rs35,000.

For example lets say a retailer pays a supplier Rs18,000 in cash on one day but splits the payment into two vouchers of Rs9,000 each to try to avoid the limit. The assessing officer will still disallow the Rs18,000 not just the amount above the limit.

Expenses That Are Only Deductible on Payment

Section 37 of the new Act says that certain expenses, like taxes, duties and cess can only be deducted when they are actually paid. This also applies to employer contributions to PF and ESI, bonus leave encashment and interest to banks and other financial institutions. If you pay these expenses before the date of the return you can still claim the deduction. However if you are paying an small enterprise under the MSMED Act, 2006 you will lose the deduction if you do not pay within the prescribed time limit.

Personal and Capital Expenditure

The new Act still does not allow expenses of the proprietor or partners or capital expenditure that creates an asset or enduring benefit as deductible business expenses. If you renovate a building it is only considered a repair if it just maintains the existing premises. If it expands or improves the asset it is considered capital expenditure. Is not allowed as a revenue expense.

Common Mistakes Businesses Make

Many businesses make mistakes when it comes to expenses. They often think that CSR spending is automatically deductible. It is not. They also try to split cash payments across vouchers to avoid the Section 36 threshold. This rarely works. They often book PF or MSME payments as deductible on accrual only to find that the claim is reversed because the payment was made after the prescribed window.

Compliance Tips

To avoid these mistakes businesses should build a checklist to flag cash payments that are nearing the Rs10,000 threshold. They should also track TDS deduction and deposit dates separately from the expense entry so that defaults are caught early. They should treat CSR spending as a distinct ledger head from the start so that it is never bundled into ordinary business expenditure by mistake.

Frequently Asked Questions

Is CSR expenditure under the new Income Tax Act 2025.

No it is not deductible.

Which section disallows cash payments above Rs10,000.

Section 36 of the Act disallows cash payments above Rs10,000.

Do MSME payment defaults get any grace period?

No MSME payment defaults do not get any grace period.

Are penalties for breaking the law deductible.

No only compensatory payments are not punitive fines or penalties.

Is capital expenditure ever treated as a revenue deduction.

No capital expenditure is never treated as a revenue deduction.

Final Word

It is very important to know what expenses are not allowed when it comes to taxes. This is because disallowances are where tax exposure can build up quietly. Businesses should review their expense ledger against these provisions before filing their taxes and flag anything that's borderline to their tax advisor early. The Income Tax Act, 2025 is very clear, about what expenses are not allowed and businesses should make sure they understand these rules to avoid any problems.