Many clients, including large corporations, are cancelling or considering cancelling year-end orders, largely to circumvent a new amendment to the Income Tax (IT) Act, 1961, effective 1 April 2024, which prohibits businesses from deducting expenses for goods and services purchased from micro and small enterprises if payments are not made within a specified period.
This amendment was meant to reinforce certain provisions of the Micro, Small and Medium Enterprises Development (MSMED) Act, 2006, that sought prompt payments to small suppliers. The MSMED Act and IT Act provisions apply exclusively to micro and small enterprises, leaving medium-sized enterprises unaffected.
Payments owed to small enterprises amount to several crores of rupees, and the delay in settling these amounts isn’t limited to private sector entities. Central and state government bodies, along with public sector companies, have collectively accumulated over ₹8,000 crore in overdue payments to these small businesses, with some of these dues lingering for multiple years.
Mint explains how the two laws are giving businesses nightmares.
What does the MSMED Act say about timely payment to small units?
The MSMED Act mandates two payment deadlines for buyers of goods and services from micro and small enterprises. Payments must be made within 45 days of supply if there’s a written agreement; otherwise, dues must be settled within 15 days.
Agreements that stipulate payment to be made after 45 days, say on the 60th day, are not considered valid under the MSMED Act. This is because certain sections of the MSMED Act can override other laws such as the Indian Contract Act, 1872.
The Act also specifies compound interest charges for late payments, emphasizing timely financial transactions to support small businesses’ sustainability.
What is the amendment to the IT Act?
While the MSMED Act provided for timely payment to sellers or service providers, in the real world, buyers delay payments. And, this was hurting the financial sustainability of small businesses. Therefore, the government felt deductions for expenditure on the purchase of goods and services should be subject to timely payment to suppliers who were small businesses.
To address the payment delays, the government modified the IT Act, requiring timely payments to small businesses for deductions in the financial year 2023-24. This change, included in the Finance Bill 2023, affects tax filings from the assessment year 2024-25 onwards, aligning with the principle that certain expenses are deductible only in the year they are paid.
Thus, if a good or service was supplied in the financial year 2023-24, the buyer was allowed to claim deduction in that year only if the seller or service provider had been paid within the stipulated period (15/45 days). If that payment is delayed, the deduction is to be claimed only against incomes of 2024-25 or the year in which it is paid.
Usually, accounting rules allow most expenses to be deducted in the year in which it is incurred even if the payment is made in another year.
What are the implications for businesses?
When a deduction is not allowed, the income liable to be taxed increases and so do tax liabilities. This is what happens to buyers of goods and services of micro and small enterprises who fail to make the payment within the stipulated period and mostly before the close of a financial year.
For instance, a business purchases certain components from a small unit on 10 February. The MSMED Act requires that the supplier should be paid by 25 February if the two parties do not have a written agreement regarding payment. If they have entered into a written agreement, the payment needs to be made by 26 March. As long as the payment is made by 31 March, the buyer will be allowed to claim deduction from income. If the payment is made after 31 March, deduction for the expenditure can be claimed in 2024-25. If the purchase date is 31 March, the seller has agreed to be paid by 15 May and the payment is made by that date, the buyer can claim deduction in 2023-24.
Since the value of purchases can run into crores of rupees, non-payment of dues will bump up the income of the buyer by the unpaid amount. Also, expenditure on paying compound interest for delayed payment is not allowed as a deduction.
What is the advice for small businesses?
Tax and legal advisors are recommending that their clients revoke their micro or small business status to bypass the 15/45 days payment regulation. They are also advising that these micro or small manufacturing businesses alter their registration to be recognized as traders instead, since the payment regulation does not affect traders.
For those businesses that require registration on the government’s Udyam portal to access priority sector lending benefits, experts are advising using the registration solely for that purpose.
By not being registered as micro or small enterprises, these businesses can negotiate longer payment terms with their clients, in accordance with the Indian Contract Act. This also eliminates the risk of order cancellations due to buyers’ compliance with the MSMED Act or IT Act amendments.