Assessing The Overreach: A Critique Of Section 43B(H) Of The Income Tax Act, 1961

The author is Malak Sheth, a student at Rajiv Gandhi National University of Law, Patiala.

Section 43B(h) of the Income-Tax Act, 1961 and the Micro, Small and Medium Enterprises Development Act, 2006- An Introduction

The State’s power of taxation is exercised by it for fiscal purposes, i.e., for raising revenue to meet public expenditures, and non-fiscal purposes, i.e., to directly produce certain economic or social benefits irrespective of whether revenue is raised or not. The Government, in pursuance of such a non-fiscal goal, inserted clause (h) in Section 43B of the Income Tax Act, 1961 (“IT Act”) through the Finance Act, 2023 to be applicable for assessment from assessment year (“AY”) 2024-25. The amendment becomes relevant when read with Section 15 of the Micro, Small and Medium Enterprises Development Act, 2006 (“MSMED Act”) which mandates the buyer of goods or services from Micro and Small Industries (since Medium enterprises are not covered by this rule), to make payment on or before the agreed-upon date in writing, not exceeding 45 days.

The cumulative effect of the amendment is that tax deductions or allowances for amounts due to small and medium-sized enterprises (“MSEs”) will only be permitted if the payment is made according to Section 15 of the MSMED Act. Therefore, the deductions for payments to be made to MSEs would not be allowed on an accrued basis but on a payment basis. The rationale behind the amendment is to use the State’s power of taxation by increasing the tax liability of the assessee, to enforce timely payments to the MSEs.

For instance, if a buyer owes an MSE supplier one crore rupees for the goods procured from it, without a written agreement, on 1st March 2024 and if they fail to make the payment within the stipulated period of 15 days under the MSMED Act, the accrued liability of the buyer would not be allowed as a deduction from the profits. This would result in the tax liability of the buyer increasing tremendously, with an estimated 30% of one crore, to amount to Rs. 30 lakhs.

It is predicted that the buyers, to avoid this increased tax liability, would make timely payments to the MSEs. Consequently, there would be better access to working capital and economic stability for these fledgling industries. However, despite the innocuous motive of the Government, it has received backlash from various sectors who fear an impact on their growth because of a change in buyers’ preference for industries not covered by the MSMED Act (including medium Enterprises).  This could help avoid the compulsory payment within the stipulated 45 days and therefore allow an extended credit period for these buyers.

Chanakya, in his Arthshastra, prudently advises the Governments to collect taxes like a honeybee, which sucks just the right amount of honey from the flower without causing any harm. The current article, considering Chanakya’s adage as the fundamental principle of taxation, delves into the criticisms of this amendment by analysing (a) the use of the State’s taxation powers to limit the freedom to contract in the MSE industry, and (b) the effect of the amendment on non-price competition in the market.

State’s Power of Taxation - Analysing the Limitations

Contracts functionalise the exchange of goods and services, not just immediately as in a barter, but over an extended period through the system of credit and the stored value of goods. It is in the materialisation of this economic rationale that parties are given the freedom to determine the terms that they may consider advantageous to their interests and are simultaneously vested with the rights to enforce the terms of such bargain.

Therefore, SMEs that wilfully contract to extend a credit line for a time longer than 45 days as stipulated under Section 15 of the MSMED Act, should be allowed to exercise their will. The State cannot, purportedly as parens patriae, be allowed to supplant the will of the contracting parties, especially not through the powers of taxation. These powers are hallowed since they are vested in the State as a part of a bargain where exaction on a person’s private property/ products of their labour is allowed, in return for the common public good. Thus, in deference to such special powers of the State, which form a part of this bargain, they must sparingly be used to reach non-fiscal objectives of the kinds that impinge on human autonomy.

Even if it is conceded that because of unequal bargaining power, contracts for delayed payments by the MSEs might not be universally consensual, it must be recognised that the business customs in industries like textile and chemical industries demand that the payments be sought after extending a generous credit period. This is, at times, based on the business realities owing to longer chains of distribution of goods, amongst others. It is inconceivable for the State to be aware of all such customs in all industries. Therefore, a universal rule in the form of section 43B(h) that is punitively applicable pan-industries, could be said to be a misuse of the State’s power of taxation.

Therefore, when industry players foresee harm to their business if credit cycles are not extended, they should be allowed to exercise their autonomy and make decisions about what is in their best interest. When the State seeks to substitute its judgement for that of the business players, unforeseeable harms are caused to the populace. For instance, buyers shift their purchases to non-MSE suppliers; intermediaries like wholesalers and retailers that are not covered by Section 15 of the MSMED Act have to make timely payments to their MSE suppliers while no such legal obligation is imposed on their buyers which ultimately disrupts the entire chain of payments and so on.

Further, even though seemingly in the interest of SMEs, the amendment could result in cyclical redundancy of these businesses. This is argued because purchases made at the start of the FY are generally covered within the customary credit cycles of 6-8 months and therefore payments for them would be made by the time of assessment. Therefore, the threat of increased tax liability calculated at the end of the financial year by disallowing deductions for accrued payments does not materialise for these purchases. However, purchases made in the third or fourth quarters, depending on the industry practice for credit cycles, could fall within the scope of section 43B(h) and be disallowed as a deduction if payment is not made within the stipulated time. Therefore, buyers could decide, for the third and fourth quarters, to buy from market players that are not covered by the MSMED Act (Including Medium Enterprises). This would ultimately lead to the exploitation of MSEs since they would be reduced to redundancy for these quarters when buyers change their preferences.

Also, the State for instance, for income under the head ‘salary’ charges tax based on the earlier of the receipt of salary or salary due to the employee. Therefore, it is unjust to not allow deductions for payments accrued but not made in case of the buyers from the MSEs when the tax on income can be collected even on a due basis.

As is axiomatic from this analysis, in certain industries, longer credit lines are extended to match their competition wherein competitiveness in prices is not feasible. Therefore, Section 43B(h) disrupts the level playing field by not allowing non-price competition in the form of credit lines. Therefore, industries where smaller players catered to buyer’s demand for relaxed payment cycles to prevent them from approaching the industry bigwigs, now face a serious existential threat. Their attractiveness was their ability to cater to business needs along with relaxed demand for payments. Conclusively, the State should not, through its power of taxation, be allowed to disrupt the level playing field. Further, the mandated payment cycle of 45 days could also hurt India’s exports from MSEs since it would reduce the competitiveness of its goods in foreign markets. This is argued because suppliers of goods from competing countries, (China for instance) allow for longer credit lines. Therefore, this improves the attractiveness of their goods for foreign buyers over Indian exporters, which would negatively impact India’s export journey.

Conclusion

The aforementioned analysis criticises Section 43B(h) for undermining the autonomy of the MSEs and disrupting the level playing field for these players by eliminating non-price competition in the form of credit cycles. The impact of this amendment, per contra to its objective of alleviating the distress of the MSEs, has resulted in huge losses for them. For instance, the Clothing Makers Association of India (CMAI) estimates that the modification will cost MSE apparel makers between Rs 5,000 and Rs 7,000 crore in losses during the January–March quarter. According to the CMAI, retailers have cancelled orders with MSEs in favour of non-MSE players (including Medium Enterprises) as a result of the new law. Thus, it could be said that Chanakya’s metaphorical honeybee has left the flower to wither and die. Therefore, Section 43B(h) should be rolled back for being an overreach of the State in the supposed exercise of the parens patriae powers and thereby causing unforeseeable harm to the MSE industry.