Section 40(a)(i) of the Income Tax Act, 1961 disallows 100% of a business expense when the payer fails to deduct tax at source on a payment to a non-resident, or deducts it but doesn’t deposit it with the government by the income tax return filing deadline under Section 139(1). The full payment gets added back to taxable income for that year. The disallowance applies to interest, royalties, fees for technical services, and any other sum chargeable to tax under the Act when paid to a non-resident or foreign company.1Indian Kanoon. The Income Tax Act, 1961 – Section 40
What Payments Trigger the Disallowance
Four categories of outbound payments fall within scope: interest, royalties, fees for technical services, and any other sum chargeable to tax under the Act.1Indian Kanoon. The Income Tax Act, 1961 – Section 40 That last catch-all is where many businesses get caught. Any payment to a non-resident that creates a tax liability in India can trigger the provision, not just the three named types.
Royalty under Section 9(1)(vi) reaches well beyond copyright or patent licensing. It covers payments for transferring rights in patents, inventions, trademarks, secret formulas, and designs, payments for sharing technical or scientific know-how, and even payments for using industrial or scientific equipment.2Indian Kanoon. The Income Tax Act, 1961 – Section 9 Fees for technical services similarly cover a wide range of managerial, technical, and consultancy work performed by foreign parties.
The provision applies in two distinct scenarios. It covers payments made outside India to any person, whether resident or non-resident. It also covers payments made within India to a non-resident individual or a foreign company.1Indian Kanoon. The Income Tax Act, 1961 – Section 40 A rupee payment credited to a non-resident’s Indian bank account falls squarely within scope. The critical factor is the recipient’s tax status, not where the money physically goes.
The TDS Timing That Keeps You Safe
Two things must happen to avoid disallowance: deduct the tax, and deposit it on time. Under Section 195, the payer must withhold tax at the applicable rate at the time the payment is made or credited to the non-resident’s account, whichever comes first. The default TDS rate for interest, royalties, and fees for technical services paid to non-residents is 20%, though this can be reduced under an applicable Double Taxation Avoidance Agreement.3Income Tax Department. TDS Rates
Once deducted, the tax must be deposited with the government by the due date for filing the payer’s income tax return under Section 139(1).1Indian Kanoon. The Income Tax Act, 1961 – Section 40 That return-filing deadline is the outer limit. Miss it, and the disallowance attaches to that year’s return. Deposit before it, even after routine monthly TDS deadlines have passed, and the expense stays deductible for the year it was incurred.
What 100% Disallowance Actually Costs
The statute is unambiguous: the full amount is added back to the payer’s taxable profits.1Indian Kanoon. The Income Tax Act, 1961 – Section 40 Consider a company that pays ₹1 crore in royalties to a foreign licensor without withholding TDS. That entire ₹1 crore loses its status as a deductible business expense. If the company’s effective tax rate is around 25% to 29% depending on income level and applicable surcharge, the disallowance creates an additional tax liability of roughly ₹25 to ₹29 lakh on a payment that would otherwise have reduced taxable income. The underlying business transaction may have been perfectly legitimate. The tax treatment of the expense hinges entirely on whether TDS obligations were met.
Compare This to the Resident Payment Rule
The gap between the non-resident and resident penalties is wide. Under Section 40(a)(ia), failing to deduct or deposit TDS on payments to residents results in a disallowance of only 30% of the expense. Section 40(a)(i) imposes a 100% disallowance for the same failure on non-resident payments. The legislature drew a harder line for cross-border transactions, where recovering tax from a non-resident recipient is far more difficult for Indian authorities.
Interest and Penalties on Top of Disallowance
The disallowance is only the deduction-side hit. The payer faces additional exposure under separate provisions at the same time.
A payer who fails to deduct or deposit TDS is treated as an “assessee in default” under Section 201(1). The payer becomes personally liable to pay the TDS amount that should have been withheld, on top of the disallowance hitting taxable income.4Indian Kanoon. The Income Tax Act, 1961 – Section 201
Interest accrues under Section 201(1A) at two rates:
- Failure to deduct: simple interest at 1% per month, or part of a month, from the date tax should have been deducted until the date of actual deduction.
- Failure to deposit after deduction: simple interest at 1.5% per month, or part of a month, from the date of deduction until the date of actual payment to the government.
Any part of a month counts as a full month, so a one-day slip into the next month doubles the interest period.4Indian Kanoon. The Income Tax Act, 1961 – Section 201 The unpaid TDS and accrued interest together become a charge on all assets of the defaulting person or company. In severe cases, prosecution under Section 276B can result in rigorous imprisonment ranging from three months to seven years for willful failure to deposit TDS that was actually deducted.
Recovering the Deduction in a Later Year
The disallowance is painful but not permanent. A proviso to Section 40(a)(i) lets the payer reclaim the deduction once the TDS obligation is finally met. When the business eventually deducts and deposits the tax, the previously disallowed expense becomes deductible in the year the tax is paid.1Indian Kanoon. The Income Tax Act, 1961 – Section 40
The timing shift works like this. If a royalty payment was made in FY 2023-24 without TDS, and the company deposits the TDS in FY 2025-26, the deduction becomes available when filing the return for AY 2026-27. The expense is reported in the schedules reserved for items allowed in the current year that were disallowed in a prior year. Clean documentation linking the late TDS deposit to the original payment and the earlier disallowance is essential.
This remedial path recovers the deduction itself. It does not erase the interest charged under Section 201(1A) or any penalties imposed during the intervening period. The time value of losing a deduction for one or more years is real, and for large payments the cash flow impact of the temporarily inflated tax bill can be significant.
How DTAAs Affect the Analysis
A tax treaty can change the Section 40(a)(i) picture in two ways. A DTAA may reduce the withholding rate below the standard 20% under domestic law. If the treaty rate is lower, the payer only needs to withhold at that rate to satisfy TDS requirements. The Income Tax Act applies only to the extent its provisions are more beneficial to the taxpayer; otherwise, the treaty provisions override.5Income Tax Department. Double Taxation Relief
More significantly, if a payment is not taxable in India at all under a DTAA, the question is whether Section 40(a)(i) can even trigger. The provision applies to sums “chargeable under this Act,” so a payment that falls outside India’s taxing rights arguably has no TDS requirement and nothing to default on. Several tribunal decisions have taken that position, though the issue has seen varying judicial treatment depending on the facts.
To claim treaty benefits, the payer should obtain a Tax Residency Certificate from the non-resident recipient and file Form 10F electronically on the income tax portal. Without that documentation, tax authorities routinely deny treaty rate applications during assessments, which can retroactively convert a compliant withholding into a shortfall and trigger disallowance.
Form 15CA and 15CB: A Related but Separate Requirement
Foreign remittances trigger a reporting requirement through Form 15CA, filed electronically before the payment is made. Form 15CB is a chartered accountant’s certificate confirming the nature of the payment, the applicable TDS rate, and whether a DTAA applies. It is required when aggregate remittances exceed ₹5 lakh during the financial year and no order from the Assessing Officer has been obtained.6Income Tax Department. Form 15CA FAQs Skipping these forms doesn’t directly trigger Section 40(a)(i) disallowance, but it draws scrutiny during assessments and can complicate proving that TDS was handled correctly.
What Happens Under the Income-tax Act, 2025
The Income-tax Act, 2025 was passed by both houses of Parliament and takes effect from April 1, 2026.7Press Information Bureau. Understanding The Income Tax Act, 2025 The new Act consolidates and restructures the 1961 legislation, renumbering sections and reorganizing TDS provisions. The core principle of Section 40(a)(i), disallowing deductions when TDS on non-resident payments is not handled properly, carries forward under the restructured provisions.
Section 40(a)(i) by its current designation continues to apply to assessments through AY 2026-27 and any pending proceedings under the 1961 Act. For transactions from FY 2026-27 onward, the corresponding provision in the 2025 Act governs. Anyone managing cross-border payments should map existing compliance processes to the restructured provisions before the changeover.