Compliance Checklist for MSME Payments and Tax Audit Reporting under Section 43B(h) for AY 2025-26

Introduction

The Micro, Small, and Medium Enterprises Development (MSMED) Act, 2006, and the Income Tax Act are key legislative tools that regulate and govern the recognition of MSMEs in India. With MSMEs being a backbone of the Indian economy, playing a vital role in both goods and services sectors, ensuring their financial health through timely payments and compliance with legal obligations is crucial.

Effective from Assessment Year (AY) 2025-26, Section 43B(h) of the Income Tax Act introduces provisions for payments made to Micro and Small Enterprises (MSEs). According to this provision, businesses are required to make payments within specified time limits—15 days for goods and services without a written agreement, and 45 days if a written agreement exists. Any failure to adhere to these timelines will result in the disallowance of expenses related to such payments, leading to potential tax repercussions.

This checklist provides businesses and auditors with a clear, step-by-step approach to ensure compliance with the regulations under Section 43B(h). It covers crucial aspects, such as MSME classification, timelines for payments, handling delayed payments, and tax audit disclosures. By adhering to the following guidelines, businesses can reduce risks, avoid penalties, and streamline their tax processes.

Checklist for Compliance with Section 43B(h) of the Income Tax Act (Effective AY 2025-26 and onwards)

1. Applicability of Section 43B(h)

Scenario: A company purchases raw materials from an MSME supplier on May 1, 2025, without a written agreement. Payment is due on May 21, 2025. To comply, the company must ensure the payment is made by May 16, 2025 (15 days from acceptance).

• Ensure compliance from AY 2025-26 onwards.

• Payments to Micro and Small Enterprises (MSEs) must be made within the prescribed time limits:

  • 15 days from acceptance for goods and services without a written agreement.

  • 45 days from acceptance if a written agreement specifies the credit period.

• Medium Enterprises are not covered under this provision.

• Example: If the company buys professional services from an MSME on April 1, 2025, the payment must be made by April 16, 2025 if no written agreement exists. Delaying this payment will lead to the disallowance of the related expense for tax purposes.

2. MSME Classification & Registration Verification

Scenario: A business uses the services of an MSME registered as a manufacturer. The supplier's Udyam Registration is cross-verified, and their GST registration is checked to confirm that they are indeed registered as a service provider or manufacturer.

• Ensure the supplier has a valid Udyam Registration Certificate.

• Verify the supplier’s GST registration to confirm whether they are a trader, manufacturer, or service provider.

• Traders registered under MSME are not covered—only payments for goods and professional services are subject to disallowance under Section 43B(h).

• Example: An MSME supplier providing manufacturing services must be verified for both Udyam and GST registrations. Payments for goods and professional services provided by such MSMEs will fall under the Section 43B(h) disallowance if not paid within the specified timelines.

• New MSME Classification Limits (effective from April 1, 2025):

  • Micro: Investment up to ₹2.5 Cr, Turnover up to ₹10 Cr.

  • Small: Investment up to ₹25 Cr, Turnover up to ₹100 Cr.

  • Medium: Investment up to ₹125 Cr, Turnover up to ₹500 Cr (Not applicable for 43B(h)).

3. Disallowance Considerations

Scenario 1: A business purchases goods from an MSME supplier, records the expense, but makes the payment 60 days later. In this case, the expense will be disallowed under Section 43B(h) despite the goods being in inventory.

• Confirm that the supplier is a registered Micro or Small Enterprise under Udyam.

• Identify payments that remain outstanding beyond the 15 or 45-day timelines.

• Ensure that the purchase amount has been debited to the Profit & Loss account in the same financial year.

• Example: If a purchase is made from an MSME on January 1, 2025, and payment is made on March 1, 2025, the expense will be disallowed for FY 2024-25 as the payment was made beyond the 15/45-day limit.

• Payments made after March 31, but within the MSME Act’s timelines, will not be disallowed for tax purposes.

4. Interest Implications Under MSMED Act

Scenario: A business fails to make timely payments to an MSME supplier, and the supplier charges interest at three times the RBI-notified rate. The business is liable for interest payment, which is not tax-deductible.

• Interest on delayed payments is calculated at three times the RBI-notified rate, compounded monthly.

• Even if the MSME supplier waives the interest, it is still legally owed.

• Example: If a business delays a payment, leading to ₹5,000 interest being charged by the MSME supplier, this interest amount is not deductible for tax purposes.

• Interest paid or payable under Section 16 of the MSMED Act is not deductible under the Income Tax Act.

5. Disclosure & Compliance Requirements

Scenario: An auditor identifies a payment that was due to an MSME on January 30, 2025, but was paid on February 15, 2025. The auditor must disclose the delayed payment in the tax audit report.

• Financial Statements (As per Section 22, MSMED Act):

  • Outstanding principal and interest amounts (separately).

  • Interest paid during the year on delayed payments.

  • Interest accrued but not yet paid.

  • Interest payable for future periods.

• Tax Audit Report (Form 3CD, Clause 22 & Clause 26):

  • Clause 22 mandates the disclosure of unpaid amounts to MSMEs beyond the prescribed time limits. If payments remain overdue beyond the prescribed timelines, they must be reported in the tax audit report.

  • Clause 26 includes a specific sub-clause for reporting disallowance under Section 43B(h) of the Income Tax Act.

  • Auditors must verify and reconcile MSME payments with financial statements, ensuring that payments to MSMEs which are delayed beyond the prescribed timelines are disclosed properly.

  • Example: If a payment is overdue, the auditor must disclose the amount in Clause 22 and report disallowed expenses in Clause 26.

6. Revised MSME Payment Reporting in Clause 22 of Form 3CD

The latest amendment to Clause 22 of Form 3CD mandates more detailed reporting for payments made to MSMEs under India’s MSME Development Act, 2006. Taxpayers must disclose the following key details for enhanced compliance and transparency:

• Total amount payable to MSMEs under Section 15 of the MSMED Act.

• Amount of interest that cannot be claimed as a deduction under Section 23 of the MSMED Act due to delayed payments.

• A clear distinction between:

  • Payments made within the prescribed period (15/45 days).

  • Payments delayed beyond the due date (overdue payments).

This updated reporting requirement aims to improve the accuracy of disclosures and provide clearer insights into the taxpayer’s compliance with MSME payment obligations.

7. Modifications in Clause 26—Deduction under Section 43B of Income-tax Act, 1961

Clause 26 of Form 3CD has been revised to enhance the clarity of reporting and differentiate between various categories of payments covered under Section 43B. The modification emphasizes specific reporting of amounts allowed as deductions only upon actual payment:

• Previously, this clause only required the disclosure of amounts allowable upon actual payment of statutory dues (e.g., taxes, duties).

• The amendment refines the language and includes specific references to payments under Section 43B(h) (related to MSME payments) and clarifies that payments to MSMEs which are delayed beyond the prescribed timelines will result in disallowance of expense.

This change ensures that auditors properly distinguish between eligible payments and those that are disallowed for tax purposes, improving the accuracy and transparency of financial statements.

8. Key Differences Between MSMED Act & Section 43B(h)

Criteria	MSMED Act	Section 43B(h) (Income Tax Act)
Applicability	Micro & Small Enterprises	Micro & Small Enterprises
Due Date for Payment	15/45 days	15/45 days
Interest on Delay	3X RBI Bank Rate (compounded monthly)	No interest provision under IT Act
Disallowance	Not applicable	Deduction disallowed for delayed payment
Interest Deductibility	Not deductible (Sec 23, MSMED Act)	Not deductible
Coverage	Goods & Services	Goods & Professional Services

9. Practical Steps for Businesses

Scenario: A company implements an automated system to alert finance teams about payment due dates to ensure compliance with MSME payment timelines.

• Verify MSME status before recording purchases and availing professional services.

• Ensure timely payments (within 15/45 days) to avoid disallowance of expenses.

• Maintain records of outstanding MSME dues for financial reporting and tax audits.

• Recognize and disclose interest on delayed payments as per the MSMED Act.

• Implement automated payment tracking systems to avoid unintentional disallowance.

• Example: Set up automated reminders in the accounting system to ensure payments are made within the required timeframe, thus avoiding disallowance due to delays.

10. Summary & Final Takeaways

Scenario: A business must ensure that payments to MSMEs are always made within the prescribed timelines to avoid penalties and tax consequences.

• Section 43B(h) applies from AY 2025-26 onwards, impacting expense deductions for delayed payments.

• Payments to Micro & Small Enterprises must be made within 15/45 days to avoid disallowance.

• Traders registered as MSMEs are excluded—only payments to service providers and manufacturers are covered.

• Professional service payments to MSMEs must comply with 15/45-day payment timelines.

• Interest on late payments under the MSMED Act must be recognized and disclosed, but it is not tax-deductible.

• Form 3CD reporting and financial statement disclosures must be made to avoid penalties.

• Proactive payment management and MSME verification are crucial to ensure tax compliance and prevent financial impact.