Deductions Allowed Only on Actual Payment: Section 37 of the Income Tax Act 2025

Section 37 of the Income-tax Act, 2025 says that seven kinds of business expenses are deductible only in the tax year in which you actually pay them, even if your books are on the mercantile (accrual) basis and the liability arose earlier. The seven are taxes and fees, employer contributions to PF and similar funds, leave encashment, bonus or commission to employees, interest to specified lenders, railway dues, and amounts owed to micro and small enterprises beyond the statutory time limit. Most of them get a grace period: pay by the due date of your return and the deduction stays in the year the liability arose.

The section applies to income chargeable under section 26 (profits and gains of business or profession). The law is as amended by the Finance Act, 2026, and the examples below use tax year 2026-27. This is a general guide. It does not map the section to any provision of the 1961 Act, because that mapping was not verified for this article.

What does section 37 actually say?

Section 37(1) takes the sums listed in section 37(2) and allows them as a deduction only in the tax year in which they are actually paid. It applies irrespective of three things:

• any provision to the contrary in the Act;
• the method of accounting you regularly follow; and
• the tax year in which the liability was incurred.

So a business that books an expense on 31 March and pays it in June cannot rely on its accrual books for these seven items. The deduction follows the payment, not the book entry. Section 37 does not create a new deduction. It only decides the year for a sum that is "otherwise allowable as a deduction under this Act".

Which payments are covered by section 37?

Section 37(2)	Sum payable	Grace period under 37(3)?
(a)	Tax, duty, cess, surcharge or fee, by whatever name called, levied under any law in force	Yes
(b)	Employer's contribution to a provident fund, superannuation fund, gratuity fund or any fund for the welfare of employees	Yes
(c)	Amount payable by the employer in lieu of leave at the credit of an employee	Yes
(d)	Any sum referred to in section 32(a): bonus or commission paid to an employee for services rendered, where the amount would not otherwise have been payable to the employee as profits or dividend	Yes
(e)	Interest on loans, advances or borrowings from "specified financial entities", as per the terms of the loan agreement	Yes
(f)	Amount payable to the Indian Railways for use of railway assets	Yes
(g)	Amount payable to a micro or small enterprise beyond the time limit in section 15 of the Micro, Small and Medium Enterprises Development Act, 2006	No

Who are "specified financial entities" for the interest rule?

Section 37(7) lists them: a public financial institution, a State Financial Corporation, a State Industrial Investment Corporation, such class of non-banking financial companies as the Central Government notifies, a scheduled bank, or a co-operative bank. A primary agricultural credit society and a primary co-operative agricultural and rural development bank are excluded.

Section 37(2)(e) names only this group. Interest owed to anyone else is outside clause (e), so it is not caught by section 37 on that ground.

Do I lose the deduction if I pay after 31 March?

Not necessarily. Section 37(3) gives a grace period for every item in section 37(2) except the MSE dues in clause (g). If you pay after the end of the tax year but on or before the due date of filing your return under section 263(1), the deduction is allowed in the tax year in which the liability was incurred.

The due date comes from the Table in section 263(1)(c):

Who	Due date (of the financial year after the tax year)
Company; assessee (other than a company) whose accounts must be audited under the Act or any other law; partner of a firm whose accounts must be audited (and certain spouses)	31 October, where section 172 does not apply
Assessee with business or professional income whose accounts need no audit; partner of a firm whose accounts need no audit	31 August, where section 172 does not apply
Any other assessee	31 July
Assessees where section 172 applies	30 November (Table Sl. No. 1)

The conditions in the Table are more detailed than this summary, so read section 263(1)(c) for your own case.

What counts as a "sum payable" for taxes and fees?

Section 37(8) explains this for clause (a) taxes, duties, cess and fees. A sum is "payable" once you have incurred the liability in the tax year, even if the law you owe it under does not require payment within that year. A levy that accrues in 2026-27 but falls due under its own law in 2027-28 is therefore still a section 37 sum, and the deduction waits for payment (or the section 37(3) grace period). Section 37 only moves the timing of a deduction that is otherwise allowable. It does not make a non-deductible sum deductible.

Real-life example. Anil's shop incurs a Rs 60,000 local fee for 2026-27, but the local law lets him pay it in instalments up to December 2027. He pays nothing by 31 March 2027. Under section 37(8) the fee is a sum payable for 2026-27. He pays it in full on 20 July 2027, before his return due date, so section 37(3) lets him claim it in 2026-27. Had he paid after the return due date, the claim would move to 2027-28.

How do I decide the year of deduction? A flowchart

Worked example 1: property tax and a late payment

Assumptions. Tax year 2026-27. Shree Traders Pvt Ltd (a company, so the due date under section 263(1)(c) is 31 October, assuming section 172 does not apply) accrues Rs 4,00,000 of municipal tax on its premises in its 2026-27 books. Nothing is paid by 31 March 2027. The tax is otherwise allowable and falls under section 37(2)(a).

When Shree Traders pays	Test	Deduction of Rs 4,00,000 falls in
20 October 2027	After 31 March 2027 but on or before 31 October 2027, so section 37(3) applies	Tax year 2026-27
15 November 2027	After the return due date, so section 37(3) does not apply	Tax year 2027-28 (the year of payment)

In the second case the company's 2026-27 taxable profit is Rs 4,00,000 higher than its books show, and the same Rs 4,00,000 comes back as a deduction in 2027-28.

Worked example 2: employer PF contribution split across years

Assumptions. Tax year 2026-27. Kapoor and Sons, a firm whose accounts are audited (due date 31 October 2027). Employer PF contribution accrued for the year is Rs 1,80,000: Rs 1,50,000 paid before 31 March 2027, and Rs 30,000 (the March contribution) still unpaid on 31 March.

Step	Rs 30,000 paid on 10 September 2027	Rs 30,000 paid on 12 November 2027
Paid in 2026-27	1,50,000	1,50,000
Paid after year end, by 31 October 2027	30,000	0
Deduction in 2026-27	1,80,000	1,50,000
Deduction in 2027-28	0	30,000

Section 37(5) is what stops a double claim: in the first column the Rs 30,000 was already deducted in 2026-27, so it cannot be deducted again in 2027-28 when it is paid.

What if the interest is converted into a new loan?

Section 37(4) closes a common shortcut. If interest on a loan from a specified financial entity is converted into a loan, an advance, a debenture or any other instrument that defers the liability to a future date, it is not deemed to have been actually paid. Only cash that settles the interest counts, not a fresh instrument that carries it forward.

Real-life example. Ravi runs a small manufacturing unit and owes Rs 90,000 of interest to a scheduled bank. The bank agrees to add the unpaid interest to a new term loan instead of asking for payment. Ravi's books show the interest as an expense. Under section 37(4) it has not been paid, so the deduction waits until he actually pays interest in cash, in the year of that payment.

Why are dues to micro and small enterprises treated differently?

Section 37(2)(g) covers amounts payable by you to a micro or small enterprise beyond the time limit in section 15 of the MSMED Act, 2006. The time limit itself is in that Act, not in the Income-tax Act, so check it there. The important difference is that section 37(3) explicitly excludes clause (g). There is no grace period.

Real-life example. Meena's firm buys Rs 2,00,000 of goods from a micro enterprise in February 2027 and does not pay within the MSMED Act time limit. On 31 March 2027 the amount is still unpaid, and the limit has passed. She pays on 10 June 2027, well before the return due date. Because clause (g) has no grace period, the Rs 2,00,000 is deductible only in tax year 2027-28, the year of payment, even though the cost belongs to 2026-27 in her books.

Does section 37 apply to contributions I collect from employees?

No. Section 37(6) says the section does not apply to a sum received by the assessee from an employee as a contribution to the funds referred to in section 2(49)(o): provident fund, superannuation fund, the Employees' State Insurance fund or any other welfare fund for employees. Those receipts are part of "income" under section 2(49)(o), and they are outside the actual-payment rule of section 37.

How does section 37 link to the tax audit report (Form 26)?

If your accounts are audited under section 63, the auditor reports these items in Form 26. Rule 47(1) says the report goes in Part A of Form 26 for a person required by another law to get accounts audited, and in Part B for any other business or professional person. Part C and D carry the particulars required under section 63 (rule 47(2)).

Rule 47(3) deals with a payment made after the report has been filed. If that payment forces a recalculation of the disallowance under section 35 or section 37, you may get a revised audit report from an accountant (as defined in section 515(3)(b)), signed and verified, and furnish it before the end of the relevant financial year that follows the tax year of the report. For tax year 2026-27, the financial year that follows is 2027-28, so the deadline is 31 March 2028.

Common mistakes with section 37

• Relying on the accrual entry. Booking the expense is not payment. The section applies irrespective of your method of accounting.
• Assuming the grace period covers MSE dues. Section 37(3) excludes clause (g).
• Counting converted interest as paid. Converting bank interest into a loan or debenture does not meet section 37(4).
• Claiming twice. If the deduction was allowed in the year of liability under section 37(3), section 37(5) denies it in the year of payment.
• Using the wrong due date. The deadline is the section 263(1) due date for you, not 31 March and not a fixed 31 July for everyone.
• Missing a revised audit report. A payment after Form 26 is furnished can change the disallowance. Rule 47(3) lets you correct it, but only within the stated window.

Quick reference

Question	Answer	Where
Which year is the deduction allowed?	The year of actual payment	Section 37(1)
Grace period?	Pay by the section 263(1) due date and claim in the year of liability	Section 37(3)
Exception to the grace period?	MSE dues under clause (g)	Section 37(3)
Interest converted into a loan or debenture?	Not treated as paid	Section 37(4)
Deducted already in the earlier year?	Not allowed again	Section 37(5)
Employee contributions you receive?	Section 37 does not apply	Section 37(6)
Revised audit report	Before the end of the following financial year	Rule 47(3)

Where this is in the Act

• Section 37(1) to (8): the actual-payment rule, the list of sums, the grace period and the definitions.
• Section 26: the head "Profits and gains of business or profession".
• Section 32(a): bonus or commission to employees (referred to in section 37(2)(d)).
• Section 2(49)(o): employee contributions to funds (referred to in section 37(6)).
• Section 63: tax audit. Section 263(1)(c): return due dates.
• Rule 47: report of audit in Form 26 and the revised report.

For other business deductions, see our guide to business income under the 2025 Act. For TDS on rent, see TDS on rent under the Income-tax Act, 2025.

How can a CA firm keep track of these payment dates?

The hard part for a practice is not the rule. It is knowing, client by client, which sums were unpaid at year end and what each client's return due date is. Finexo's practice management software lets a CA firm keep client-wise due dates and tasks in one place, so a pending PF, tax or interest payment can be chased before the date passes. It does not compute the deduction or prepare Form 26.

This article explains the Income-tax Act, 2025 (as amended by the Finance Act, 2026) and the Income-tax Rules, 2026. It is general information, not tax advice. Confirm the position for a specific case with a qualified chartered accountant.