MSME Payment Rule

The Micro, Small, and Medium Enterprise Development Act (MSMED) of 206 and the new GST return filing system are reshaping the financial landscape for the small businesses of India. Along with these, recent MSME rules for payment changes influence the payment cycles, cash flow, and tax obligations within the MSME ecosystem. 

Background of the New GST Return Filing System

The new GST return filing system introduces a revised classification for taxpayers based on their annual turnover. This change aims to simplify the tax filing process, particularly for smaller businesses. Under this system, businesses are categorized as follows:

• Small Taxpayers: These entities have an aggregate annual turnover of up to ₹5 crores in the previous financial year. Most MSMEs fall into this category. 
• Large Taxpayers: This group includes businesses with an aggregate annual turnover exceeding ₹5 crores in the preceding year. 

One of the key features of this new system is the flexibility it offers to small taxpayers. They now have the option to file their GST returns on a quarterly basis. This can significantly reduce their compliance burden. In contrast, large taxpayers are required to continue with monthly return filing. 

Another important aspect of the new system is the mechanism for claiming input tax credit (ITC). Registered buyers can now claim ITC in their ANX-2 form only for invoices that their suppliers have uploaded to their corresponding ANX-1 forms. This change aims to improve the accuracy of tax credits and reduce discrepancies in the system. 

Background of the MSMED Act, 2006

The MSMED Act of 2006 is a cornerstone legislation designed to protect and promote the interests of micro, small, and medium enterprises in India. One of its most significant provisions is the stipulation of a 45-day credit period for payments to MSME suppliers. This rule was implemented to address the chronic issue of delayed payments, which often creates cash flow problems for smaller businesses.

To further strengthen this protection, the Ministry of Micro, Small, & Medium Enterprises launched the MSME Samadhaan portal on October 30, 2017. This online platform empowers micro and small entrepreneurs across India by allowing them to directly register complaints about delayed payments from various government entities, including Central Ministries, Departments, Central Public Sector Enterprises (CPSEs), and State Governments. This initiative represents a significant step towards ensuring timely payments and financial stability for MSMEs. 

Understanding the 45-Day and 15-Day Payment Cycle

The MSMED Act introduces specific payment terms to safeguard the financial interests of MSMEs. These terms are crucial for both suppliers and buyers to understand:

• In the absence of a mutually agreed payment date, buyers must abide by the MSME 45-day payment rule. They should settle their dues to MSME suppliers within 45 days of receiving goods or services. 

• Even if a buyer and an MSME supplier agree on a credit period exceeding 45 days, the MSMED Act overrides this agreement. It mandates that payment must still be made within the 45-day window of the date of receipt of goods or services. 

• In scenarios where no specific credit period has been agreed upon, the MSME regulations stipulate an even shorter payment window. In such cases, buyers are required to make payments to their MSME suppliers within just 15 days of receiving the goods or services. 

These provisions aim to ensure a steady cash flow for MSMEs. It enables them to maintain their operations and growth without the burden of extended payment cycles. 

Changes that Come into Effect from 1st April 2024

With the new financial year starting, businesses must gear up for significant changes in MSME payment terms to manage their accounts payable. This is particularly true when dealing with MSME suppliers. These adjustments will affect how expenses are recognized and the conditions under which they are deductible. Here is what businesses need to prioritize:

• Create a Detailed Vendor List: The first and most crucial step is to create a comprehensive list of all vendors. This is not just about having a simple database of suppliers. Businesses need to go a step further and categorize their vendors, with a special focus on identifying which ones qualify as MSMEs under the MSMED Act. This categorization is critical because the new rules apply specifically to transactions with registered MSMEs. To do this effectively, businesses should:

• Review all existing vendor contracts and documentation
• Reach out to suppliers to confirm their MSME status
• Update their vendor management systems to flag MSME suppliers
• Implement a process for regular updates of this information, as a supplier’s MSME status can change over time

• Record All Outstanding Payables: Businesses need to compile a detailed record of all outstanding payables as of March 31, 2024. This is not just about knowing the total amount owed; it requires a granular breakdown of:

• The specific amount owed to each supplier
• The date of each invoice
• The due date for each payment as per the agreed terms
• Whether the supplier is an MSME
• The age of each payable

This detailed record serves multiple purposes as it provides a clear picture of the company’s financial obligations. It helps identify which payables might be affected by the new ones as well as allows for better cash flow management and planning.

• Understanding Allowance and Disallowance Rules: Perhaps the most critical aspect of these changes is understanding how the new MSME payments rule will affect the allowance and disallowance of experts related to pending payments to MSMEs. This understanding is crucial for accurate tax planning and financial reporting. Key points to understand include:

• The 45-day and 15-day MSME payment time limit for suppliers
• The impact of exceeding these limits on tax deductions
• The differentiation between payments made within the same financial year versus those made in subsequent years

Important Points to be Considered for Allowances and Disallowances of Pending Payments as Expenses

Let’s delve into these different payment scenarios and how they will be treated under the new rules:

Situation 1: Same Financial Year Payments

If a buyer pays an MSME supplier within the same financial year, even if it is beyond the 45-day or 15-day limit, the expense can still be claimed as a deduction in that year itself. This scenario provides some flexibility for businesses that might occasionally exceed the payment limit but still manage to settle their dues before the financial year ends. 

For example, if a company receives an invoice from an MSME supplier on May 1, 2023, and pays it on February 28, 2025, it is beyond the 45-day limit but within the same financial year. They can still claim this expense as a deduction for the financial year 2024-25. 

Situation 2: Subsequent Financial Year Payments (Beyond Stipulated Period)

For payments made to MSMEs beyond the stipulated period and in a subsequent financial year, the deduction can only be claimed in the year of the actual payment. This scenario is designed to discourage delayed payments that stretch beyond the financial year. 

For instance, if a company receives an invoice on February 1, 2025, but only pays in on April 15, 2025, it falls in the next financial year and beyond the 45-day limit. The company can only claim this expense as a deduction in the financial year 2025-26, even though the expense was incurred in 2024-25.

Situation 3: Next Year Payments Within Approved Credit Period

When expenses are accrued in one financial year, but payment is made in the next year within the MSME Act’s approved credit period, the deduction can be claimed in the year of accrual. This scenario recognizes that some payments might legitimately fall into the next financial year due to the timing of invoices near the year-end. 

For example, if an MSME invoice is received on March 15, 2025, and paid on April 20, 2025, it is within the 45-day limit. However, it falls in the next financial year. This expense can still be claimed as a deduction for the financial year 2024-25. 

Situation 4: Subsequent Year Payments Beyond Credit Period

If payment is made in the subsequent financial year and beyond the MSME Act’s credit period, the deduction is only allowed in the year of the actual payment, not on an accrual basis. This scenario is the most stringent and is designed to strongly discourage late payments to MSMEs. 

For instance, if an invoice is received on January 15, 2025, but only paid on May 30, 2025, it is both in the next financial year and beyond the 45-day limit. This expense can only be claimed as a deduction in the financial year 2025-26.

These scenarios highlight the importance of timely payments to MSME suppliers. Businesses that fail to pay within the stipulated periods risk losing the tax deductions in the current year. They also face potential cash flow issues due to the bunching up of tax deductions in future years.

Impact of Disallowance of ExpensesWhen Bills are Overdue Under Section 43 (b)(H)?

An important point to note is that when payments to MSME suppliers are not made within the prescribed 15-day or 45-day cycle, Section 43 (b) (h) does not grant any disallowance. Instead, the allowance is granted only on an actual payment basis. This means that businesses cannot claim expenses for unpaid MSME invoices until they make the payment. This is regardless of when the expense was incurred. 

Key Points as Per Recent Amendments 

As businesses prepare for these changes, it is crucial to remember several key points:

• Implementation Date: These amendments regarding the allowance and disallowance of pending payments to MSMEs will take effect from April 1, 2024. They apply to the assessment year 2024-25 and onwards. Businesses must ensure that their payment practices comply with these new rules from this date to avoid disallowed expenses and potential penalties. Early preparation is vital to meet the requirements without disrupting regular financial operations. 

• Scope of Application: The new rules under Section 438 (h) of the Income Tax Act 1961 specifically apply to micro and small enterprises, not medium enterprises. This distinction is important as it directly impacts how different businesses handle their accounts payable and comply with the new regulations. Companies should accurately classify their vendors to determine which of them fall under the “small and micro” categories to ensure adherence. 

• Delayed Payments: If a supplier makes delayed payments before filing their Income Tax returns for that year, deductions can only be claimed in the year of actual payment. It cannot be done in the year expenses were accrued. This provision reinforces the importance of timely payments to MSME suppliers to ensure that businesses can benefit from deductions in the appropriate financial year. Keeping track of payment timelines will be crucial to maximize allowable deductions and avoid cash flow issues.

• UDYAM Registration: For suppliers to claim disallowance under Section 438 (h), they must inform their MSME partners about their registration under the UDYAM scheme. Failure to do so may result in the inability to claim this disallowance. It impacts both suppliers and buyers. Therefore, businesses should encourage their MSME suppliers to maintain valid UDYAM registration and share this information promptly to avoid any future disputes or compliance issues. 

• Retroactive Application: These changes do not apply to amounts outstanding to MSMEs as of March 31, 2023. They only affect transactions from the next financial year onwards. This means businesses will not have to reassess past transactions, but they must closely monitor all new transactions starting April 1, 2024. A clear understanding of this cut-off is essential to apply the new rules correctly and avoid any misapplication or confusion.  

Conclusion

The recent amendments to the Income Tax Act, especially Section 438 (h), present new challenges for businesses dealing with MSME suppliers. To navigate the changes as per the  MSME income tax rule, businesses must maintain accurate records, understand the MSME status of their vendors, and align their payment processes with the MSMED Act. Regularly updating tax strategies will help in adapting to the evolving regulations and minimizing potential disallowances. Ignoring these updates could lead to unexpected financial setbacks or compliance issues. Rely on Lendingkart for valuable resources and insights to support businesses in understanding these changes and staying compliant.