The biggest problem faced by small enterprises is delayed payment of their dues by large enterprises as it results in a shortage of working capital severely impacting their production

An amendment to the Income Tax Act, introduced through Finance Act 2023, and effective from April 1, 2024 stops businesses from claiming tax deductions for payments beyond 45 days to the Micro, Small and Medium Enterprises (MSMEs) for supply of goods and services has caused much consternation. The MSMEs are ancillary units engaged in the production, manufacturing and processing of goods and commodities (mostly intermediate goods) which are supplied to large enterprises or master units. These units operate on a small scale and are further categorized into micro, small and medium enterprises depending on the ‘investment’ and ‘turnover’ threshold as defined under the Micro, Small and Medium Enterprises Development Act, 2006.

A micro-enterprise is one where investment in the plant and machinery or equipment doesn’t exceed Rs 10 million and turnover doesn’t exceed Rs 50 million. A small enterprise is an entity where investment in the plant and machinery is less than 100 million and turnover doesn’t exceed Rs 500 million. For a medium enterprise, the thresholds are set at Rs 200 million for investment in the plant and machinery or equipment and  Rs 1000 million for turnover. According to the Ministry of Statistics & Programme Implementation, the share of MSME Gross Value Added (GVA) in India's Gross Domestic Product (GDP) is around 30 per cent. The share of MSME manufacturing output in all India Manufacturing output is even higher at around 36 per cent.

The share of export of MSME-specified products in all India exports has oscillated between 44 – 50 per cent during the last couple of years, according to the Directorate General of Commercial Intelligence and Statistics (DGCIS). As for employment, according to a report released by the McKinsey Global Institute (MGI), MSMEs in India contribute 62 per cent to the total. Looking at the omnibus ‘informal’ sector – apart from MSMEs, it also includes proprietary household and partnership establishments – its contribution to employment is even higher at more than 75 per cent whereas in GDP its share is almost 50 per cent.The MSMEs thus play a predominating role in shaping the prospects of the economy more so in promoting ‘inclusive’ development with particular emphasis on increasing employment and income and reducing income inequalities.

Yet, they have borne the brunt of far-reaching economic decisions implemented by the Modi – Government during its first two terms such as demonetization (2016) and introduction of the Goods and Services Tax (GST), 2017 also the devastating impact of the Corona – pandemic (2020). The government has taken several mitigation steps including a Rs 500,000 crore Emergency Credit Line Guarantee Scheme (ECLGS) for businesses/MSMEs; equity infusion of Rs 50,000 crore through MSME Self-Reliant India Fund; no global tenders for procurement up to Rs. 200 crores (it bolsters their chances of securing government contract); relaxing threshold for classification of MSMEs; extension of non-tax benefits for 3 years in case of an upward change in status of MSMEs; inclusion of retail and wholesale trades as MSMEs; launch of Udyam Assist Platform (UAP) to bring the Informal Micro Enterprises (IMEs) under the formal ambit for availing the benefit under Priority Sector Lending (PSL); launch of an online Portal “Champions” to cover various aspects of e-governance including grievance redress and handholding of MSMEs and so on.

Even as all these initiatives seek to address issues of credit availability, technology infusion, market support etc, a problem haunting small enterprises has to do with delayed payment of their dues by large enterprises. When they don’t receive payment for the goods supplied by them, it results in a shortage of working capital severely impacting their ‘ability to continue with production’.  To address this problem, Section 15 of the MSMEs Development Act 2006, had mandated payments to micro and small enterprises within 45 days in case of written agreement (in case, there was no written agreement, the time limit was set at 15 days). In 2019, the Ministry of Corporate Affairs came up with the Specified Companies (Furnishing of information about payment to micro and small enterprise suppliers) Order that required large firms to file returns every six months even if there is no outstanding to MSME beyond 45 days.

Yet, the problem persisted forcing numerous firms to down shutters.  This prompted the Union Government to look for a solution under the IT Act (1961). The Finance Act 2023, inserted Section 43B(h) in the IT Act (1961), which prescribes that if a larger company doesn’t make payments to micro and small enterprises within 45 days in case of written agreements, it cannot deduct that expense while calculating the taxable income of the relevant financial year. How does it impact the large enterprises? To arrive at the profits during a financial year (FY) and hence the income on which tax is levied (known in IT parlance as ‘taxable income’), a company deducts all expenses incurred on running the business from the total revenue it earns. The payments made by it for the purchase of goods from the MSMEs are an important item of expense; therefore it is deductible from the revenue.

If, it doesn’t pay the small firm say Rs 5 lakh within the prescribed 45 days, Section 43B(h) will kick in and the large firm won’t be allowed to deduct this amount in that FY thereby increasing its taxable income to that extent. So, it will end up paying more tax during that FY. Taking an effective corporate tax of 34.9 per cent (basic corporate tax of 30 per cent plus 12 per cent surcharge plus 4 per cent Health & Education Cess), the extra tax works out to Rs 174,500/-. This will be a deterrent strong enough to dissuade large enterprises from holding back payments to MSMEs.

It is not as if this extra tax ends up impacting the company’s balance sheet forever. This additional tax paid (albeit due to delays in making payments to MSMEs) can be adjusted the following year when the company pays the supplier.

The Section thus strikes a good balance between the interests of all stakeholders. Even while creating a strong incentive for large enterprises to prioritize payments to the MSMEs thereby bolstering the latter’s financial health and growth, it doesn’t unduly penalize the former.  Meanwhile, the Ministry of Corporate Affairs has also relaxed the reporting requirements under its 2019 Order. A notification issued on July 15, 2024, requires that “only those specified companies which are having payments pending to any micro or small enterprises for more than 45 days from the date of acceptance or the date of deemed acceptance of the goods or services under section 9 of the MSMEs Development Act, 2006 shall furnish the information”. Earlier, they were required to furnish even if there was no outstanding to MSME beyond 45 days.

Yet, industries and businesses have asked Finance Minister Nirmala Sitharaman to defer the implementation of the clause in the IT Act by a year to April 2025.

At the same time, we see reports of large enterprises arm-twisting small firms by deciding not to buy from MSMEs; instead deal with those MSMEs that are not registered with the Udyam portal (It's an online system for registering MSMEs, launched by the Union MSME ministry) or from non-MSMEs. This must be avoided. Section 43B(h) of the IT Act should be given a fair chance to succeed.

(The writer is a policy analyst; views are personal)