MSME Payments Under New Tax Law: A Corporate Compliance Guide

Key Takeaways

• Shift to Payment-Basis Deduction: The new tax framework, embodied by Section 43B(h) of the Income Tax Act, mandates a crucial shift from accrual to a payment-based system for deducting expenses related to goods and services procured from registered Micro and Small Enterprises (MSEs). An expense is only deductible in the year it is actually paid if the payment exceeds the statutory deadlines.
• Strict Payment Timelines Are Now Law: Businesses must pay registered Micro and Small Enterprise vendors within 45 days if a written agreement exists, or within 15 days if there is no agreement. Failure to meet these deadlines results in the disallowance of the expense for that financial year, shifting the deduction to the year of actual payment.
• Inapplicability to Non-Registered & Medium Enterprises: This stringent payment-linked deduction rule does not apply to vendors who are not registered under the MSMED Act (i.e., do not have a Udyam Registration Number) or to those classified as 'Medium' enterprises. The compliance burden, therefore, is on the purchasing company to identify and verify the status of its vendors.
• Mandatory Vendor Verification: It is now imperative for all companies to implement a robust process to obtain Udyam Registration Certificates from their suppliers. This verification is the only way to correctly classify vendors and ensure compliance, thereby avoiding unintentional disallowances and increased tax liability.

PART 1: EXECUTIVE SUMMARY

This compliance guide outlines the transition from the prior expense allowance system under the Income Tax Act, 1961, to the new regime governed by the Direct Tax Code 2025, which incorporates the principles of Section 43B(h). This change fundamentally alters how corporations can claim deductions for payments due to Micro and Small Enterprise (MSE) vendors.

• The Old Law (1961): Under the erstwhile system, corporate taxpayers following the mercantile method of accounting could claim expenses on an accrual basis. This meant a deduction could be claimed for the financial year in which the liability was incurred, regardless of when the payment was actually made to the vendor. This practice often led to significant delays in payments to smaller businesses, impacting their cash flow and operational stability.

• The New Law (2025): The new framework introduces a critical linkage between the timing of payment and the eligibility for a tax deduction. As per Section 43B(h) of the Income Tax Act, any sum payable to a registered Micro or Small Enterprise will be allowed as a deduction in the financial year of accrual only if it is paid within the time limit stipulated in the MSMED Act, 2006. This limit is 15 days without a written agreement and a maximum of 45 days with one. If payment is delayed beyond these dates, the deduction is deferred to the financial year in which the payment is actually made, leading to a higher taxable income in the year of accrual.

• Who is Impacted: This change directly impacts all business entities subject to tax audit that procure goods or services from suppliers registered as Micro or Small Enterprises under the MSMED Act. The onus is entirely on the buyer to identify, verify, and track these vendors to ensure timely payments. The law does not apply to unregistered vendors or registered Medium enterprises, making vendor classification a critical compliance task.

PART 2: DETAILED TAX ANALYSIS

1. Background & Corporate Impact

The introduction of provisions under Section 43B(h) is a strategic legislative measure aimed at alleviating the working capital constraints faced by Micro and Small Enterprises (MSEs) due to delayed payments from larger corporate buyers. By linking the buyer's tax deduction to the actual payment date, the government has created a powerful financial incentive for timely settlement of dues.

For corporations, the impact is profound. It necessitates a paradigm shift in procurement and payment policies. The erstwhile practice of extending credit terms beyond 45 days for MSE vendors is no longer tax-efficient. Delaying payments now carries a direct financial penalty in the form of increased tax liability for the year the expense was accrued. This requires companies to overhaul their vendor management systems, from onboarding and verification to payment processing, to mitigate tax risks and avoid interest penalties under the MSMED Act.

2. 1961 Act vs 2025 Direct Tax Code

The table below contrasts the previous tax treatment with the new compliance requirements for expenses incurred towards Micro and Small vendors.

Core Topic: Treatment of Non-Registered MSME Vendors A critical point of clarity is that these stringent rules do not apply to vendors who are not registered on the Udyam portal. For payments to unregistered suppliers, the traditional accrual-based deduction continues to apply. However, this distinction creates a significant compliance challenge. A business can no longer assume a vendor's status. Proactive verification is the only safeguard against incorrectly applying the accrual method to a vendor who is, in fact, a registered Micro or Small enterprise.

3. Audit & ERP Reporting Requirements

The new compliance regime necessitates significant enhancements in internal controls, ERP systems, and audit procedures.

• ERP System Updates:

  • Vendor Master File: The vendor master database must be updated to include a field for "MSME Status" (Micro/Small/Medium/Not Registered) and the "Udyam Registration Number."
  • Automated Payment Alerts: ERP systems should be configured to flag invoices from MSE vendors and create alerts for payment deadlines (e.g., at T+10 days and T+40 days) to prevent breaches.
  • Deduction Logic: The system's accounting logic must be able to differentiate between timely and delayed payments to MSEs to correctly calculate the allowable deduction for a given financial year.

• Tax Audit Reporting (Form 3CD):

  • Auditors are now required to provide detailed disclosures regarding payments to MSMEs.
  • Clause 22 of Form 3CD has been amended to require reporting of the total amount payable to MSMEs and a specific breakdown of payments made within the statutory 45-day period versus those that were delayed.
  • Any amount disallowed under Section 43B(h) due to delayed payment must be explicitly reported, directly impacting the computation of taxable income.

4. Financial Controller's Action Plan 2026

To navigate this transition successfully, Financial Controllers and CFOs must implement a structured action plan immediately.

1. Vendor Database Overhaul (Immediate Priority):

   • Initiate a formal communication campaign to all existing vendors requesting them to furnish their Udyam Registration Certificate.
   • Cross-verify every submitted Udyam Registration Number on the official government portal to confirm its authenticity and the vendor's classification (Micro, Small, or Medium).

2. Update Standard Operating Procedures (SOPs):

   • Vendor Onboarding: Modify the new vendor registration process to make the submission and verification of a Udyam Certificate a mandatory step.
   • Procurement & Contracting: Ensure all new written agreements with vendors clearly state payment terms that are compliant with the MSMED Act (i.e., not exceeding 45 days for MSEs).
   • Accounts Payable: Revise payment processing workflows to prioritize invoices from registered MSE vendors to ensure they are settled well within the statutory deadlines.

3. ERP & Systems Integration:

   • Liaise with the IT department to implement the necessary changes to the vendor master and payment processing modules in the company's ERP system.
   • Explore using verification APIs that can integrate with the ERP to automate the Udyam registration check for new and existing vendors.

4. Internal Training & Communication:

   • Conduct training sessions for procurement, accounts payable, and legal teams to educate them on the new law, its financial implications, and the updated internal processes.

5. Final Advisory

The transition to the new tax framework under the Direct Tax Code 2025, which codifies the principles of Section 43B(h), is more than a tax compliance exercise; it is a fundamental shift in corporate financial discipline. The key risk for corporations is not the rule itself, but the failure to establish robust internal systems to manage it. While payments to non-registered MSME vendors remain unaffected and can be claimed on an accrual basis, the failure to accurately identify which vendors fall into this category can lead to significant tax disallowances.

Our team strongly advises all businesses to treat vendor verification not as a one-time task but as a continuous process. An annual re-verification of all vendors is recommended to account for any changes in their MSME status. Proactive compliance is the only effective strategy to safeguard against adverse tax consequences.

💡 Corporate Tax Tip: Ensure your business is fully compliant with the new Direct Tax Code 2025 to avoid hefty corporate penalties.