Tax Audit Season: Building a Defensible Documentation File

Introduction : A tax audit report is signed by a chartered accountant, but the file behind it is built by the business over the whole year. When an assessing officer later questions an expense, a loan or a payment to a director's relative, the dispute is seldom about whether the transaction took place. It is about whether the business can prove, with dated and consistent papers, what happened and why. A good number of additions are made because the file is thin and not because the underlying dealing was improper.

The cycle for assessment year 2026-27, which covers the financial year 2025-26, is the last to run under section 44AB of the Income-tax Act, 1961. From the tax year 2026-27 the audit requirement sits in section 63 of the Income-tax Act, 2025, and the report is furnished in Form No. 26.

This blog sets out the statutory provisions on tax audit, related-party payments and payments to micro and small enterprises, examines how courts and tribunals treat documentary evidence, summarises the relevant judgments, and ends with a documentation checklist that businesses can adapt to their own records.

Legal Provisions

1.1 Tax audit: Section 44AB and Section 63

Section 44AB of the 1961 Act requires an audit of accounts where the turnover of a business exceeds the prescribed limit, where the gross receipts of a professional exceed ₹50 lakh, and in certain presumptive taxation cases where the income declared is lower than the deemed income. The limit for a business is ₹1 crore, which rises to ₹10 crore where cash receipts and cash payments each stay within five per cent of the total. The report must be furnished by the specified date, which is one month before the due date for filing the return. Default attracts a penalty under section 271B of 0.5 per cent of turnover, subject to a ceiling of ₹1,50,000. Section 63 of the 2025 Act carries the requirement forward, and Form No. 26 replaces the three earlier forms, 3CA, 3CB and 3CD.

1.2 Related-party payments: Section 40A(2)

Under section 40A(2)(a) the Assessing Officer may disallow so much of an expenditure as he considers excessive or unreasonable, having regard to the fair market value of the goods, services or facilities, the legitimate needs of the business and the benefit derived by the payer. The provision applies where the payment is made to a person specified in section 40A(2)(b), a class that covers directors, partners, their relatives and persons holding a substantial interest of twenty per cent or more. Clause 23 of Form 3CD requires the auditor to report particulars of such payments, but the auditor is not asked to say whether they are excessive. Section 188 of the Companies Act, 2013 requires board approval for specified related-party contracts, and section 184 requires a director to disclose his or her interest.

1.3 Payments to micro and small enterprises: Section 43B(h)

Section 43B(h), inserted by the Finance Act, 2023 and now found at section 37(2)(g) of the 2025 Act, allows a deduction for a sum payable to a micro or small enterprise only in the year of actual payment if the payment is made after the time limit in section 15 of the MSMED Act, 2006.

Section 15 requires payment by the agreed date, which cannot be later than 45 days from the day of acceptance, and within 15 days where there is no written agreement. Interest under section 16 runs at three times the bank rate notified by the Reserve Bank of India, compounded monthly, and section 23 bars its deduction in computing income. Because section 2(n) defines a supplier by reference to the filing of a memorandum, which today means Udyam registration, the registration certificate is the starting document for every vendor. A company that owes a micro or small enterprise beyond 45 days must also file MSME Form I with the Registrar every half-year. On the audit side, clause 22 of Form 3CD deals with the interest and clause 26 with sums disallowable under section 43B, including clause (h).

1.4 Evidence and record-keeping

Section 68 of the 1961 Act, which corresponds to section 102 of the 2025 Act, treats a sum credited in the books as income where the assessee offers no explanation of its nature and source or where the explanation is not found satisfactory. For companies, section 118 of the Companies Act, 2013 requires minutes of board meetings to be kept and compliance with the secretarial standards, which include signing and dating the minutes by the chairperson.

Legal Analysis

2.1 The audit report does not prove the transaction

A signed audit report does not settle the question. The report is the accountant's statement of particulars, prepared from the records the assessee produces, and the officer remains free to test the underlying transaction. The burden of showing the nature and source of a credit, and the genuineness of an expense, stays with the assessee. The courts have also made clear that documents are not read in isolation. They are tested against the surrounding circumstances and against ordinary human conduct.

The result is that no single document carries the file. An invoice proves little unless a contract explains why the supply was needed, a delivery record shows that it was made and a bank entry shows how it was paid.

2.2 The four core records

Invoices should identify the parties, the goods or services, the rate and the tax, and should link to a purchase order or contract. A contract signed after a notice is received carries little weight, and the contract is also the document that fixes the credit period, which decides the position under section 43B(h).

Board minutes show that a related-party contract, a loan or a director's remuneration was approved by the right body, on disclosed interests and for stated reasons. Minutes written in a hurry before the audit, with dates that do not match the bank trail, damage the credibility of the rest of the file. Reconciliations connect the ledger to the outside world: vendor statements, bank statements, GST returns and the tax deducted at source that appears in the deductee's records. Unexplained differences are what draw attention. In Ram Baboo Agrawal a bare confirmation from the lender was held insufficient without proof of identity and capacity, which suggests that a signed balance confirmation also has limits as a reconciliation.

2.3 Related-party transactions: two views

The revenue's position is that connected parties do not bargain at arm's length, so the assessee should show why the price was fair. The taxpayer's position is that section 40A(2) is not a presumption against every related-party transaction. It asks the Assessing Officer to form an opinion on excessiveness, and that opinion has to rest on material such as comparables. The Delhi Tribunal took the second view in Pankaj Kalra. Reporting under clause 23 is likewise a disclosure and not a finding. A 2026 Tribunal ruling on a revision under section 263 treated the entry in Form 3CD as identifying a transaction that needs examination and not as proof of a disallowable amount.

In practice the two positions meet at the file. Even if the officer must show excessiveness, a business with no benchmark gives the officer little to contend against and the Tribunal little to rely on in the assessee's favour. A file that holds quotations from unrelated vendors, a rate card or a valuation, evidence that the service was actually rendered, and the board approval, leaves little room for an adverse opinion and gives an appellate forum a basis for reversing one.

2.4 MSME payments: a timing rule that behaves like a permanent one

Section 43B(h) is a timing provision. The deduction is deferred and returns in the year of payment. The effect in practice can be harsher. The test is applied at year-end, so where the time limit has expired by 31 March a payment made in April does not rescue the deduction for the earlier year, and the section 16 interest is never deductible at all. The documentation questions are factual and dated: whether the vendor held Udyam registration on the date of supply, the date of acceptance or deemed acceptance, whether a written agreement fixed a credit period within 45 days, and whether a genuine dispute was raised in writing. The Supreme Court in Silpi Industries is reported to have treated registration on the date of supply as the relevant point, so the certificate has to be read together with the invoice date.

Supporters of the rule say it disciplines large buyers who stretch credit terms at the cost of small suppliers. Critics point to the burden of classifying every vendor and the uncertainty over registrations by traders. The sensible course is to collect the Udyam certificate at onboarding and record the classification decision for every vendor.

Case Laws

Sumati Dayal v. CIT, (1995) 214 ITR 801 (SC)

Facts: The assessee had substantial credits in her books that she explained as winnings from horse races, and she produced documents in support of the claim. The tax authorities rejected the explanation.

Legal Issue: Whether the documents produced were enough to discharge the burden of explaining the credits, or whether the authorities could look behind them.

Holding: The Supreme Court upheld the rejection of the claim. It held that the taxing authorities may look at the surrounding circumstances to find out the reality behind the recitals in a document, and that evidence has to be judged by the test of human probabilities, a principle taken from CIT v. Durga Prasad More, (1971) 82 ITR 540 (SC). A formally complete document can still fail if it does not fit ordinary business conduct.

Kishinchand Chellaram v. CIT, (1980) 125 ITR 713 (SC)

As reported, the Supreme Court placed the burden of explaining the nature and source of a credit in the books on the assessee and held that the officer need not accept an explanation merely because some paper is offered in support of it.

Ram Baboo Agrawal v. CIT, (2018) 404 ITR 198 (All)

As reported, the High Court held that a bare confirmation from a creditor is not sufficient and that identity, creditworthiness and genuineness must each be shown, and it upheld the addition under section 68. Confirmations support a file but do not replace the underlying proof.

ACIT v. Pankaj Kalra, ITA No. 855/Del/2025 (ITAT Delhi)

For assessment year 2017-18 the Tribunal dismissed the revenue's appeal and held that the mere existence of a related-party transaction does not trigger section 40A(2)(b) unless the Assessing Officer shows by comparables that the payment was excessive or unreasonable. Comparables are best prepared before a dispute starts.

Silpi Industries v. Kerala State Road Transport Corporation (SC, 2021)

As discussed in commentary, the Supreme Court held that registration should exist on the date of supply for the delayed payment provisions of the MSMED Act to apply. The date on the Udyam certificate therefore has to be matched to each invoice, since invoices raised before registration may fall outside section 43B(h).

Practical Implications

A thin file is paid for through additions that are litigated for years, interest and penalty on the resulting demand, and management time spent rebuilding records after the people involved have moved on. Form No. 26 is reported to bring additional disclosures on electronic books and audit observations, which will raise the standard further. Four points follow.

First, records should be created when the transaction happens and not collected when the auditor arrives. A contract, a board approval or a vendor's Udyam certificate obtained after the event carries little weight.

Second, one person should own the file and review it each quarter.

Third, the auditor should see the file before the books close, because some gaps can still be cured, for example by clearing an overdue MSME bill before 31 March or by obtaining board approval before a related-party payment and not after.

Fourth, the file should be consistent across sources. The books, GST returns, bank statements and the deductee's records should tell the same story, since an officer can compare them.

The following checklist brings these points together.

Area	Records to keep	Question it answers
Invoices	Tax invoice with description, rate and GSTIN; purchase order or work order; delivery challan or proof of completion	Was the supply real and for the business?
Contracts	Agreement signed before supply; scope, price and credit period; written amendments	What was agreed, and when?
Board minutes	Approval of related-party contracts, loans and remuneration; director's disclosure of interest; signed and dated minutes	Who approved, and on what disclosure?
Reconciliations	Bank reconciliation; vendor and customer confirmations; books against GST returns; TDS against Form 26AS	Do the records agree with third-party data?
Related parties	List of related parties; quotations or rate card; proof of service rendered; clause 23 working	Is the price defensible?
MSME vendors	Udyam certificate with date; trader or non-trader classification; acceptance date; ageing at 31 March; dispute letters	Is any amount exposed under section 43B(h)?
Loans and credits	Identity and PAN; bank statements; return of income; source of funds of the lender	Are identity, creditworthiness and genuineness shown?
Statutory dues	Challans and returns for TDS, GST and employee contributions; MSME Form I	Is any payment late or any disallowance triggered?

Conclusion

The main finding is that audit outcomes follow the quality of records more closely than the nature of the transaction. A signed report does not lighten the assessee's burden, the courts continue to read documents against the surrounding circumstances, and the two areas that now draw the most attention, related-party payments and MSME dues, are both decided on dated, document-level facts.

Two changes would help. The Central Board of Direct Taxes could issue a clarification on the treatment of Udyam-registered traders and on the date from which acceptance is counted for section 43B(h), since both points currently depend on commentary and not on the text. Guidance with Form No. 26 on the supporting file an auditor should expect for related-party payments would also reduce disputes over what counts as adequate benchmarking. For businesses, documentation is best treated as a year-round control and not as a task for the week the auditor arrives.

Author: Shubham Bohra in case of any queries please contact/write back to us via email to content@khuranaandkhurana.com or at  Khurana & Khurana, Advocates and IP Attorney

Endnotes

1. Income-tax Act, 1961, s. 44AB; Income-tax Act, 2025, s. 63; Central Board of Direct Taxes, FAQs on Form No. 26, available at: https://www.incometaxindia.gov.in/documents/d/guest/form-26-faqs  That the 2025-26 cycle is the last under s. 44AB is noted in Tax Audit FY 2025-26: Section 44AB, Form 3CD Nuances & AY 2026-27 Changes, TaxGuru, available at: https://taxguru.in/?p=1076948 

2. Income-tax Act, 1961, s. 44AB; CBDT, FAQs on Form No. 26 (supra note 1).

3. Income-tax Act, 1961, s. 44AB, Explanation (ii); CBDT, Circular No. 15/2025 (extending the return due date and, with it, the specified date for AY 2025-26), available at: https://incometaxindia.gov.in/communications/circular/circular-15-2025.pdf 

4. Income-tax Act, 1961, s. 271B.

5. Income-tax Act, 2025, s. 63; Income-tax Rules, 2026, r. 47; CBDT, FAQs on Form No. 26 (supra note 1); Section 44AB Tax Audit: The Limit, the Due Date and the Penalty, CalcGuru, available at: https://calcguru.in/section-44ab-tax-audit-limit-due-date-penalty/

6. Income-tax Act, 1961, s. 40A(2)(a), (b).

7. Income-tax Rules, 1962, App. II, Form No. 3CD, cl. 23; Deductions on Payments to Relatives, TaxGuru, available at: https://taxguru.in/income-tax/deductions-payments-relatives-business-tax-guide.html 

8. Companies Act, 2013, ss. 184, 188.

9. Income-tax Act, 1961, s. 43B(h) (inserted by the Finance Act, 2023); Income-tax Act, 2025, s. 37(2)(g); Finance Ministry Clarifies Section 43B(h) and 45-Day MSME Payment Rule (reply in the Rajya Sabha dated July 21, 2026), TaxGuru, available at: https://taxguru.in/income-tax/finance-ministry-clarifies-section-43bh-45-day-msme-payment-rule.html

10. Micro, Small and Medium Enterprises Development Act, 2006, s. 15.

11. Micro, Small and Medium Enterprises Development Act, 2006, ss. 16, 23.

12. Micro, Small and Medium Enterprises Development Act, 2006, ss. 2(n), 8.

13. Companies Act, 2013, s. 405; MSME Form I (half-yearly return of outstanding dues to micro and small enterprises).

14. Income-tax Rules, 1962, App. II, Form No. 3CD, cls. 22, 26; Opinion: MSME Compliance Dynamics – A Tale of Two Stakeholders, Taxmann, available at: https://www.taxmann.com/post/blog/opinion-msme-compliance-dynamics-a-tale-of-two-stakeholders

15. Income-tax Act, 1961, s. 68; Income-tax Act, 2025, s. 102; Opinion: Tax Treatment of Loans and Cash Credits Under Section 68, Taxmann (July 3, 2026), available at: https://www.taxmann.com/post/blog/opinion-tax-treatment-of-loans-and-cash-credits-under-section-68/

16. Companies Act, 2013, s. 118(1), (10); Institute of Company Secretaries of India, Secretarial Standard-1 on Meetings of the Board of Directors.

17. Kishinchand Chellaram v. CIT, (1980) 125 ITR 713 (SC).

18. Sumati Dayal v. CIT, 1995 Supp (2) SCC 453 : (1995) 214 ITR 801 (SC); CIT v. Durga Prasad More, (1971) 82 ITR 540 (SC).

19. Ram Baboo Agrawal v. CIT, (2018) 404 ITR 198 (All).

20. ACIT v. Pankaj Kalra, ITA No. 855/Del/2025 (ITAT Delhi), available at: https://taxguru.in/income-tax/mere-existence-of-related-party-transaction-does-not-trigger-s-40a-2-b.html

21. Section 263 Revision Quashed Where AO Examined Related-Party Payments, 2026 taxguru.in 16400, available at: https://taxguru.in/?p=1092354

22. Income-tax Act, 1961, s. 43B(h); Section 43B(h): Paying MSME Vendors Within 45 Days, Patron Accounting (July 20, 2026), available at: https://www.patronaccounting.com/blog/43bh-msme-vendor-payment-ap

23. Micro, Small and Medium Enterprises Development Act, 2006, s. 23; TaxGuru, available at: https://taxguru.in/?p=1052048

24. Silpi Industries v. Kerala State Road Transport Corporation (SC, 2021), as discussed in Section 43B(h) and the Udyam registration question, Mondaq, available at: https://www.mondaq.co.uk/india/sales-taxes-vat-gst/1445962/