Wrong TDS Code Under Income Tax Act, 2025 Can Trigger 30% Disallowance

The 30% Disallowance Trap in Section 35(b) of the Income Tax Act, 2025: When a Wrong TDS Payment Code Under Section 393 Triggers Full Business Expenditure Disallowance — The Code 1026 vs. Code 1027 Paradox

The Income Tax Act, 2025, effective from 1st April 2026, consolidates all non-salary TDS obligations into a single Section 393, replacing the entire 194-series with 92 numeric payment codes. The old Section 194J has been split into three distinct codes: Code 1026 for fees for technical services at 2%, Code 1027 for fees for professional services at 10%, and Code 1028 for director’s remuneration at 10%. A deductor who selects Code 1026 instead of Code 1027 under-deducts TDS by 8%, triggering potential 30% disallowance of the entire expenditure under Section 35(b) of the new Act. Critically, the protective judicial precedents under old Section 40(a)(ia) — which held that TDS deducted under a wrong section does not trigger disallowance — may not survive transplantation to the new Act, given the structural consolidation of all TDS within a single Section 393 and the newly binding force of CBDT circulars under Section 400(2). This article analyses the three dimensions of this paradox and recommends urgent CBDT guidance.

Introduction

India’s tax law underwent its most significant structural transformation in six decades on 1st April 2026, when the Income Tax Act, 2025 replaced the Income Tax Act, 1961. Among the most consequential structural changes for day-to-day tax compliance is the consolidation of all non-salary TDS provisions — previously scattered across more than 20 sections from Section 192 to Section 195 — into a single master Section 393, organised as a table-driven framework with 92 numeric payment codes.

The stated objective of this consolidation was simplification — and for most deductors, it is. However, the consolidation has created a dangerous structural paradox in the application of Section 35(b) of the new Act [the equivalent of old Section 40(a)(ia)]: the provision that disallows 30% of business expenditure where TDS was not deducted or not deposited. Under the old Act, the courts had consistently held that deducting TDS under a wrong section — for example, Code 194C at 2% instead of Code 194J at 10% — did not attract disallowance because the taxpayer had taken a bona fide possible view and had actually deducted some tax. Under the new Act, it is no longer self-evident that this protection survives, for reasons that are analytically novel and potentially far-reaching.

As Q1 TDS returns for Tax Year 2026-27 are due to be filed in July 2026 — the first time the 92-code system is used — thousands of deductors are selecting payment codes for April 2026 transactions without any CBDT guidance on the Section 35(b) consequences of a wrong code selection. This article analyses that gap.

The Structural Change: From 194-Series Sections to 92 Payment Codes

2.1 The Old Framework Under Section 40(a)(ia) / 194J

Under the Income Tax Act, 1961, Section 194J imposed TDS obligations on fees for professional and technical services under a single section, with a long-standing ambiguity between ‘professional services’ (10%) and ‘technical services’ (2% post Finance Act, 2020). Practitioners routinely debated whether a payment was for professional services or technical services — a distinction that courts resolved case-by-case, with the Assessing Officer often taking a different view from the taxpayer.

The consequence of a wrong call — deducting at 2% when 10% was required — was governed by Section 40(a)(ia), which disallowed 30% of the expenditure if TDS was not deducted or not deposited. However, the critical judicial protection that evolved over years was this: where the taxpayer had deducted TDS under a ‘wrong section’ (e.g., 194C instead of 194J) and had actually paid that TDS to the government, the courts held that Section 40(a)(ia) did not apply, because the taxpayer had not ‘failed to deduct’ — they had deducted, albeit under the wrong provision.

2.2 The New Framework Under Section 393 and Section 35(b)

Under the Income Tax Act, 2025, old Section 194J has been dissolved into three separate codes within Section 393: Code 1026 (fees for technical services, royalty on films, call centre operations — rate: 2%); Code 1027 (fees for professional services — doctors, lawyers, chartered accountants, architects, engineers — rate: 10%); and Code 1028 (director’s remuneration — rate: 10%). All three codes now exist within a single statutory provision — Section 393 — rather than across different sections of the Act.

Section 35(b) of the new Act [equivalent to old Section 40(a)(ia)] provides: ‘30% of any sum payable to a resident on which tax was deductible but not deducted or not deposited by the due date of filing return under Section 423(1) shall be disallowed while computing income under the head profits and gains of business or profession.’ The language is substantively identical to old Section 40(a)(ia). What has changed is the structural context in which it operates.

The Core Paradox: Does ‘Wrong Code’ Equal ‘Wrong Section’?

3.1  The Critical Structural Question

Under the old Act, when a deductor used Section 194C (2%) instead of Section 194J (10%), the courts held that they had deducted TDS ‘under a different section’ — and that Section 40(a)(ia) required a complete failure to deduct, not a shortfall under the wrong section. This protection rested fundamentally on the fact that 194C and 194J were separate, independent statutory provisions. The deductor could argue that they had taken a possible legal position as to which section applied.

Under the new Act, Codes 1026 and 1027 are not separate sections. They are serial numbers within a single table inside a single Section 393. The question — which no court has yet addressed — is whether selecting Code 1026 instead of Code 1027 constitutes:

(a) Deduction of TDS ‘under a different provision’ (analogous to old wrong-section protection), in which case Section 35(b) may not apply; or

(b) An ‘under-deduction’ within a single section (Section 393), the 8% shortfall being treated as partial non-deduction triggering Section 35(b) on the full 30% disallowance basis.

The answer is not obvious. The consolidated structure of Section 393 — where all payment types from contractor fees to professional fees to director commissions live in the same section — makes it far harder to argue that selecting the wrong row in the same table is equivalent to applying a ‘different section’ of the Act. This is a fresh legal question with no precedent under the new Act.

3.2  The Section 400(2) Binding Circular Problem

The second dimension of the paradox is Section 400(2) of the Income Tax Act, 2025, which has no equivalent in the old Act. Section 400(2) expressly provides that all CBDT circulars on TDS and TCS matters are mandatorily binding on all deductors and tax authorities. Under the old Act, CBDT circulars were binding on the Revenue but not on the taxpayer in the same mandatory sense, and courts consistently held that a taxpayer who had taken a ‘possible view’ consistent with any reasonable interpretation of the law could not be penalised for following that view.

Under the new Act, if CBDT has issued (or issues) a circular or FAQ clarifying that Code 1027 applies to professional services and Code 1026 applies to technical services, a deductor who selects Code 1026 for a payment to a chartered accountant can no longer claim a ‘bona fide possible view’ defence. The circular is now binding on them as a matter of statutory law under Section 400(2). This fundamentally changes the nature of the wrong-code risk — it is no longer a grey interpretational area; it is a compliance default.

3.3  The Proviso Protection — And Its Limits

Both old Section 40(a)(ia) and new Section 35(b) contain a proviso: if the payee (deductee) has included the relevant income in their own return of income and has paid the tax thereon, no disallowance shall be made in the hands of the deductor. This proviso has provided significant relief in practice under the old Act.

Under the new 92-code system, this proviso protection is complicated in a specific way. When a deductor deducts TDS under Code 1026 (2%) and issues a TDS certificate (Form 131) for that amount, the deductee’s Form 168 [new Form 26AS equivalent] shows credit for TDS at 2% only. If the correct rate was Code 1027 (10%), the deductee has received 8% less TDS credit than they were entitled to. The deductee may or may not have paid their own advance tax to cover the balance. If they have not, the proviso may offer incomplete protection — the deductor cannot fully invoke it unless the deductee’s return reflects the full income and full tax. This creates a situation where the deductor’s disallowance risk depends on the tax behaviour of the deductee — an uncomfortable dependency that is entirely new to the 2025 Act framework.

Has This Issue Been Settled by Any Judicial or Administrative Authority?

As of the date of this article, the Income Tax Act, 2025 has been in force for exactly ten days. No court, ITAT, or CBDT has addressed the interaction between wrong payment code selection under Section 393 and disallowance under Section 35(b). No circular or FAQ from CBDT addresses this specific question. The CBDT’s official guidance on the new TDS framework has focused exclusively on the mechanics of the code system — urging deductors to update ERP systems and TDS return references — without addressing the legal consequences of a code selection error.

The existing judicial precedents under old Section 40(a)(ia) on ‘wrong section TDS’ carry only persuasive value under the new Act. They are not binding interpretations of Section 35(b) of ITA 2025, which is a new provision in a new statute. A High Court or Supreme Court ruling under the old Act cannot be mechanically applied to Section 35(b) without examining whether the structural consolidation of TDS within Section 393 changes the analytical framework — which, as argued above, it arguably does.

Relevant Cases on Analogous Issues Under the Old Act

The following judicial precedents under the old Income Tax Act, 1961 are the closest available authority on the ‘wrong section TDS disallowance’ question. They were decided under Section 40(a)(ia) and carry persuasive value only in interpreting Section 35(b):

CIT v. S.K. Tekariwal [2014] 361 ITR 432 (Cal HC)

The assessee deducted TDS at 1% under Section 194C on payment to a machinery contractor, while the Revenue contended that 10% should have been deducted under Section 194I. The Calcutta High Court dismissed the Revenue’s appeal, holding that deduction under a wrong section does not attract Section 40(a)(ia) disallowance. This is the most directly analogous old-Act precedent. However, it was decided in a framework where 194C and 194I were separate statutory provisions — a situation that does not perfectly map to Code 1026 vs. Code 1027 within a single Section 393.

CIT v. PVS Memorial Hospital Ltd. [2016] 380 ITR 284 (Ker HC)

The assessee deducted TDS under Section 194C instead of Section 194J on payments for professional services. The Kerala High Court held that Section 40(a)(ia) was not applicable, relying on the principle that the section is a machinery provision — not a charging section — and that a bona fide deduction under any provision of Chapter XVII-B satisfies its requirement. The Court referred to the Supreme Court’s ruling in Gurusahai Saigal v. CIT [1963] 48 ITR 1 (SC) on the interpretive primacy of bona fide compliance.

ITAT Delhi — Wrong Section (194C vs 194J) — February 2026

The Delhi ITAT, in a ruling pronounced in February 2026 under the old Act, upheld the CIT(A)’s deletion of a Section 40(a)(ia) disallowance, reiterating that deduction under a wrong section does not trigger disallowance where the taxpayer had taken a possible view. While this ruling was under old Act provisions, it represents the most current judicial statement on the subject and is highly persuasive for assessments under ITA 2025 as well.

In re: Analysis of Section 40(a)(ia) — BCAJ Article (Pradip Kapasi, Gautam Nayak)

This authoritative BCAJ article analysed the ‘wrong section TDS’ controversy and concluded that the protection from disallowance should extend to cases of bona fide wrong-section deduction. The article’s reasoning — that Section 40(a)(ia) penalises non-deduction, not wrong-deduction — is directly applicable to the Section 35(b) analysis under ITA 2025, subject to the structural qualifications arising from the consolidation within Section 393 discussed above.

Cases That Would Have Altered the Analysis if Available

—  A Supreme Court ruling expressly holding that ‘deduction of TDS under a different provision of the same chapter constitutes compliance for Section 40(a)(ia) purposes’ would have directly settled the Code 1026 vs. Code 1027 question under Section 35(b) — but no such ruling exists.

—  Any High Court or ITAT ruling specifically addressing TDS deducted under a wrong row or serial number within a consolidated TDS table (as opposed to a wrong standalone section) would have clarified whether the ‘wrong code within same section’ scenario is analytically equivalent to ‘wrong section’. No such ruling exists.

—  A CBDT Circular under Section 400(2) of ITA 2025 explicitly exempting code selection errors made in good faith from Section 35(b) consequences would have resolved the compliance risk for deductors — but no such circular has been issued.

The absence of these authorities is precisely what makes this an unresolved legal question requiring urgent attention.

Summary of the Legal Position — Old Act vs. New Act

Key Takeaways for Practitioners

First, the transition from a section-based to a code-based TDS system under Section 393 is not merely a formatting change — it carries genuine substantive legal risk. The judicial protection for ‘wrong section’ TDS deductions under old Section 40(a)(ia) was built on the premise that 194C and 194J were independent statutory provisions. That premise does not automatically translate to a scenario where Code 1026 and Code 1027 are serial numbers in the same table within the same Section 393. Practitioners must alert clients to this distinction before the July 2026 TDS return filing cycle.

Second, Code 1026 vs. Code 1027 is the highest-risk code selection error of the new system because (a) the rate differential is the widest (8 percentage points), (b) the professional vs. technical service distinction was already heavily litigated under the old Act, and (c) CBDT has issued binding guidance under Section 400(2) that is being progressively codified in circulars. Any deductor who selects Code 1026 for a payment to a CA, lawyer, doctor, architect, or engineer should be aware that they face potential 30% disallowance of the full expenditure under Section 35(b) — with the old ‘wrong section’ protection being legally uncertain.

Third, the mandatory binding nature of CBDT circulars under Section 400(2) fundamentally changes the risk architecture. Under the old Act, a deductor could argue that they had taken a reasonable position in the absence of clear law. Under the new Act, once CBDT clarifies that a particular payment is a professional service (Code 1027), there is no ‘possible view’ defence. Deductors should update their vendor classification master to map each vendor and payment type to the correct code, supported by a documented basis for that classification.

Fourth, the proviso to Section 35(b) — that no disallowance shall be made where the deductee has included the income in their return and paid the tax — offers a potential escape route, but it is not reliably available. In a Code 1026 (2%) vs. Code 1027 (10%) scenario, the deductee has received a TDS certificate for 2% only. The proviso requires that the deductee has paid the full tax due (including the 8% not deducted). Unless the deductee has paid advance tax or self-assessment tax covering the shortfall, the proviso may only partially protect the deductor.

Fifth, CBDT must urgently issue a formal Circular under Section 400(2) addressing the Section 35(b) consequences of code selection errors — before the July 2026 TDS return season creates a wave of demand notices. The Circular should draw from the settled old-Act judicial position and confirm that a good-faith code selection error within Section 393 (where the taxpayer deducted some TDS and deposited it) does not attract Section 35(b) disallowance, provided the shortfall is made good before the due date of filing the return of income.

Conclusion

The transition to a 92-code TDS system under the Income Tax Act, 2025 represents a genuine achievement in legislative simplification. However, the consolidation of all TDS provisions within a single Section 393 has — perhaps inadvertently — created a legal ambiguity of serious proportions: whether the judicially evolved protection against disallowance for ‘wrong section TDS’ under old Section 40(a)(ia) survives transplantation into the new Section 35(b) framework, given that the ‘different sections’ rationale for that protection no longer applies in the same way to ‘different codes within the same section.’

When this structural ambiguity is combined with the new mandatory binding force of CBDT circulars under Section 400(2), the result is a compliance trap that is both novel and potentially significant in financial terms. The Code 1026 vs. Code 1027 paradox is not merely a theoretical concern — it is a live practical risk for every deductor making professional fee payments from 1st April 2026 onwards.

So, my recommendation that CBDT issue a Circular urgently addressing:

(i)  Whether selecting a wrong payment code within Section 393 (where TDS was actually deducted and deposited) constitutes a ‘failure to deduct’ for Section 35(b) purposes or a deduction under an incorrect row number — with the former attracting disallowance and the latter not;

(ii)  A declaratory confirmation that the principle established by the Calcutta High Court in CIT v. S.K. Tekariwal and the Kerala High Court in CIT v. PVS Memorial Hospital — that bona fide wrong-provision TDS does not trigger disallowance — applies with equal force to bona fide wrong-code TDS under Section 393 of the Income Tax Act, 2025;

(iii)  The specific treatment of Code 1026 vs. Code 1027 misclassifications, given the longstanding ambiguity between technical and professional services, and a direction that the shortfall in TDS (8%) may be made good before the due date of return filing without attracting Section 35(b) disallowance on the full expenditure; and

(iv)  Clarification on the availability of the proviso to Section 35(b) in cases where the deductee has not received full TDS credit in Form 168 due to the deductor’s code selection error, and the steps available to both parties to remedy this.

The stakes are high. For businesses making large-value professional fee payments — consulting firms, hospital chains, engineering companies, financial services entities — a 30% disallowance of the entire expenditure would be a disproportionate penalty for what is, in substance, an 8% TDS shortfall arising from the most contested classification in the entire TDS statute. The legislature designed Section 35(b) to enforce TDS compliance, not to penalise good-faith classification errors. CBDT should say so clearly — before the first set of demand notices is issued in Tax Year 2026-27.