Fees vs Penalty. Conversion of Penalty in to Fees by Union Budget 2026
Fees vs Penalty under the Income-tax Act, 2025
A Critical Analysis of the Conversion of Tax Audit Penalty into Late Fee by Finance Bill 2026
Introduction
The distinction between a “fee” and a “penalty” occupies a central place in Indian fiscal jurisprudence. Courts have repeatedly held that the nature of a levy must be determined not by the label assigned by the legislature, but by its substance, purpose, and effect. While a penalty is imposed as a consequence of breach of law and is inherently punitive or deterrent, a fee is compensatory in nature and is ordinarily levied for a service rendered or for permitting a regulated course of action. This distinction becomes particularly significant when a levy, earlier recognised as a penalty with attendant safeguards, is recharacterised as a fee without altering the underlying default.
The Finance Bill 2026 marks a paradigm shift in this regard. One of the notable changes introduced is the removal of the penalty for failure to get accounts audited under section 446 and the introduction, in its place, of a “fee” for delay in getting books of account audited or furnishing the audit report under section 228.
While, on the surface, this change appears to align the audit default with other late-compliance fees such as late filing of return, a closer examination of the statutory text and legislative architecture reveals that the issue is far more nuanced. This article undertakes a detailed examination of this shift, grounded strictly in the bare provisions of the Income-tax Act, 2025, and analyses whether the conversion of penalty into fee can withstand judicial scrutiny.
Statutory Position under the Income-tax Act, 2025 – Bare Text
Section 446 – Failure to get accounts audited (as originally enacted)
Section 446 of the Income-tax Act, 2025, as originally enacted, provided as under:
“If any person fails to get his accounts audited for any tax year or years or furnish the audit report as required under section 63, the Assessing Officer may impose a penalty on such person, which shall be the lesser of—
(a) 0.5% of the total sales, turnover or gross receipts in business, or the gross receipts in profession for such tax year or years; or
(b) ₹1,50,000.”
The provision was clearly couched as a penalty provision, both in nomenclature and in substance. The use of the expression “may impose a penalty” vested discretion in the Assessing Officer, and the quantum of penalty was linked to turnover or gross receipts, subject to a monetary cap.
Section 470 – Penalty not to be imposed in certain cases
Section 470 of the Act provided an important statutory safeguard:
“No penalty shall be imposed for any failure referred to in section 446, if the person proves that there was reasonable cause for the said failure.”
Thus, the legislative scheme recognised that failure to get accounts audited could occur due to bona fide or unavoidable circumstances and expressly protected assessees from penal consequences where reasonable cause was established.
Statutory Changes Introduced – Bare Reference
Removal of audit default from Section 446
Under the amended framework, section 446 no longer deals with failure to get accounts audited. The provision has been substituted to deal with other categories of defaults (including reporting-related defaults, such as those relating to virtual digital assets). This is not an incidental omission but a conscious legislative act removing tax audit default from the penalty chapter of the Act.
Insertion of audit default into Section 428 – Fee provision
The consequence of delay in tax audit is now governed by section 428, which is titled:
“Fee for default in furnishing return of income, audited accounts and reports.”
Section 428(c), as visible from the bare text, provides:
“Where any person fails to get his accounts audited for any tax year or years and furnish the report of such audit as required under section 63, he shall be liable to pay by way of fee—(i) a sum of ₹75,000 for a delay up to one month for which such failure continues; and(ii) a sum of ₹1,50,000 thereafter.”
Notably, section 428 also contains provisions for fee for late filing of return and belated filing beyond prescribed periods. Thus, structurally, audit delay has been placed alongside other late-compliance defaults.
Nature of the Change: From Penalty to Late-Compliance Fee
At a purely textual level, the legislature has effected three significant changes. First, the levy for audit default is no longer described as a “penalty” but as a “fee”. Secondly, the discretionary language “may impose” has been replaced with the mandatory expression “shall be liable to pay”. Thirdly, the protective provision of reasonable cause under section 470, which applies only to penalties, has been rendered inapplicable to audit delay.
Equally important is what has not changed. The underlying statutory obligation to get accounts audited under section 63 remains intact. The maximum monetary exposure continues to be ₹1,50,000. The levy continues to be triggered by non-compliance with a statutory mandate. The change, therefore, lies not in the nature of the obligation, but in the classification of the consequence.
Fee versus Penalty: The Jurisprudential Framework
Indian courts have consistently held that the distinction between fee and penalty depends on the purpose and effect of the levy. A fee is generally upheld when it compensates the State for services rendered or permits a regulated course of action, such as delayed compliance. Penalties, on the other hand, are imposed as a deterrent against breach and carry a punitive character, even when they are civil in nature.
In the income-tax context, this distinction has been applied while upholding late-filing fees for returns and statements. Such fees have been sustained because they permit delayed compliance and regularise the default upon payment. Once the fee is paid and the return is filed, the legal defect stands cured and the return becomes valid in the eyes of law.
Under the Income Tax Act 1961 ( now Income Tax Act 2025) , penalties are prescribed for specific breaches such as concealment or misreporting of income, non-filing of returns, non-compliance with TDS/TCS obligations, etc. These penalties serve a punitive and deterrent function – they are intended to penalize tax evaders or defaulters. For example, Section 270A imposes a penalty for under-reporting or misreporting of income (ranging from 50% to 200% of the tax amount, depending on intent), and earlier Section 271(1)(c) penalized concealment of income. Such penalties require a quasi-judicial proceeding by the tax authority, with an opportunity for the taxpayer to be heard, reflecting their punitive nature. The Supreme Court in Hindustan Steel Ltd. v. State of Orissa famously underscored that penalty proceedings are quasi-criminal, and that “penalty will not ordinarily be imposed unless the party obliged acted deliberately in defiance of law or was guilty of conduct contumacious or dishonest, or acted in conscious disregard of its obligation”. Even where a default is proven, the authority must exercise discretion judiciously and may refrain from penalizing technical or minor breaches, especially if committed under a bona fide belief. This principle highlights that penalties are linked to culpability and the gravity of contravention, not merely the fact of non-compliance.
By contrast, the Income Tax Act also provides for certain fees, which are fixed charges of an administrative nature. A notable example is the late filing fee introduced by Section 234F (inserted in 2017), which requires an assessee to pay a fee (up to ₹5,000, or ₹1,000 for small incomes) for filing the return of income beyond the prescribed due date. Similarly, Section 234E imposes a fee of ₹200 per day for delayed filing of TDS/TCS statements. These amounts are expressly labelled as “fee” and not “penalty” in the statute. They are automatically levied as a condition for accepting a late filing, without the need for any adjudication or proof of willful default. In fact, the Madras High Court in case of Qutalys Software Technologies Private Limited versus Union Of India ( 13331 of 2019 dated 11th March 2020) has upheld the constitutionality of Section 234E, emphasizing that it “is not punitive in nature but a fee – a fixed charge for the extra work caused to the Department by delayed TDS statements”. The Court noted that Section 234E’s levy is “purely compensatory”, meant to ensure timely compliance, whereas a separate provision (Section 271H) provides a discretionary penalty for more serious defaults (such as prolonged failure to file or non-payment of tax). In other words, 234E’s late fee is automatic and compensatory, capped by the amount of tax involved, while penalties under Section 271H are punitive, invoked only in aggravated cases (and after giving the taxpayer a hearing). The fee under 234E thus “ensures the assessee files the statement in time” without being a punishment. Courts have likewise observed that a fee like 234E or 234F actually confers a benefit – it allows delayed compliance for a price – whereas a penalty would imply a punitive sanction for the default. Consistently, penalties for tax law breaches (e.g. concealment) have also been held non-deductible as business expenditure due to their punitive hue, whereas certain fees or interest (being compensatory) may be deductible in theory (though specific provisions of tax law, like Explanation 1 to Section 37, disallow even compensatory payments for violation of law).
In sum, under income tax law, a penalty (imposed under provisions like Sections 270A or the older 271 series) is a punishment for a tax-related offence – it requires breach of law plus a degree of culpability, and is imposed through a defined adjudicatory process, often with some discretion and relief for bona fide mistakes (e.g. Section 273B provides that no penalty shall be imposed for certain failures if the taxpayer shows reasonable cause). A fee, on the other hand, is a monetary charge for a privilege or to compensate the government’s effort in administering late compliance or special services – it is typically fixed by statute and automatically payable on the occurrence of the event (e.g. filing beyond due date), without connoting any moral blame. The nomenclature used by the law is generally conclusive of its nature, but courts will look at substance: as the Supreme Court advised in case of Prakash Cotton Mills Private Limited vs Commissioner of Income Tax (Central Bombay) , “the nomenclature of the impost is not conclusive; one must examine whether it is essentially compensatory or penal in nature”. If the impost is found to be compensatory (fees, interest, liquidated damages), it is treated differently in law than a penalty which is purely to chastise a breach.
Audit Delay Fee vis-à-vis Late Return Fee – Structural Similarity and Functional Difference
It is important to acknowledge that section 428(c) is framed as a fee for delay, not as a fee for total non-compliance. In that sense, it is structurally aligned with clauses (a) and (b) of section 428, which impose fees for late filing of return. The legislative intent is clearly to treat audit and audit report as time-bound compliances, the delay of which attracts a fee.
However, the critical distinction lies not in timing, but in function and consequence. Filing of return is a procedural interface with the tax administration. The law itself contemplates delayed filing and provides an express mechanism for regularisation through payment of fee. Audit, on the other hand, is not merely a filing requirement. It is a substantive statutory assurance mechanism intended to ensure correctness, credibility, and contemporaneous verification of accounts.
A delayed audit is not equivalent to a delayed return. Audit is an independent professional certification that underpins the integrity of reported income. Delay in audit defeats the objective of contemporaneous verification and can have cascading effects on assessment timelines and compliance architecture. While delayed filing of return is a tolerated deviation cured by fee, delayed audit impairs the very purpose of the statutory mandate.
Quantum, Proportionality, and the Penal Effect of the Fee
One of the most significant aspects of section 428(c) is the quantum of fee prescribed. A fee of ₹75,000 for a delay up to one month, escalating to ₹1,50,000 thereafter, is disproportionately high when compared to other late-compliance fees under the same section. Late filing of return attracts a fee of ₹1,000 or ₹5,000, linked to income thresholds. The audit fee, however, is not linked to turnover, income, or scale of business.
This flat and steep quantum gives the levy a punitive effect, particularly for small and medium taxpayers. When a late fee is so onerous that it effectively punishes rather than compensates, courts have been willing to examine whether it has crossed the constitutional boundary between fee and penalty.
Removal of Reasonable-Cause Protection and Its Legal Implications
Under the earlier regime, section 470 expressly protected assessees from penalty where reasonable cause was established. Circumstances such as illness, auditor resignation, natural calamities, or genuine hardships were recognised as valid defences. The migration of audit default to section 428 has resulted in the complete removal of this statutory safety valve.
Unlike late filing of return, where the system itself builds in tolerance through extended timelines and lower fees, audit delay now attracts a rigid and automatic levy with no statutory mechanism for relief. This inflexibility significantly strengthens the argument that the levy, though labelled as a fee, operates with the severity of a penalty.
Colourable Legislative Device: Substance over Form
The doctrine of substance over form and the principle against colourable legislation are well established in Indian constitutional law. What the legislature cannot do directly, it cannot do indirectly. In the present case, the legislature has removed audit default from the penalty chapter, retained the same monetary ceiling, eliminated discretion and reasonable-cause protection, and reintroduced the levy under the fee chapter.
When viewed holistically, the essential character of the levy remains unchanged. It continues to arise from breach of a statutory obligation, carries a deterrent impact, and imposes a substantial financial burden. The change in label and location, without a corresponding change in substance, renders the provision vulnerable to challenge as a colourable device intended to bypass settled penalty jurisprudence.
Conclusion
The reclassification of tax audit default from penalty under section 446 to fee under section 428(c) of the Income-tax Act, 2025 represents a significant shift in legislative approach. While the framing of the levy as a late-compliance fee brings it structurally closer to other fee provisions, its quantum, rigidity, and removal of safeguards distinguish it sharply from ordinary late-filing fees.
In substance, the levy retains several attributes of a penalty: it is triggered by breach, carries a deterrent impact, and lacks compensatory justification. Courts, applying the settled principles of substance over form, proportionality, and arbitrariness, may therefore be called upon to examine whether section 428(c), despite its nomenclature, operates as a penal provision in disguise. The ultimate judicial response will shape the contours of fee-versus-penalty jurisprudence under the new Income-tax Act, 2025 and will be closely watched by both taxpayers and professionals alike.
Author’s opinion- While the constitutional validity of certain fee provisions under the Income-tax Act, 1961—such as section 234E—has been upheld by various High Courts, the levy introduced under section 428(c) of the Income-tax Act, 2025 stands on a materially different footing. Unlike earlier late-filing fees, the quantum and structure of the present levy appear significantly more severe, raising concerns of disproportionality and a potential penal effect in substance. In the author’s considered view, this distinction warrants a closer constitutional examination rather than a mechanical reliance on earlier precedents.
Disclaimer
This article is published for informational and analytical purposes only. While due care has been taken in interpreting statutory provisions and judicial precedents, readers are advised to seek independent professional advice before acting on any matter discussed herein. The author assumes no responsibility for decisions taken based on this article.