Section 40A(2)(b): Tax Implications of Related Party Payments

Section 40A(2)(b) of the Income Tax Act means that if a taxpayer makes a payment to a related party, they cannot claim it as a business expense if they cannot prove that the payment was at market value and necessary for business purposes.

Section 40A of Income Tax Act talks about “Expenses or payments not deductible in certain circumstances”.

Payments made to relatives and associates

Section 40A(2)(a) states where the assessee incurs any expenditure in respect of which a payment has been made or is to be made to a specified person (clause (b)- below) that the expenditure will be considered to be excessive or unreasonable shall be disallowed by the Assessing Officer. While doing so he shall have due regard to:

• The fair market value of the goods, service of facilities for which the payment is made; or

• The legitimate needs of the business or profession carried on by the assessee; or

• The benefit derived by or accruing to the assessee from such a payment

Note

It is to be noted that the disallowance under this section is not automatic and will be disallowed only if Assessing Officer finds such expenditure as unreasonable or excessive in nature.

Further, no disallowance, on account of any expenditure being excessive or unreasonable having regard to the fair market value, shall be made in respect of a specified domestic transaction referred to in section 92BA, if such transaction is at arm’s length price.

Excessive payments to Related Party Transactions

In simple words, Section 40A(2) talks about Excessive payments to Related Party Transactions.

Section 40A(2)(b)- the specified persons referred to in clause (a) are the following, namely:—

• Where the assessee is a individual – any relative of the assessee

• Where the assessee is a company, firm, association of persons or Hindu Undivided Family (HUF)- any director of the company, partner of the firm, or member of the association or family, or any relative of such director, partner or member.

• Any individual who has a substantial interest in the business or profession of the assessee, or any relative of such individual.

• A company, firm, association of persons or Hindu undivided family having a substantial interest in the business or profession of the assessee or any director, partner or member of such company, firm, association or family, or any relative of such director, partner or member

• A company, firm, association of persons or Hindu undivided family of which a director, partner or member, as the case may be, has a substantial interest in the business or profession of the assessee; or any director, partner or member of such company, firm, association or family or any relative of such director, partner or member.

• Any person who carries on a business or profession,—

1. where the assessee being an individual, or any relative of such assessee, has a substantial interest in the business or profession of that person; or
2. where the assessee being a company, firm, association of persons or Hindu undivided family, or any director of such company, partner of such firm or member of the association or family, or any relative of such director, partner or member, has a substantial interest in the business or profession of that person

Other Terminologies

Relative

Section 2(41) of Income Tax Act, 1961, Relative, in relation to an “individual”, means the spouse, brother or sister or any lineal ascendant or descendant of that individual.

Where the assessee is a Firm/ HUF/ AOP

The relationship shall be determined with reference to the partners or members or persons having substantial interest in such Firm/ HUF/ AOP.

Where the assessee is a Company

The relationship shall be determined with reference to the directors or persons having substantial interest in the Company.

Substantial Interest in a business or profession

If

• in a case where the business or profession is carried on by a company, such person is, at any time during the previous year, the beneficial owner of shares carrying not less than twenty per cent of the voting power; and

• in any other case, such person is, at any time during the previous year, beneficially entitled to not less than twenty per cent of the profits of such business or profession.

Conclusion

Section 40A of the Income Tax Act empowers the authorities to disallow certain expenditures made to specified persons.

However, business owners can claim for business-related expenditure.

Further, impermissible deductions under this section will be considered as void for transactions specified in Section 92BA.

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