The Income Tax Act empowers the assessing officer under Section 40A(2) to not allow to claim deductions on certain expenses made by specific person. This comprehensive guide by H&R Block explains which ‘relatives’ are disallowed from claiming deductions as per Section 40A(2).
The section 40(a)(2) of the Income Tax Act, 1961 states that, where the assessee incurs any expenditure, in respect of which payment is made or is to be made to certain specified persons (i.e. relatives or close associates of the assessee), and the assessing officer is of the opinion that such expenditure is excessive or unreasonable having regard to the fair market value of the goods, services or facilities for which the payment is made or the legitimate needs of the business or profession of the assessee or the benefit derived or accruing to him therefrom, so much of the expenditure, as is so considered by him to be excessive or unreasonable, shall not be allowed as a deduction.
For expenditure to be disallowed under this section, the following three conditions must be fulfilled:
Then, the amount considered unreasonable or excessive by the AO will be disallowed under this section.
The above does not apply for disallowance in respect of a specific transaction referred to in section 92BA if such transaction is at arm’s length price as defined in clause (ii) of section 92F. The provisions of section 40A(2) are applicable when any one of the above conditions is satisfied. The expense will be disallowed if it satisfies any of the above mentioned conditions.
Clause (a) of section 40A(2) talks about the expenditure incurred in respect of payments being made to certain specified persons mentioned in clause (b) of the same section.
The persons included in section 40(A)(2)(b) are mentioned as follows:
Particulars of payment made or to be made to specified persons under section 40A(2)(b) should be in the following way:
For this sub-section, a person shall be deemed to have a substantial interest in a business or profession, if:
ABC ltd purchased goods worth rupees 3,00,000 from one of its directors. The market value of such goods is rupees 2,50,000.
Thus, in this situation, rupees 50,000 which is unreasonable under the provisions of this section will be disallowed under this section.
While working for the assessee a related person may incur expenditure on behalf of the assessee. While making payments, the related person is making payment for and on account the assessee and not on his account and therefore, when the assessee makes a reimbursement to the related person it does not amount to payment to a related person.
Section 40A(2) is regarding certain expenses incurred by the assessee in respect of which payment has been made or is to be made to any person referred to in clause (b) of section 40A(2). The specified person is essentially a relative or a close associate of the assessee.