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Section 40A(2) – Disallowance of Payment made to Relatives

Last Update Date : September 25, 2018

section 40a2

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).

What is Section 40(a)(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.

Disallowance of Expenditure made to Relatives under Section 40(a)(2)

For expenditure to be disallowed under this section, the following three conditions must be fulfilled:

  • The payment must be in respect of an expenditure
  • The payment must be made to certain specified persons
  • The assessing officer is of the opinion that such expenditure is unreasonable and excessive having regards to the:
    1. The fair market value of the goods, services or facilities for which the payment has been made
    2. The benefits derived by or accruing to the assessee from the payment made
    3. The legitimate business needs of the assessee’s business or professions

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.

Section 40(A)(2)(b) – Specified Persons under the Act

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:

  • Where the assessee is an individual (any relative of the assessee)
  • Where the assessee is a company or a firm, association of persons or a Hindu Undivided Family (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 or 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 members, 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 is 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, Hindu Undivided Family, or any director of such company, partner of such firm or member of such association or family or relative of such director, partner or member has a substantial interest in the business or profession of that person.

Particulars of payment made or to be made to specified persons under section 40A(2)(b) should be in the following way:

  • Name of recipient/beneficiary in case of credit
  • Relationship
  • Nature of payment
  • Amount

Meaning of Substantial Interest

For this sub-section, a person shall be deemed to have a substantial interest in a business or profession, if:

  • in a case where the business or profession is carried on by the company, such specified person was the beneficial owner of shares in the previous year (the shares not being entitled to a fixed rate of dividend, whether with or without a right to participate in profits), carrying more than or equal to 20% of voting power, and
  • in any other case, such person is, at any time during the previous year, beneficially entitled to more than or equal to 20% of the profits of such business or profession

Illustrations

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.

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