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Section 40A(2) for Related Party Transactions under Income Tax

section-40-a-2-for-related-party-transactions-under-income-tax

Section 40A(2) of the Income Tax Act, 1961 (“the Act”) relates to disallowance of expenditure paid to a related party which is excessive or unreasonable compared to the fair market value of the goods, services or facilities. Section 40A(2)(a) empowers the assessing officer to disallow such excessive or unreasonable part of the expenditure claimed by the assessee which is paid to the related party whereas section 40A(2)(b) lists out the persons who and when can be treated as ‘related parties’ for the purpose of income tax. The Tax Audit Report in Form 3CD also requires disclosure of related party transactions.


Section 40A(2) deals with related party transactions. Before explaining the provision, it is imperative to understand the meaning of the terms “Relative” and “Person having a substantial interest”


Section 2(41) of the Act defines the term "relative", in relation to an individual, means the husband, wife, brother or sister or any lineal ascendant or descendant of that individual.


A person is deemed to have substantial interest in-


  • A company, if the person holds at any time during the previous year beneficial ownership of at least 20% of equity shares (voting rights) in that company, and


  • Other cases, if the person is beneficially entitled to at least 20% of share of profits of such business or profession at any time during the previous year


The bare provision of Section 40A(1) and 40A(2) is reproduced below-


Expenses or payments not deductible in certain circumstances.

40A. (1) The provisions of this section shall have effect notwithstanding anything to the contrary contained in any other provision of this Act relating to the computation of income under the head "Profits and gains of business or profession".

(2)(a) Where the assessee incurs any expenditure in respect of which payment has been or is to be made to any person referred to in clause (b) of this sub-section, and the Assessing Officer is of 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 by 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 :

Provided that for an assessment year commencing on or before the 1st day of April, 2016 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 as defined in clause (ii) of section 92F.

(b) The persons referred to in clause (a) are the following, namely :—

(i)

where the assessee is an individual

 

any relative of the assessee;

(ii)

where the assessee is a company, firm, association of persons or 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;

(iii)

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

(iv)

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 or any other company carrying on business or profession in which the first mentioned company has substantial interest;

(v)

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;

(vi)

any person who carries on a business or profession,—

(A)  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

(B)  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.

 

Explanation.—For the purposes of this sub-section, a person shall be deemed to have a substantial interest in a business or profession, if,—

(a)  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 (not being shares entitled to a fixed rate of dividend whether with or without a right to participate in profits) carrying not less than twenty per cent of the voting power; and

(b)  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.


Section 40(A)(2) provides that expenditure for which payment has been or is to be made to certain specified persons listed in the section 40(A)(2)(b) shall not be allowed as deduction if, in the opinion of the Assessing Officer, such expenditure is excessive or unreasonable having regard to: 

(i) the fair market value of the goods, services or facilities for which the payment is made; or

(ii) for the legitimate needs of business or profession of the assessee; or 

(iii) the benefit derived by or accruing to the assessee from such expenditure. 


Conditions to be fulfilled for disallowance of any expenditure under section 40A(2)


For an amount to be disallowed under this section, following conditions have to be fulfilled-

(i) the payment is in respect of any expenditure 

(ii) the payment has been made or is to be made to a person specified in section 40A(2)(b) (hereinafter referred to as specified person or related person) in respect of such expenditure 

(iii) the Assessing Officer is of the opinion that such expenditure is excessive or unreasonable having regard to: 

(a) the fair market value of the goods, services or facilities for which payment is made; or 

(b) the legitimate business needs of the assessee's business or profession; or 

(c) the benefit derived by or accruing to the assessee from the payment. 

(iv) in respect of a specified domestic transaction referred to in section 92BA, the transaction is not at arm's length price as defined in clause (ii) of section 92F. (This was applicable till AY 2016-17 and is not applicable from A.Y. 2017-18


If any of the above conditions is satisfied, then so much of the expenditure as is so considered by the Assessing Officer to be excessive or unreasonable, shall not be allowed as a deduction.


Section 40A(2) is applicable where any of the requirements mentioned in (a), (b) and (c) above is satisfied and it is not necessary that all the three requirements should be cumulatively satisfied. [Coronation Flour Mills v ACIT (2009) 314 ITR 1 (Guj)]. 


Where to discharge burden under section 40A(2)(b), no exercise was done by revenue nor even a remote attempt was made to establish that professional fees paid to advocate firm was excessive, no disallowance could be made on such payment. [CIT vs Johnson & Johnson Ltd. (2017) 80 taxmann.com 337 (Bom)


Where AO disallowed payments of hire charges of barges made by assessee under section 40A(2)(a) on ground that payments so made were excessive and unreasonable, in view of fact that said charges were fixed by State Barge Owners Association, Tribunal was justified in deleting impugned disallowance. [CIT vs Goa Minerals (P.) Ltd. (2017) 85 taxmann.com 130 (Bom)


Legislative History of section 40A(2)


The provisions related to expenditure incurred in businesses and professions involving payment to relatives and associate concerns under section 40A(2) was explained by the CBDT in its Circular No. 6-P, dated 6-7-1968.


The Finance Act, 1968 had introduced the section 40A, with effect from 1-4-1968. Under sub-section (2) of section 40A, expenditure incurred in a business or profession for which payment has been or is to be made to the taxpayer’s relatives or associate concerns is liable to be disallowed in computing the profits of the business or profession to the extent the expenditure is considered to be excessive or unreasonable. 


The reasonableness of any expenditure is to be judged 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 or the benefit derived by, or accruing to, the taxpayer from the expenditure


Such portion of the expenditure which, in the opinion of the Income-tax Officer, is excessive or unreasonable according to these criteria is to be disallowed in computing the profits of the business or profession.


It may be noted that the provision is applicable to all categories of expenditure incurred in businesses and professions, including expenditure on purchase of raw materials, stores or goods, salaries to employees and also other expenditure on professional services, or by way of brokerage, commission, interest, etc. 


Where payment for any expenditure is found to have been made to a relative or associate concern falling within the specified categories, it will be necessary for the Income-tax Officer to scrutinise the reasonableness of the expenditure with reference to the criteria mentioned in the section


The Income-tax Officer is expected to exercise his judgment in a reasonable and fair manner. It should be borne in mind that the provision is meant to check evasion of tax through excessive or unreasonable payments to relatives and associate concerns and should not be applied in a manner which will cause hardship in bona fide cases.


Hence, the disallowance under this section cannot be made arbitrarily or in a mechanical manner. Adequate safeguards have been provided in bona fide cases since the objective of section 40A(2) is to prevent diversion of income.


Specified (or related) persons under section 40A(2)


The specified (or related) persons, in case of various assessees are as under-

Assessee

(who makes the payment)

Specified (or related) persons in Sec. 40A(2)(b)

Where the assessee is an Individual

(i) any relative of such individual; [Sec. 40A(2)(b)(i)]

(ii) any person in whose business or profession the assessee (i.e. individual) -

himself or

any relative of such individual

 has a substantial interest. [Sec. 40A(2)(b)(vi)(A)]

Where the assessee is a Company, firm, AOP or HUF 

(i) [Sec. 40A(2)(b)(ii)]

Company

Any director of the company

Any relative of such director

Firm

Any Partner of the firm

Any relative of such partner

AOP/HUF

Any member of the AOP or HUF, or

Any relative of such member

(ii) any person in whose business or profession the assessee (i.e. Company, firm, AOP or HUF)-

itself,or

any director, or

any partner, or

any member, or

any relative of above persons,

has a substantial interest. [Sec. 40A(2)(b)(vi)(B)]

Any assessee

(Individual, Company, Firm, etc, having business or profession)

(i) An Individual or any relative of such individual who has a substantial interest in the business or profession of the assessee. [Sec. 40A(2)(b)(iii)]


(ii) Where- [Sec. 40A(2)(b)(iv)]

A company*

or any director,  or 

any relative of such director

A firm

or any partner, or

any relative of such partner

AOP or HUF

or any member, or

any relative of such member

any other company carrying on business or profession in which the first mentioned company* has substantial interest

having a substantial interest in the business or profession of the assessee


(iii) Where- [Sec. 40A(2)(b)(v)]

any director of a

Company, or

any partner of  a

Firm, or

any member of an

AOP/HUF

has a substantial interest in the business or profession of the assessee, then the following persons are related person with the assessee (company,firm,etc.)-

Such a company

or any director,  or 

any relative of such director

Such a  firm

or any partner, or

any relative of such partner

Such an AOP or HUF

or any member, or

any relative of such member


Meaning of substantial interest in a business or profession


A person shall be deemed to have a substantial interest in a business or profession, if,—

Where the business or profession is carried on by a company

Such a person is, at any time during the previous year, the beneficial owner of shares (not being shares entitled to a fixed rate of dividend whether with or without a right to participate in profits) carrying not less than 20 percent of the voting power.


In other words, the person beneficially owns 20% of the equity shares of a company at any time during the previous year

In any other case

Such a person is, at any time during the previous year, beneficially entitled to not less than 20 percent of the profits of such business or profession.


Let us discuss the relationship and related persons for each of the sub-clauses specified in section 40A(2)(b) with illustrations.


The relationship should be read with Section 40(A)(2)(a) with section 40A(2)(b). As such, for sub-clause (i) of section 40A(2)(b), the related person transactions should be read as follows-


Section 40A(2)(b)(i)


(i) Where any assessee, being an individual who carries on business or profession, makes any payment for any expenditure to any relative of such Individual, then the transaction is a related party transaction under section 40A(2)(b)(i).


Example: Mr. Rakesh is a Chartered Accountant who is in practice. He derives his income from the profession. For the financial year 2019-20, he has made payment for office rent to his wife Mrs. Rakesh.


As per section 2(41), the spouse of an Individual is a relative, hence the rent transaction is a ‘related party transaction’ for the purpose of income tax.


In this case, a sole proprietor or a professional if makes any payment for any business expenditure to any relative (spouse, brother, sister, father, mother, son, daughter, grandfather, grandmother, great grandfather or grandmother, grandchildren or great grandchildren and so on.) then such a transaction is always a related party transaction for the purpose of income tax. 


Section 40A(2)(b)(ii)


(ii) Any transaction between a company and its director is a  ‘related party transaction’ for the purpose of income tax. Not only this, any transaction between a company and any relative of any of its directors is a  ‘related party transaction’ for the purpose of income tax under section 40A(2)(b)(ii).


Example: Mr. Rakesh is a director of X Ltd. which is engaged in the business of manufacturing steel pipes. For the financial year 2019-20, X Ltd. has made payment for office rent to Mrs. Rakesh, wife Mr. Rakesh.


As per section 2(41), the spouse of an Individual is a relative, hence the rent transaction between X Ltd. and Mrs Rakesh, wife of its director Mr. Rakesh,  is a ‘related party transaction’ for X Ltd. under the income tax.


Similarly, any transaction between a firm and its partner is a  ‘related party transaction’ for the purpose of income tax. Not only this, any transaction between a firm and any relative of any of its partners is a  ‘related party transaction’ for the purpose of income tax under section 40A(2)(b)(ii).


Example: Mr. Rakesh is a partner of XYZ & Co. which is engaged in the business of trading of steel pipes. For the financial year 2019-20, XYZ & Co. has made payment for office rent to Mrs. Rakesh, wife Mr. Rakesh.


As per section 2(41), the spouse of an Individual is a relative, hence the rent transaction between XYZ & Co. and Mrs Rakesh, wife of its partner, Mr. Rakesh,  is a ‘related party transaction’ for XYZ & Co. under the income tax.


In this case, if a company enters into any transaction with its director or any relative of the director, whether or not the director has any substantial interest in the company, the said transaction will be covered by section 40A(2)(a) as a related party transaction for the purpose of income tax. In this context, it must be noted that the transaction must be related to payment of expenditure for the business of the company. 


Section 40A(2)(b)(iii)


(iii) Where any assessee makes any payment for any expenditure to any Individual who has a substantial interest in the business or profession of the assessee or any relative of such Individual, then the transaction is a related party transaction under section 40A(2)(b)(iii).


Example: ABC Private Ltd. has made payment for office rent to Mr. Rakesh who holds 21 percent of shares of ABC Private Ltd. This is a ‘related party transaction’ for ABC Private Ltd. under the income tax. The position will also remain the same if the rent is paid to the wife of Mr. Rakesh.


In an another example, Mrs. Meera holds 10% of equity shares of ABC Pvt. Ltd. Mr. Rakesh holds 25% of equity shares of ABC Pvt. Ltd. Mrs. Meera is mother of Mr. Rakesh. The company purchased goods from Mrs. Meera. Whether the payment to Mrs. Meera for the purchase transactions would come under section 40A(2)(b)(iii).


Since Mrs. Meera is a relative of Mr. Rakesh who holds substantial interest in ABC Pvt. Ltd., the purchase transaction is squarely covered by section 40A(2)(b)(iii). The fact that her holding is less than 20% is irrelevant since she is a relative of other shareholder who is substantially interested.


What would be the reply if assume that Mr. Rakesh also holds 10% shareholding in the company instead of 25%.


In this case, the purchase transaction would not fall under section 40A(2)(b)(iii). For determining the threshold limit of substantial holding, standalone holding needs to be considered and shall not be clubbed under any circumstances.




Section 40A(2)(b)(iv)


(iv) Where any assessee makes any payment for any expenditure to any company which has a substantial interest in the business or profession of the assessee and any director of such a company or any relative of such director, then the transaction is a related party transaction under section 40A(2)(b)(iv).


Example: ABC Private Ltd. has made payment for office rent to XYZ Ltd.which holds 21 percent of shares of ABC Private Ltd. Mr. Rakesh is a director of XYZ Ltd. This is a ‘related party transaction’ for ABC Private Ltd. under the income tax. The position will also remain the same if the rent is paid to Mr. Rakesh or wife of Mr. Rakesh.




Further, where any assessee company makes any payment for any expenditure to a company having a substantial interest in the business or profession of the assessee or any other company carrying on business or profession in which the first mentioned company has substantial interest, then such a transaction is a related party transaction under section 40A(2)(b)(iv).


In other words, where any assessee company makes any payment for any expenditure to any company whose substantial shareholder company also holds substantial shareholdings in other company which is a substantial shareholder of the assessee company, then such a transaction is a related party transaction under section 40A(2)(b)(iv).


In this case it must be remembered that payment transaction from holding company to subsidiary company is not covered under section 40A(2)(b)(iv) since the holding company holds substantial interest in the subsidiary company and not the subsidiary company holds any interest in the holding company. If the subsidiary company makes any payment to its holding company then the transaction will be a related party transaction for the subsidiary company.


Example: F Pvt. Ltd. holds 30% shares in GB Pvt. Ltd. and 25% shares in IP Limited. Hence, any transaction between IP Ltd. and GB Pvt Ltd. shall be a related party transaction under section 40A(2)(b)(iv) for IP Ltd.


Suppose, IP Ltd. pays rent to GB Pvt Ltd. This transaction is covered by Section 40A(2)(b).






Section 40A(2)(b)(v)


(v) Where any assessee makes any payment for any expenditure to any company whose any of the director of the company has a substantial interest in the business or profession of the assessee then any transaction with such a company in which he is a director or relative of such director or any other director of the company is a related party transaction under the income tax as per under section 40A(2)(b)(v). 


Similar provision is provided for a firm, AOP and HUF.


Example: Mr. Rakesh is a director of X Ltd. He holds 25% equity shares of Y Ltd. He is also a partner of Wye & Co. having a 30% profit sharing ratio.


Y Ltd. paid rent to X Ltd. and purchased certain consumable items from Wye & Co. during FY 2019-20.


The rent transaction between Y Ltd. and X Ltd. is a related party transaction since the payee’s director holds substantial interest in Y Ltd. The position would remain the same had the rent was paid to Mr. Rakesh  or Mrs. Rakesh, wife of Mr. Rakesh, instead of payment of X Ltd.


Similarly, the purchase transaction between Y Ltd. and Wye & Co. is also a related party transaction for the above mentioned reason.



Section 40A(2)(b)(vi)


(vi) (A) Where any individual assessee makes any payment for any expenditure to any person having business or profession and the individual or any relative of such individual has a substantial interest in the business or profession of that person, then any payment for expenditure between the individual and the person shall be regarded as a related party transaction for the purpose of income tax.


(B) Where the assessee is a company and makes any payment for any expenditure to any person having business or profession and the company or any director of the assessee company or relative of auch director has a substantial interest in the business or profession of that person, then any payment for expenditure between the company and the person shall be regarded as a related party transaction for the purpose of income tax.


Similar provision is provided for a firm or an AOP/HUF and the partners and members and relatives of such partner or member.


From the above discussion, the related party transactions are determined from the point of the assessee. The relationship of the related party may be ‘from the assessee’ (because of the relationship of the assessee with the other party) or ‘in the assessee’ (because of the relationship of the other party with the assessee) with the other person. Further, the assessee are Individuals, Company, Firms (including LLP), AOP/HUF.


The relationship may be due to being a relative of the specified individuals or because of substantial interest. Furthermore, it must be noted that the condition of having substantial interest shall be at any time during the previous year in which the transaction took place and not at the end of the year.


It is further to be noted that simply making payments to related parties does not amount to disallowance. The disallowance of any such expenditure is restricted to the excessive or unreasonable portion of the expenditure as compared to the market value of the goods, services or facilities.


It is necessary that there must be a business or profession to attract the provisions of section 40A(2). If there is no case of business or profession, then section 40A(2) does not attract.


Summary of the specified persons in section 40A(2)(b) in graphical presentation-


I. Relationship of the related partyfrom the assessee’ (because of the relationship of the assessee with the other party) [Section 40A(2)(b)(i) & (ii)]

Assessee

Individual

Company

Firm (LLPs)

AOP

HUF

Other Persons

Relatives

Directors

Partners

Members

Members


Relatives of directors

Relatives of partners

Relatives of members

Relatives of members


II. Relationship of the related party ‘in the assessee’ (because of the relationship of the other party with the assessee) [Section 40A(2)(b)(iii) & (iv)]

Other Persons  having substantial interest in the business or profession of the assessee 

Individual

Company

Firm (LLPs)

AOP

HUF

Relatives

Directors

Partners

Members

Members


Relatives of directors

Relatives of partners

Relatives of members

Relatives of members


One more case in section 40A(2)(b)(iv) not reflected in the above graphics is the case of common substantial shareholders. This is applicable for companies only. Firms are not covered. This case is already discussed earlier and hence not repeated here.


III. Relationship of the related party ‘in the assessee’ (because of the relationship of the other party with the assessee) [Section 40A(2)(b)(v)]

Other Persons  having substantial interest in the business or profession of the assessee 

Directors

Partners

Members

Members

Company

Firm

AOP

HUF

Other directors

Other partners

Other members

Other members

Relatives of directors

Relatives of partners

Relatives of members

Relatives of members


Note: Although common substantial shareholder is covered as specified or related person, there is no provision of common directors to qualify to be a related party. Even a common substantial shareholder is covered as specified or related person but if the common shareholder has no substantial holdings, there will be no case of being a  related person.


Reporting of payments made to related persons in Tax Audit Report in Form 3CD


Clause 23 of Tax Audit Report in Form 3CD requires reporting of ‘Particulars of payments made to persons specified under section 40A(2)(b)’.


Clause 23 of the Form No. 3CD requires only actual payments to persons specified in section 40A(2)(b) to be reported and not the amounts claimed in or debited to profit and loss account. [Film Shoppe (India) Pvt. Ltd. vs. ITO (ITA No. 2019/Mum/2003) (Mum-Trib.)]


The tax auditor should give the particulars of payments for gooods or services or facilities to the persons specified in section 40A(2)(b) and not his opinion whether the payment made is excesseive or unreasonable. Further, there is not requiremetn of reporting of fair market value.


In this context, the procedure enumerated in the ‘Guidance Note on Tax Audit under Section 44AB of the Income-tax Act, 1961’ issued by the ICAI may be followed by the tax auditor for this purpose.


Judicial Precedents


The provisions of section 40A(2) is illustrated with following judicial precedents:


Section 40A(2)(a) pertains to disallowance to an expenditure which is made by the assessee i.e. an amount actually spent by the assessee as an expenditure. There has to be an expenditure incurred before the provision can be said to be applicable. A trade discount is not an expenditure,therefore, there does not arise the question of applicability of Section 40-A(2)(b). [United Exports vs CIT (ITA No. 356/2009) (Delhi HC)]


Remuneration including commission paid to directors within the limits prescribed by the Companies Act, sitting fees paid to directors cannot be disallowed under section 40A(2)(b). [IMA-PG India Pvt. Ltd. vs Addl. CIT (ITA No. 2801/Mum/2005, ITA No. 3385/Mum/2006, ITA No. 2938/Mum/2009) (Mum-Trib.)]


Whether expenses claimed by an assessee were excessive or not under the provisions of Section 40A(2) of the Act, is essentially a question of fact and is not a question of law. [CIT v. Shiv Kumar (2013) 354 ITR 19 (Delhi)]


Where the holding company makes payment to a subsidiary and the expenditure laid out or incurred is wholly for the business of the assessee holding company, then the same cannot be disallowed under section 40A(2)(b). [CIT vs. Raman Boards Ltd.(2013) 355 ITR 305 (Kar.)]


Where a person sells goods to a related person at a rate lower than market rate there is no expenditure incurred by him and thus section 40A(2)(a) cannot be invoked for making addition of the amount of deficit. [CIT vs. A.K. Subbaraya Chetty & Sons (1980) 123 ITR 592 (Mad)]


Section 40A(2)(a) cannot have any application, unless it is first held that the expenditure on rent was excessive or unreasonable. [Upper India Publishing House P Ltd vs. CIT (1979) 117 ITR 569 (SC)]


The goods, services and facilities referred to in section 40A(2)(a) are those which have a market value and which are commercial in character. [T.T. (P) Ltd vs. ITO (1980) 121 ITR 551 (Kar.)]


Section 40A(2) shall operate only if the assessee is carrying on any business or profession. When the assessee was not carrying on any business or profession (neither the assessee had shown any income from business or profession nor the AO has held so) then the provisions of section 40A(2) were rightly held to be not applicable. [DCIT vs. Mayurika S. Poddar (1997) 59 TTJ 372 (Mum-Trib.)]


Provisions of Section 40A(2)(a) are not applicable to a co-operative Society. [CIT vs. Terna Shetkari Sahakari Sakhar Karkhana Ltd. (2008) 215 CTR 124/301 ITR 222 (Bom)]


If the amount of expenditure was made for the purpose of business and was commercially expedient and the Assessing Officer fails to prove by any comparable case or comparison by market rate as to how the amount paid by the assessee is excessive or unreasonable, no disallowance under section 40A(2)(a) can be made for making payments to a person specified in section 40A(2)(b).


Further, where the assessee has paid the actual rent and reimbursed the actual expenditure to the person specified in section 40A(2)(b) which does not involve any mark-up or profit element, no disallowance under section 40A(2)(a) can be made.

[CIT vs. Modi Xerox Ltd (No. 2) (2012) 344 ITR 411/ (2010) 41 DTR 53 (All.) / Income Tax Appeal No. 30 of 2001 (Allahabad High Court) decided on 15.04.2010]


Substantial interest has to be determined on a standalone basis and not by clubbing direct and indirect shareholding in a company for the purposes of determining the threshold of “substantial interest” as specified in explanation (a) to section 40A(2)(b) of the Act.


Assessee had purchased the loans and the same were reflected in the balance sheet and not profit and loss account of the assessee company. Thus, it was a transaction of a purchase of an asset. Accordingly, the acquisition of an asset cannot be said to be in the nature of an expenditure.  The word ‘expenditure’ is to be understood as an amount expended on a revenue account and hence, the capital expenditure on acquisition of an asset cannot be said to be in the nature of expenditure so as to come within the ambit of section 40A(2)(a).


Any payment made to a trust set up for the benefit of the employees of the assessee company would not fall within explanation (b) to section 40A(2)(b) of the Act since there was no question of the assessee company being entitled to 20% of the profits of such trust. [HDFC Bank Ltd. vs. CIT (Writ Petition No. 462/2017) Bombay HC]


Holding and Subsidiary Company: Where the payment for expenditure is made by holding company to its subsidiary company, the transaction will not fall under section 40A(2)(b)(iv). In other words, Subsidiary company is not a related person within meaning of section 40A(2)(b)(ii)/(iv) and, thus, payment made by assessee (holding company) to its subsidiary company cannot be disallowed by invoking provisions of said section.


In law, a holding company is a member of a subsidiary company and holds more than 50 per cent equity share capital of the subsidiary company (except in cases where it controls the composition of the board of directors without holding majority of the shares). While the holding company is a member of its subsidiary company, the subsidiary company is not a member of the holding company. As the subsidiary company is not a member of the assessee holding company, sub-clause (iv) of clause (b) of section 40A(2) of the Act is also not attracted.

[CIT vs. V.S. Dempo & Co. Pvt. Ltd.(2011) 336 ITR 209 (Bom.)/Tax Appeal No. 22 of 2005] followed in CIT vs. Raman Boards Ltd.(2013) 355 ITR 305 (Kar.)


Payments made to relatives (wife and son) of a deceased partner of a firm is covered by section 40A(2). [Anandji Shah vs. CIT (1990) 181 ITR 171 (Ker)]


The goods, services and facilities referred to in section 40A(2)(a) are those which have a market value and which are commercial in character.  But section 40A was introduced in the year 1968 in the Act apparently for the purpose of preventing the abuse of excessive or unreasonable payments being made by assessee to persons referred to therein in lieu of goods, services and facilities. If the payments represent a fair market value then there is no limitation on the total amount payable during any period. [T.T. Pvt. Ltd vs. ITO (1980) 121 ITR 551 (Kar)]


The onus is on the Revenue to prove that the assessee has made excessive and unreasonable payment to the sister concern for making the disallowance u/s 40A(2)(b). [DCIT v Computer Graphics Ltd. 285 ITR 84 (Mad)]


Where the amount of commission paid was not exorbitant and that there exist commercial consideration or business expediency for the payment of such an exorbitant commission, it will not come under the provisions of section 40A(2). It is well-settled law that so far as the questions of commercial expediency and business needs of an organisation are concerned, it is not the view-point of a revenue officer which should count but it should be the view-point of an ordinary businessman. [Voltamp Transformers (P) Ltd. vs. CIT, (1981) 129 ITR 105 (Guj)] Also see: Hinduja Group India Ltd. vs ACIT (ITA No.4458/Mum/2014) (Mum-Trib.)


Where the assessee company and the parent company are paying tax at the maximum marginal rate there was no question of evading the payment of tax and therefore there is no need to exercise the power under section 40A. [CIT vs. Enviro Control Associated Pvt Ltd (2014) 43 taxman.com 291 (Guj.)] Also see PCIT vs. Gujarat Gas Financial Services Limited (Tax Appeals No. 428 to 431 of 2015) Guj. HC.


Even though assessee had made payments to related parties, if there was no material on record to demonstrate that payment made was excessive and unreasonable having regard to market rate, disallowance under section 40A(2) by AO cannot be made. [Motilal Laxmichand Sanghavi Vs ACIT (ITA Nos. 3110 to 3112 of 2018) (Mum-Trib.)]


Prevailing market rates of interest for the loans of permanent and long term in nature cannot be compared with rates of interest for the loans of temporary nature. [CIT vs. Shiv Agrevo Ltd. (D.B. Income Tax Appeal No. 460/2009) (Rajasthan High Court)]


Salary to the partner is being regulated by the provisions of section 40(b) of the Income Tax Act. It is to be paid in accordance with the provision stipulated in the deed which should be in commensurate with the provisions of section 40(b) of the Income Tax Act. On such salary payment, provisions of section 40A(2) cannot be invoked. [DCIT Vs M/s. Eurotex Chemicals (ITA No. 1714/Ahd/2013) (Ahd-Trib.)]


Loan taken from the relatives cannot be compared with bank loan because loan from the relatives are without security, while loan from the bank is secured for the purpose of making disallowance under section 40A(2)(b). [ACIT vs. Raj Steel Industries (ITA No. 2245/Ahd/2010) (ITAT Ahmedabad)] Also see Vipul Y. Mehta vs. ACIT (ITA No. 869/Ahd/2010).


Where without offering the discount the goods are not saleable and offering the discounts are in accordance with the legitimate needs of the business of the assessee, the AO could not apply the provisions of Section 40A(2)(b) of the Act. [ITO v. Media Satellite & Telecom Ltd. (ITA No. 415/Del/2015) (Del-Trib.)]


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