Section 40A(2) of the Income Tax Act: Disallowance on Expenditures Explained

Section 40A(2) of the Income Tax Act allows an Assessing Income Tax Officer to disallow an individual or an entity to claim expenses as deductions. This comes into effect when he or she believes that those payments made to a specific individual or entity are unreasonable or excessive of the fair market value of the concerned services, goods or facilities. Keep reading to know more about this Section.

Which Deductions Are Disallowed Under Section 40A(2)?

Section 40A(2) of the Income Tax Act is applicable when the transaction meets the following three objectives:

The payment is an expenditure of any type.
The payment is made or to be made to "specified persons" as mentioned in the Income Tax Act.
The expenses are made or to be made above the fair market value of the services, goods or facility in question.

What Is Substantial Interest & Specified Person in Section 40A(2)?

There are two things that individuals must know. Firstly, an assessee of a firm who holds a substantial interest and had paid or will pay an amount excessive of the FMV of the services or goods provided as identified by an Assessing Officer.

Secondly, there is a list of different categories of "specified persons" with whom the assessee of that firm transacts payment and cannot claim that expense as a deduction.

1. Substantial Interest

Substantial interest applies when an individual holds a majority share and has above 20% of the voting rights in a company. Or else, an individual who receives a minimum of 20% profits made by such a company and holds a substantial interest. This second situation considers sole proprietorship, Body of Individuals, Associations of Persons.

2. Specified Persons

The “specified person” enlisted in the Income Tax Act can be either an enterprise or an individual.

Who Are Included in the List of Specified Persons?

Here is the list of who all are included followed by illustrations:

1. Individuals

Relatives as per the Section 2 (41) of the Income Tax Act 1961 are as follows:

Siblings
Spouse of the primary stakeholder
Lineal descendant or ascendant of a family, including grandparents, children and parents

This concerned Section is applicable when any of these individuals mentioned above holds a substantial interest in a company. For example:

Mr Ashok operates his business. He also holds a share of 22% in a corporation owned by his close relative. If Mr Ashok pays an amount to the firm his relative owns, then the firm is a "specified person". In this case, Section 40A(2) becomes applicable.

2. Firm/ Enterprise/Company/Hindu Undivided Family

Directors, individuals of an assessee company who are partners in a business, any member of Hindu Undivided Family fall under this category of taxpayers. Body of Individuals and Association of Persons also belong to this category.

For example:

Suppose a director of firm XYZ Ltd. holds approximately 40% share in an organisation named ABC Ltd. These two firms exchange substantial transactions. In this case, firm ABC Ltd. is a "specified person."

If an Assessing Officer identifies that the transaction from firm ABC Ltd. to XYZ Ltd. is excessive of the FMV of goods or services provided, then he or she can initiate an investigation.

Note that the director's close family member, part-time or full-time business partner or member automatically holds a substantial interest in an organisation. Besides, if a relative of the parties mentioned above holds a share from which the assessee company derives benefits, that shall be identified as substantial interest.

For example:

Suppose a sibling of the firm XYZ ltd.'s director receives above 20% of the profits made by another organisation, AVC Ltd. If there are business transactions between these two firms, AVC Ltd. is a "specified person".

3. Other Taxpayers

Individuals who showcase a vital interest in a taxpayer's profession or business are "specified persons."

For example:

Mr Alok holds a 30% equity in XYZ Ltd. If there are any business transactions between these two, then Mr Alok is a "specified person".

Hindu Undivided Family, Body of Individuals, Associations of Persons who display a strong interest in a third-party firm are "specified persons".

For example:

Suppose ACV Ltd. receives a 30% profit generated by a business operated by Mr Alok. If there are any business transactions between two entities, the former is a "specified person" to Mr Alok.

This is all about Section 40A(2) of the Income Tax Act. Knowing about this will help taxpayers remain careful about the expenditures incurred and avoid legal inconvenience in the future.

Frequently Asked Questions

✓ Are disallowed deductions under Section 40A(2) void if transactions are made as per Section 92BA?

Yes, prohibitions on expenses under Section 40A(2) of the Income Tax Act are deemed void in the case of certain transactions specified in Section 92BA. This is valid when the transaction is determined at arm's length price as stated in Section 92F of the ITA.

✓ Can business or professional entities claim expenditures incurred in their professions?

Yes, businesses can claim expenditures incurred from the income earned. However, Section 40A(2) of the Income Tax Act applies when a business owner pays an excessive quantum of money to a "specified person".

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Section 40A(2) of the Income Tax Act: Disallowance on Expenditures Explained

Which Deductions Are Disallowed Under Section 40A(2)?

What Is Substantial Interest & Specified Person in Section 40A(2)?

1. Substantial Interest

2. Specified Persons

Who Are Included in the List of Specified Persons?

1. Individuals

2. Firm/ Enterprise/Company/Hindu Undivided Family

3. Other Taxpayers

Frequently Asked Questions

✓ Are disallowed deductions under Section 40A(2) void if transactions are made as per Section 92BA?

✓ Can business or professional entities claim expenditures incurred in their professions?

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