Businesses often interact with various parties, including related entities or relatives. While these transactions may offer benefits, they also come under the scrutiny of tax authorities. Specifically, Section 40A(2) of the Income Tax Act, 1961, lays down guidelines for expenditures made to relatives and associates. This article dives deep into the legal framework surrounding payments to relatives in business, focusing on the compliance and disclosure requirements that businesses must adhere to.
A company in the course of running its business enters into various transaction with different parties including its related parties. Accordingly, related party transactions are a norm Businesses often interact with various parties, including related entities or relatives. While these transactions may offer benefits, they also come under the scrutiny of tax authorities. Specifically, Section 40A(2) of the Income Tax Act, 1961, lays down guidelines for expenditures made to relatives and associates. This article dives deep into the legal framework surrounding payments to relatives in business, focusing on the compliance and disclosure requirements that businesses must adhere to.al feature of business. While entering into a contract with a related party, such related party may get favoured treatment in terms of pricing or on some other conditions which may affect the financial position of the company. Hence, the income tax act contains detailed compliances and disclosure provisions with respect to payment to any related parties.
Every transaction with related parties may not always be related party transaction but every related party transactions is certainly with a related party. In order to understand the nuances of related party transactions, it is necessary to understand the provisions of the law, meaning of certain terms and its disclosures in the report.
Section 40A(2) of the Income Tax Act,1961 talks about payment of an expenditure to relatives and associates persons. This means that if there is payment made to a person who is your relative, such payments shall come under this section. The section is narrated below:
“It provides that where the assessee incurs any expenditure in respect of which payment is to be made to a specified person 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 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 deduction.”
For example: If any person purchases goods from specified person for Rs.50,000 and treats the same as expense in the Profit and Loss Account. However, the fair market value of such goods is only Rs.40,000. This means, the person should have charged only Rs. 40,000 in the debit of Profit and Loss A/c. According to this section, excess amount of Rs. 10,000 shall be added back to the net profit while computing the income of the business.
Some Important Terms:
1. The different categories of taxpayers for imposing the provisions of section 40A(2) are as follows.
| Assessee (Who has made the payment) | Specified or Related Persons | ||||||||||||||
| Where the assessee is an Individual | (i) any relative of such individual
(ii) any person in whose business or profession the assessee (i.e. individual) – himself or any relative of such individual has a substantial interest. |
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| Where the assessee is a Company, firm, AOP or HUF | (i)
(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. |
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| Any assessee (Individual, Company, Firm, etc, having business or profession)
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(i) An Individual or any relative of such individual who has a substantial interest in the business or profession of the assessee.
(ii) Where:-
having a substantial interest in the business or profession of the assessee (iii) Where any director of a company, partner of a firm or member of the association or family, has a substantial interest in the business or profession of the assessee, then the following persons are related person with the assessee:
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2. A person shall be deemed to have a substantial interest in a business or profession, if:
i. 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 20% of the voting power; and
ii. in any other case, such person is, at any time during the previous year, beneficially entitled to not less than 20% of the profits of such business or profession.
3. 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.
Reporting of payments made to related persons in Tax Audit Report in Form 3CD
Clause 23 of the Tax Audit Report (Form 3CD) require the auditor to give details of payments made under section 40A(2)(b). He is not required to give his opinion on the un-reasonability/excessiveness of the payments.
The auditor may refer to the details given in the annual accounts for related party transactions for examining and reporting under this clause. Thereafter, the auditor should consider maintaining the following information in his working papers for the purpose of reporting.
| Name of the Related Person | PAN of the related person | Aadhar Number of the Related Person, if any | Relation | Date | Nature of Transaction | Payment made (Amount) |
| (1) | (2) | (3) | (4) | (5) | (6) | (7) |
Conclusion
Related party transactions are common but come with a layer of compliance and disclosure obligations. Understanding Section 40A(2) and its implications can help businesses navigate the complex landscape of tax deductions on payments to relatives. Consulting a professional for tailored advice can further ensure that you remain within the bounds of the law, thereby safeguarding your business from potential penalties and liabilities.
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