Summary: CA Mickey and CA Mini delve into Section 40A(2)(b) of the Income Tax Act, which aims to prevent excessive or unreasonable payments to specified persons, such as relatives or influential entities. They use the case of Artisans Micro Finance (P) Ltd. v. ITO (2015) to illustrate the application of this provision. Section 40A(2)(b) allows the Assessing Officer (AO) to disallow payments that exceed fair market value or are deemed unnecessary for the business’s legitimate needs. The discussion highlights the criteria used by AOs to determine the reasonableness of payments, including fair market value, business necessity, and benefits derived. The ITAT’s ruling in the Artisans case underscores the need for substantial evidence when disallowing payments, emphasizing that arbitrary disallowances without concrete proof are likely to be overturned. The article also covers practical implications of Section 40A(2)(b) through other case laws and provides guidance on how companies can protect themselves against disallowance and the potential consequences if payments are disallowed.
CA Mickey and CA Mini are two experienced professionals. Today They decode complexities of Section 40A(2)(b) and focusing on how this section is applied to prevent excessive or unreasonable payments to specified persons i.e. relatives, directors, or entities with substantial influence as per income tax Act.
They taken Artisans Micro Finance (P) Ltd. v. ITO (2015) 064 (II) ITCL 0596 as reference and decoding complete provision of section 40A(2)(b) & also exploring how the Income Tax Appellate Tribunal (ITAT) assessed reasonableness of payments made to relative.
At the end also there is summary of other referred case law which you can use for practical implications of Section 40A(2)(b) of IT Act.
1. Mini – Hey Mini, I was just reading case involving excessive payments to relatives under Section 40A(2)(b) of IT Act and in that case is quite interesting and brings up some complex points about disallowance of payments deemed excessive by Officer
2. Mickey – Oh that sounds challenging … Could you explain basics of Section 40A(2)(b) first?
CA Mini- The purpose of Section 40A(2)(b) is to prevent tax evasion through excessive or unreasonable payments to specified person like relatives, directors, or entities with a substantial interest in the assessee’s business. This section empowers AO to disallow any portion of payment that exceeds fair market value or is deemed unnecessary for the legitimate needs of the business.
CA Mickey- Who are “specified persons” u/s. 40A(2)(b)?
CA mini-
It deals with specific individuals
- Relatives of the assessed individual.
- Directors, partners, or members of a company, corporation, association, or HUF, or their relatives.
- Persons interested in the business or profession of the assessee or their relatives.
- Companies having significant interests in the business of the assessee or their directors, partners, members, or relatives.
- Any person in whom the assessee or their relatives have a substantial interest in the trade or business.
CA Mickey- What criteria does the Assessing Officer consider to determine if payment is excessive or unreasonable?
CA Mini- AO considers following criteria —
- Fair market value of the goods, services, or facilities.
- Legitimate needs of the business or profession.
- The benefit derived by the assessee from the expenditure.
If payment exceeds what is reasonable under these factors, it can be disallowed.
CA Mickey- How does Section 40A(2)(b) impact payments made to relatives or other specified persons?
CA Mini- Section 40A(2)(b) helps the AO to find out such payments by allowing the AO to scrutinize and disallow portion that are deemed to be unreasonable. It will ensure that transactions with related parties are conducted at arm’s length & do not lead to tax evasion or any such tax planning part.
CA Mickey- What is the role of fair market value in determining the payment mate u/s. 40A(2)(b)?
CA Mini- Fair market value is benchmark to assess whether a payment is excessive or not ?. AO compares that payment made to the specified person with the fair market value of similar goods or services to determine whether it is reasonable. If the payment is higher without justification, it may be disallowed.
CA Mickey- Can you explain the legitimate needs of the business as considered u/s. 0A(2)(b)?
CA Mini- Legitimate needs refer to the actual requirements of business for goods, services, or facilities. u/s. 40A(2)(b), AO evaluates whether any expenditure was necessary for business operations or inflated to benefit a related party. Payments beyond genuine needs can be disallowed.
CA Mickey- How does benefit derived by assessee from the expenditure affect disallowance under Section 40A(2)(b)?
CA Mini- If the expenditure leads to substantial benefits for the business, it is less likely to be disallowed. However if the benefits do not justify the amount spent then AO may consider payment excessive & disallow portion deemed unreasonable.
CA Mickey- What are evidence must AO provide to justify a disallowance u/s. 40A(2)(b)?
CA Mini- AO must provide concrete evidence that payment is excessive or unreasonable by providing market comparisons, analysis of business necessity, or other relevant data. Mere assertion without proof is insufficient for disallowance.
CA Mickey- How can a company protect itself against disallowance u/s. 40A(2)(b)?
CA Mini- Company can preserve itself by providing evidence like market rates, details of services rendered, qualifications of recipients & also industry standards. Demonstrating this business necessity & benefits derived from payment can also support the defense.
CA Mickey- What are the potential consequences for a company if a payment is disallowed u/s. 40A(2)(b)?
CA Mini- If a payment is disallowed, it increases company’s taxable income, leading to higher tax liability. Additionally, the company may face penalties along with interest on the additional tax levied. It can also trigger further scrutiny of transactions by the tax authorities.
CA Mickey- How does the relationship between assessee & recipient affect the AO’s decision under Section 40A(2)(b)?
CA Mini- Relationship is crucial part in this. Payment to close relatives or influential persons are scrutinized more closely. AO assesses whether relationship has led to non-arm’s-length transactions that result in excessive payments.
CA Mickey- What are some common examples of payments that may be disallowed under Section 40A(2)(b)?
CA Mini- Common examples include-
- Excessive salaries or fees to relatives or directors.
- Inflated prices for goods or services from related entities.
- High-interest payments on loans from specified persons.
Above payments are checked to ensure they align with market value and business needs.
CA Mickey- How can a company justify high payments to directors or relatives under Section 40A(2)(b)?
CA Mini- The company can justify high payments by showing the recipients’ qualifications, market rates for similar roles, and contributions to the business. Comparing current payments with the recipients’ previous salaries or market benchmarks can also help.
CA Mickey- What role does the previous employment and salary history of directors play in defending against disallowance?
CA Mini- Previous employment and salary history are vital in protecting high payments. If directors earned similar or higher salaries in previous roles, it indicates that his current remuneration is in line with market standards and justifiable.
CA Mickey- How does the ITAT view disallowances made under Section 40A(2)(b)?
CA Mini- The ITAT critically examines AO’s reasoning. If disallowances are made without substantial evidence or fail to consider business context and market standards, the ITAT is likely to overturn them, as seen in cases like Artisans Micro Finance (P) Ltd. v. ITO i.e. in that case expense was allowed
Here is entire precis : –
Business disallowance beneath phase 40A(2)(b)–Excessive or unreasonable payment Remuneration to administrators–Assessee filed its return of profits declaring loss. During evaluation, proceedings AO noted that assessee had debited personnel’ remuneration which included lawsuits amount paid to directors. AO mentioned that profits paid to directors became fifty six.57 consistent with cent of overall revenue charges and 44.60 in keeping with cent of total receipt. He treated it as unreasonable and excessive and limited the remuneration to directors to twenty in step with cent of receipts and thus allowed only a part of remuneration and closing changed into introduced to the earnings of assessee below section 40A(2)(b). CIT(A) confirmed the disallowance made via AO. Held: The remuneration acquired by means of directors from assessee could not be said to be excessive by way of keeping in view their previous experience and earlier employment. Moreover, AO had no longer added any cloth on record to confirm that as to how and in what way the remuneration paid to the administrators become excessive. He had additionally no longer given any foundation for allowing the remuneration @ 20 in keeping with cent of general receipts. Therefore, the disallowance made through AO and sustained through CIT(A) became no longer justified
CA Mickey- What steps should Assessee take if it disagrees with Authorities opinion u/s. 40A(2)(b)?
CA Mini- The company should appeal to the Commissioner of Income Tax (Appeals) first. If unresolved, it can escalate the case to the ITAT and, if needed, to higher courts. Gathering robust evidence and legal arguments is crucial at each stage.
CA Mickey- Can disallowances under Section 40A(2)(b) be challenged in higher courts?
CA Mini- Yes, absolutely disallowances can be challenged in higher courts including High Court and Supreme Court. Companies can argue against arbitrary disallowances, provided they present strong evidence and legal reasoning.
CA Mickey- What is the significance of the ITAT’s decision in favor of the company in this case?
CA Mini- The ITAT’s decision in favor of Artisans Micro Finance (P) Ltd. underscores the importance of evidence in disallowances. It demonstrates that arbitrary disallowances without substantial proof will likely be overturned, setting example for similar cases here are list of such case laws that are referred case law as well as case law in my knowledge . . .
- ITO v. Hemato Oncology Clinic (Ahmedabad) (P.) Ltd ITA No. 1610/Del/2013 (Del-Trib) 2015 TaxPub(DT) 2317
The AO disallowed 15% of payments made to doctors, reasoning they were excessive. However, the Tribunal found that the AO lacked a basis for what constituted fair market value and ruled that the disallowance was unjustified. The case highlights that payments to seasoned professionals cannot be compared with those of less experienced peers.
- Global Innovsource Search Solutions (P.) Ltd. v. ITO & Asstt. CIT v. Ashok J Patel (2013) 57 SOT 139 (Mum ‘G’-Trib) –
The AO must provide cogent evidence that a payment is excessive. Disallowances cannot be sustained merely by comparing payments with previous years without demonstrating excessiveness or unreasonableness.
- PRM Securities (P.) Ltd. v. ITO (2012) 44 (II) ITCL 503 (Ahd ‘C’-Trib) –
The Tribunal held that the AO’s failure to justify disallowance with evidence or market comparisons invalidated the disallowance of directors’ remuneration.
- CIT v. CMC Machinery (2012) 44 (II) ITCL 503 (Ahd ‘C’-Trib)-
The AO needs comparable instances or evidence to demonstrate that expenses to related parties were excessive. The legitimacy of business needs is also crucial in determining whether a payment is excessive.
- CIT v. Modi Olivetti Ltd. & Subhash Chander & Co. v. ITO (2004) 85 TTJ (Del-Trib) 1038.-
Disallowance under Section 40A(2)(b) requires evidence of the fair market value. Without it, the disallowance is not justified, and the burden of proof lies with the AO.
- CIT v. Spark Hotels (P.) Ltd. (2012) 52 SOT 395 (Del ‘G’-Trib)-
The AO must record findings on whether the expenditure is excessive or unreasonable concerning market value, business needs, or benefits derived. Disallowance without basis is unjustified.
CA Mickey- How do subsequent years’ financial performance influence the assessment u/s. 40A(2)(b)?
CA Mini- Improved financial performance in subsequent years can justify payments made, showing that they were reasonable and contributed to business growth. This was highlighted in the Artisans Micro Finance case, where the ITAT noted the company’s increased receipts in later years.
CA Mickey- What are the key takeaways from this case for other companies facing similar issues?
CA Mini-
Key takeaways
include the importance of documenting and justifying payments, ensuring they align with market standards, and preparing for potential legal challenges. Companies should also be proactive in addressing any concerns raised by tax authorities.
CA Mickey- How does Section 40A(2)(b) differ from other provisions related to disallowance of expenses?
CA Mini- Section 40A(2)(b) specifically targets payments to related parties, focusing on preventing tax evasion through non-arm’s-length transactions. Other provisions might disallow expenses for different reasons, such as non-business purposes or lack of documentation.
CA Mickey- What are the implications of the ITAT’s ruling on future assessments under Section 40A(2)(b)?
CA Mini- Ruling sets example that future assessments must be backed by evidence. AO need to provide concrete proof when disallowing payments & arbitrary decisions are likely to be challenged and overturned on appeal.
CA Mickey- Can the disallowance under Section 40A(2)(b) affect the overall tax liability of the company?
CA Mini- Yes, disallowances increase the company’s taxable income, leading to higher tax liability. This can also result in penalties and interest, affecting the company’s overall financial standing.
CA Mickey- What precautions can companies take to avoid disallowances u/s. 40A(2)(b)?
CA Mini- Companies should ensure that communications with related parties are strong, fair market valuations are recorded from official records & need for payment of the business is justified. Regular audits & legal reviews can help identify and address potential problems before they are flagged by tax authorities.
CA Mickey- How does case of Artisan Microfinance (P) Ltd v ITO help in understanding Section 40A(2)(b)?
CA Mini- This case highlights the importance of clear evidence by AOs when payment is disallowed under Section 40A(2)(b). It emphasizes the importance of considering profitability, market value and operating conditions in understanding payment analysis.
In this exhaustive discussions, CA Mickey & CA Mini highlighted complexities of Section 40A(2)(b) of IT Act and worried importance of dealing with specific persons at arm’s length in emphasis – Artisans Micro Finance (P) Ltd . v. Through the lens of the ITO- case it has shown how important it is for companies to prove payments with clear documentations & market comparisons with records, especially when dealing with related parties transactions.
Disclaimer: In This article, we have just discussed most questions and answers and can not be taken as professional advice. You may or may not rely on answered expressed in these questions and answers to make business or compliance decisions. If you are seeking professional advice, please consult a professional. Any comments/suggestions regarding this article can be sent to [email protected] or WhatsApp on 8000777854
Author Bio
