Whenever we heard “Related Party Transactions”, our mind, by default, starts thinking about various issues like how is it related? Whether is it under Income Tax Law or Goods & Services Tax or Company Law? How to comply stringent provisions? What are the repercussions for failing to do so? etc.
It is an essential to have a thorough knowledge of all the applicable laws before entering into any transactions but not restricted to “Related Party Transactions” (In short RPTs).
The current article exclusively dealt with “RPTs” under Income Tax Laws (in short “the Act”) in a brief manner.
Related Party Transactions – Various Statues
The Term RPTs – Defined?
The term ‘Relative’ in relating to an individual has been defined under sub-section (41) of Section 2, as the husband, wife, brother or sister or any lineal ascendant or descendant of that individual.
Further, the Section 40A (2) defined “Related Parties and its close associates.” In a condensed form, they are as follows:
|Assessee||Relatives or Associates|
|In case of Individual||• Any relative of the assessee
• Any person in whose business or profession the assessee himself or his relative has a substantial interest.
|In case of Company, Firm, Association of person & Hindu Undivided Family
• Member of the association
• Member of the Family & Relatives of them
Any person in whose business or profession, as said above or relative of him of her has “substantial Interest.”
Any Individual who has “substantial interest” in the business or profession of the “Assessee.”
A Company or Firm or AoP or HUF having a substantial interest” in the business or profession of the “Assessee.”
Any other company carrying on business or profession in which the first mentioned has “substantial interest”
|“Substantial Interest” – Meaning of
Any person shall be deemed to have a ‘Substantial Interest’ in a business or profession where,
• In case of Company, such beneficial owner of shares (not being a shares entitled dividend with or without participating in profits) having not less than 20% voting power. And
• In any other case, such person, beneficial entitled to not less than 20% of the profits of such business or profession.
Expenditures and relevant provisions – In Brief
Section 37 of the Act provides certain deductions, which are not allowed to claim under other provisions say or as enumerated in Section 30 to 36. However, the given expenditure should pass three tests. They are –
Whether expenditure should –
A condensed list of allowable as well as not allowed expenses
|Expenses allowable – Section 37(1)||Expenses not allowed – Section 37 (1)|
|1. Legal Expenses – with exceptions
2. Interests – with exceptions
3. Brokerage and commission – with exceptions
4. Fines, penalties, damages, compensation or like
5. Compensation includes payment made to an employee, Gratuity paid to the widow of a director, Pension paid to dependents of former employees, etc.
6. Expenditure incurred during ceremonial, annual days, gifts made during a marriage or like occasions etc.
7. Duties and Taxes – Local tax paid on business or profession, Professional tax paid to the State machinery, purchase tax etc.
8. Certain expenses under CBDT’s or the Board’s due Instructions
|1. Legal Expenses, as incurred by a partner in proceedings for dissolution of the partnership.
2. Interests – Like paid for delay in emitting due Income tax liability etc.
3. Brokerage and commission – like in connection with the issuance of preference shares, secret commissions, etc.
4. Retrenchment compensation
5. Expenditure incurred for poojas or dinner on special occasions
6. Duties and Taxes – Like Income Tax and wealth-tax [Also disallowed u/s. 40(a)]
7. Corporate Social Responsibility (CSR) Expenditure – with exceptions
8. Miscellaneous expenses incurred for
• Acquiring goodwill,
• Relocation of registered office or factory etc.
• To acquire perfect title of a capital asset
Related Party Transactions and Specific Provisions
Section 40A of the Act extensively dealt with certain expenses or payments not deductible under given circumstances. Various sub-section of the Section also has an overriding effect on other provisions. To substantiate this, sub-section (1) of Section 40A, clearly states that “Have effect notwithstanding anything contrary contained in any other provisions.”
Sub-section (2) of Section 40A, effectively, disallows certain expenses or payments made to relatives or their close associates, as the case may be.
Ingredients of sub-section 2 of Section 40A
A plain reading of the said sub-section reveals that for expenditure or an amount to disallow, three conditions shall be met. They are –
1. The payment should be related to any expenditure
2. The said payment shall be made or to be made to a relative or close associate
3. The payment shall be considered as excessive or unreasonable when compared to ‘Fair Market Value (FMV)’ or legitimate needs of a business/profession or accrual of benefit to the assessee.
The Hon’ble Gujarat High Court in Coronation Flour Mills v ACIT 314 ITR 1, 188 Taxman 257 held that if a particular transaction justifies any of one the said three conditions, the assessing officer has discretionary as well as statutory powers to disallow the expenditure to the extent he believes excessive or unreasonable.
With respect to domestic transfer pricing, the Central Government vide Finance Act 2016 w.e.f 01.04.2017, having regard to FMV, excludes any expenditure referred in Section 92BA with subject to the definition of ‘Arm’s Length Price’ even though it is excessive or unreasonable.
Applicability: However, the said exemption applies only when the aggregate of the transactions entered into by the assessee crosses or exceeds Rs. 20 Crore (up to the assessment year 2015-16 same was restricted to Rs. 5 Crore) in an applicable previous year.
A condensed list of specific disallowance under Section 40
1. Interest, royalty fees payable outside India or in India to a non –resident
2. Any sum – where failed to deduct 30 percent TDS or TCS as the case may be.
3. Any consideration – where failed to deduct 6 percent Equalisation Levy (also known also ‘Google Tax..!!’) paid or payable to a non-resident for a specified service as prescribed.
4. Tax and Wealth Tax
5. Certain charges paid to the State Government on its undertakings.
6. Salaries payable outside India or to a non-resident – Where failed to deduct tax at source.
Interestingly, the Section 40A (2) is without a precedent in the Indian Tax Laws. The reason is no doubt that any expenditure which is incurred out of extra commercial considerations should not be allowed as a deduction under tax laws.
1. Whether “Excessive or unreasonable” wording is a question of law or fact?
It is ‘Question of fact’. The Hon’ble Supreme Court ruled in Upper India Publishing House v CIT 117 ITR 569.
2. Whether a subsidiary company is a relative?
No. A subsidiary company is not a relative under clause (b). S. Dempo and Co. Pvt. Ltd. v. CIT 336 ITR 209
3. Sufficient Material is necessary
To prove that the expenditure was not excessive or unreasonable, the assessee is under obligation to provide sufficient material. Further, the assessing officer’s decision on disallowing the expenditure on grounds of ‘excessive or unreasonable’ should be on well-founded reasons. NEPC Ltd. v. CIT 303 ITR 271
4. FMV and Comparison
The assessing officer, while comparing the prices should compare which is prevailing in a local market in the same year. Denso Haryana Pvt. Ltd. v. CIT 328 ITR 14, 190 Taxman 389
5. Whether trade discounts allowed?
Since assessee does not incur expenditure on trade discounts, no disallowance can be made. Subbaraya v. CIT 123 ITR 592
6. To disallow, satisfying any one of three conditions is enough?
The three conditions are independent and need not exist simultaneously. As held in Coronation Flour Mills (supra).
In present – day of context and mandatory disclosures requirements under various statues, an assessee or an entity, having awareness of ‘Related Party Transactions and its provisions’ became a necessity, in turn, same will safeguard the interest of both the assessee as well as the Revenue.
The Author is a budding Tax Law Professional and can be reached at firstname.lastname@example.org