Related Party Transactions – Section 40A(2) of Income Tax Act,1961

Introduction

Section 40A(2) of Income Tax Act, 1961 deals with payments to relatives and associated persons.

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 an assessee purchases goods from specified person for Rs.25,000 and debits the said amount in the Profit and Loss Account. But the fair market value of such goods is only Rs.20,000. This means, the assessee should have charged only Rs. 20,000 in the Profit and Loss A/c.

Therefore, according to section 40A(2) of Income Tax Act, 1961, excess amount of Rs.5,000 is to be added back to net profit while computing business income of the assessee.

Further transactions undertaken by the assessee with the below mentioned  specified person which is treated as expenditure for the assessee, will be regarded as related party transactions and such transactions are required to be reported in clause 23 of FORM 3CD.

List of specified persons

If assessee is an individual

• Any relative of the individual assessee is the specified person of the individual assessee.
• Any person carrying on business or profession is the specified person of the individual assessee, if
  • The individual assessee has a substantial interest in the business of that person or
  • Any relative of the individual assessee has a substantial interest in the business of that person

(Refer the meaning of relative and substantial interest at the end of the article)

Example – An individual assessee’s wife is entitled to share of profit@30% in a partnership firm. By virtue of this the said firm is to be treated as specified person of the individual assessee. The individual assessee purchases goods from the firm in the course of his business. The said transaction of purchase of goods is to be treated as related party transaction.

If assessee is a company

• Director of the assessee-company or any relative of such director is the specified person of the assessee-company.
• Any individual having substantial interest in the business or profession of the assessee-company, so the said individual or any relative of such individual is the specified person of the assessee-company.

Example – An individual is holding shares carrying voting power of 25% in a company. By virtue of this individual and his relatives will be treated as specified person of the company. The said individual’s wife is rendering legal services to the company. The transaction of availment of legal services is to be treated as related party transaction.

• Any person who carries on business or profession is the specified person of the assessee-company if the assessee-company or director of the assessee-company or relative of such director has substantial interest in the business of that person.

Example – A company is using patented process for manufacture of goods for which royalty is required to be paid to a firm. The brother of the company’s director is the partner of the firm entitled to share of profit@50%. By virtue of this the firm is the specified person of the company and transaction involving payment of royalty is to be treated as related party transaction.

If assessee is the firm

• Partner of the firm or relative of such partner is the specified person of the assessee-firm.
• Any person carrying on business or profession is the specified person of the firm if the firm or partner of the firm or relative of such partner has substantial interest in the business of that person

If assessee is the HUF

• Member of the family or relative of such member is the specified person of the assessee HUF.
• Any person carrying on business or profession is the specified person of the HUF if the HUF or member of family or relative of such member has substantial interest in the business of that person.

If assessee is the AOP

• Member of AOP or relative of such member is the specified person of the assessee AOP.
• Any person carrying on business or profession is the specified person of the AOP if the AOP or member of AOP or relative of such member has substantial interest in the business of that person.

All assessees

• Company having substantial interest in the assessee’s business, so the said company or director of such company or relative of such director is the specified person of the assessee.

Example – Assessee is a company XYZ Ltd. A company ABC Ltd. is holding shares carrying voting power of 25% in XYZ Ltd. By virtue of this ABC Ltd. and its directors as well as relatives of such directors will be treated as specified person of XYZ Ltd. XYZ Ltd. is purchasing goods from ABC Ltd. The said transaction of purchase is to be treated as related party transaction

• FIRM having substantial interest in the assessee’s business, so the said firm or partner of such firm or relative of such partner is the specified person of the assessee

Example – Assessee is a company XYZ Ltd. A partnership firm M/s PQR holds shares carrying voting power of 22% in the assessee-company. By virtue of this, firm M/s PQR and all its partners as well as relatives of all partners will be treated as specified person of the assessee-company XYZ Ltd. XYZ Ltd. is incurring expenditure by way of rent for which payment is required to be made to an individual named as ‘P’ who is partner of M/s PQR. This transaction of rent is to be treated as related party transaction.

• HUF having substantial interest in the assessee’s business, so the said HUF or member of such HUF or relative of such member is the specified person of the assessee.
• AOP having substantial interest in the assessee’s business, so the said AOP or member of such AOP or relative of such member is the specified person of the assessee.
• A director of a company having substantial interest in the assessee’s business, so the said director and the company of which he is the director is the specified person of the assessee.

Example – An individual ‘A’ is entitled to 35% share of profit in assessee-firm M/s ABC. ‘A’ is also director in AD Ltd. By virtue of this, individual A and AD Ltd. are treated as specified person of assessee-firm M/s ABC Ltd. M/s ABC is availing professional services from AD Ltd. for which payment is required to be made to the company. The said transaction of professional services is to be treated as related party transaction

• A partner of a firm having substantial interest in the assessee’s business, so the said partner and the firm of which he is the partner is the specified person of the assessee.

Example – An individual ‘C’ is a shareholder of an assessee-company DZ Ltd holding shares carrying voting power of 34%. C is also a partner in M/s ABC. By virtue of this, C and M/s ABC would be treated as specified person of assessee-company DZ Ltd. DZ Ltd. gets goods manufactured on job work basis from M/s ABC. The said transaction of job work is to be treated as related party transaction.

• A member of a HUF having substantial interest in the assessee’s business, so the said member and HUF of which he is the member is the specified person of the assessee.
• A member of an AOP having substantial interest in the assessee’s business, so the said member and AOP of which he is the member is the specified person of the assessee.

Defination of relative

Relative in relation to an individual means the spouse, brother or sister or any lineal ascendant or descendant of that individual.

Meaning of substantial interest in a business or profession

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

• 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 equity shares carrying not less than 20% of the voting power and
• 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