Section 40A of the Income-tax Act specifies circumstances in which certain expenses or payments are not deductible while computing taxable business income. These disallowances apply when conditions laid down in the Act are not met, ensuring that only legitimate business expenses are claimed. One major provision concerns payments made to related or specified persons under Section 40A(2). Expenditure paid to such persons may be disallowed to the extent it is considered excessive or unreasonable when compared to fair market value, legitimate business needs, or actual benefit derived. However, specified domestic transactions that meet the arm’s length standard under Section 92F are not subject to this disallowance. The law details an extensive list of “specified persons” depending on the nature of the assessee, including relatives, partners, directors, members of groups such as firms, companies, AOPs, BOIs, HUFs, and persons having substantial interest in the assessee’s business. The term “relative” includes spouse, siblings, and lineal ascendants or descendants, while “substantial interest” refers to ownership of at least 20% of shares (other than fixed-dividend shares) or profits. Another key disallowance applies under Section 40A(3)/(3A) for payments above Rs. 10,000 made in cash, except where payments are made for hiring or leasing goods carriages, where the threshold is Rs. 35,000. Payments must be made through account-payee cheque, bank draft, or electronic modes to qualify for deduction, although Rule 6DD provides specific exceptions to avoid genuine hardship.
Additional restrictions apply to certain provisions and contributions. Under Section 40A(7), a deduction for gratuity is not allowed if it is merely a provision, unless it is contributed to an approved gratuity fund or relates to gratuity that actually becomes payable during the year. Once a provision has been allowed in an earlier year, the actual payment later cannot be claimed again as a deduction. Similarly, Section 40A(9) disallows contributions made by an employer to non-statutory or unapproved employee welfare funds, trusts, or entities. Deductions are permitted only for contributions to recognised provident funds, approved superannuation funds, approved gratuity funds, or other contributions specifically allowed by law. Payments to any other type of employee welfare fund without statutory backing are fully disallowed. Further, Section 40A(13) deals with “marked-to-market” losses arising from valuation of securities. Under ICDS-VIII, listed securities held as stock-in-trade may be valued at the lower of cost or net realisable value, allowing losses under Section 36(1)(xviii) and taxing gains as business income. However, unlisted or non-quoted securities must be recognised at actual cost, and any notional gain or loss recorded in the books is disallowed under Section 40A(13). The topic concludes with multiple-choice questions reinforcing concepts such as the definition of specified persons, allowable contributions, valuation rules for securities, and the scope of disallowances. Overall, Section 40A ensures that deductions are confined to genuine and legally compliant business expenses and prevents misuse through excessive, unapproved, or non-transparent payments.
Expenses or payments not deductible in certain circumstances
Provision of Section 40A enumerates certain expenses which are disallowed while computing the taxable income of an assessee. If certain conditions are not satisfied, these amounts will not be allowable as a deduction while computing the business income of the assessee. [Section 40A]
The disallowance under section 40A shall be as under:
Disallowance of payment made to related parties [Section 40A(2)]
Any expenditure, in respect of which, payment has been made to the specified persons, shall be disallowed to the extent such expenditure is considered excessive or unreasonable having regard to the fair market value of goods or services or facilities or legitimate business needs of the business of the assessee or benefit derived by or accruing to the assessee as a result of the expenditure.
No expenditure in a transaction, being a specified domestic transaction incurred for an assessment year commencing on or after April 01, 2016, shall be disallowed by treating it as excessive or unreasonable having regard to its fair market value, if it is at its arm’s length price as defined under section 92F(ii).
The specified persons for various types of assessee are discussed below:
| Specified persons to whom payment has been made | ||
| An Individual | a) | Any relative of such individual |
| b) | To a person in whose business the individual or any of his relatives has a substantial interest | |
| A Company | c) | Director of the Company |
| d) | Any relative of the director | |
| e) | To a person in whose business the company or any of its directors or relative of such directors has a substantial interest. | |
| A Firm | f) | Partner of the firm |
| g) | Any relative of the partner | |
| h) | To a person in whose business the firm or any of its partners or relative of such partners has a substantial interest. | |
| AOP/BOI | i) | Members of the AOP/BOI |
| j) | Any relative of the members | |
| k) | To a person in whose business the AOP/BOI or any of its members or relative of such members has a substantial interest. | |
| A HUF | l) | To a member of the family |
| m) | Any relative of the members | |
| n) | To a person in whose business the HUF or any of its members or relative of such members has a substantial interest. | |
| Any other taxpayer | o) | To an individual who has a substantial interest in the business of a taxpayer |
| p) | Any relative of such individual | |
| Any other taxpayer | q) | To a company which has a substantial interest in the business of the taxpayer |
| r) | Any director of such company | |
| s) | Any relative of such director | |
| t) | Any other company carrying on business or profession in which the above-mentioned company has a substantial interest | |
| Any other taxpayer | u) | To a Firm or AOP or HUF who has a substantial interest in the business of the taxpayer |
| v) | Partner or member of such person | |
| w) | Any relative of such partner or member | |
| Any other taxpayer | x) | To a company, one of whose directors has a substantial interest in the business of the taxpayer |
| y) | Any director of such company | |
| z) | Any relative of such director | |
| Any other taxpayer | aa) | To a Firm or AOP or HUF, one of whose partners/members has a substantial interest in the business of the taxpayer |
| bb) | Any partner or member of such person | |
| cc) | Any relative of such partner or member | |
Meaning of ‘Relative’
The term ‘relative’ in relation to an individual shall include husband, wife, brother or sister, or any lineal ascendant or descendant of that individual.
Meaning of ‘Substantial Interest’
A person is deemed to have a substantial interest in the business or profession if such person is the beneficial owner of at least:
a. 20% share (not being shares entitled to a fixed rate of dividend whether with or without a right to participate in profits) at any time during the relevant previous year, if business or profession is carried on by a company;
b. 20% of profits at any time during the previous year, if business or profession is carried on by any other concern.
Disallowance of payment made in cash [Section 40A(3)/(3A)]
No deduction shall be allowed for an expenditure, even if it is deductible under any other provision if payment (or aggregate of payments) for such expenditure to a person in a day exceeds Rs. 10,000 and it is made by any mode other than account payee cheque or bank draft or electronic clearing system through a bank account or through prescribed electronic modes.
In case payment is made for plying, hiring, or leasing goods carriages, the ceiling of Rs. 35,000 shall be considered instead of Rs. 10,000.
Further, Rule 6DD specifies certain circumstances where disallowance should not be made.
Disallowance of provision for gratuity [Section 40A(7)]
No deduction is admissible in respect of any provision made by the assessee for payment of gratuity to his employees on their retirement or on termination of their employment for any reason. However, the restriction does not apply in the following cases:
a. Any provision made for payment of gratuity by way of contribution towards an approved gratuity fund; or
b. Any provision for payment of gratuity that has become payable during the previous year.
If such provision for payment of gratuity has been allowed as a deduction in any of the previous years, no deduction will be allowed again when payment is actually made out of such provision, whether by way of contribution to approved gratuity fund or by way of payment to the employee.
Disallowance of contributions to non-statutory funds [Section 40A(9)]
Any sum paid by the employer by way of contribution towards a recognised provident fund, approved superannuation fund, pension scheme, or approved gratuity fund is deductible to the extent such contribution is permissible under income-tax law or any other law for the time being in force.
However, no deduction is allowable for the employer’s contribution towards a fund (for the benefit of employees) that is otherwise not required by any law. Thus, the deduction is not allowable in respect of any sum paid by the employer towards the setting up or formation of or as a contribution paid to any fund, trust, company, AOP, BOI, societies or it is paid by way of contribution to any fund that is not a recognised provident fund, approved superannuation fund, or gratuity fund.
For example, an employer’s contribution towards an unrecognised provident fund or any other staff welfare fund (without any statutory requirement) will be disallowed under this provision.
Disallowance for marked-to-market loss [Section 40A(13)]
‘Marked-to-Market’ is a methodology of revaluing a financial instrument based on its market price on the closing day of the accounting period. A financial instrument is valued at a market rate to report its actual value on the date of reporting.
As per ICDS-VIII (Securities), listed securities held as stock-in-trade shall be valued at the lower of the actual cost initially recognised or the net realisable value at the end of the previous year. If any loss arises due to such restatement, it shall be allowed as a deduction under Section 36(1)(xviii) of the Income Tax Act. However, if any gain arises due to such valuation, it shall be taxable as business income under Section 28.
The option to restate the value at the year-end shall not be available in respect of securities that are not listed or are listed but not quoted on a recognised stock exchange. Such securities shall be recognised in the books at the actual cost at which it has been recognised initially. If any notional gain or loss is recognised by the assessee in the books, it shall be disallowed under Section 40A(13).
MCQs
Q1. Who is considered a specified person under section 40A(2) with respect to an individual?
a. Any relative of such individual
b. A person in whose business the individual or any of his relatives has a substantial interest
c. Both (a) and (b)
d. None of the above
Correct answer: (c)
Justification of the correct answer: As per section 40A(2) any relative of the individual or any person in whose business the individual or any of his relatives has a substantial interest is considered a specified person.
Q2. Who is considered a specified person under section 40A(2) with respect to a company?
a. Director of the company
b. Employee of the company
c. Debtor/Creditor of the company
d. None of the above
Correct answer: (a)
Justification of the correct answer: As per section 40A(2), the director of a company or any relative of the director or any person in whose business the company or any of its directors or relative of such directors has a substantial interest is considered a specified person.
Q3. Relative under section 40A(2) includes
a. Spouse
b. Brother/Sister
c. Lineal ascendant/descendant
d. All of the above
Correct answer: (d)
Justification of the correct answer: The term ‘relative’ in relation to an individual shall include husband, wife, brother or sister, or any lineal ascendant or descendant of that individual.
Q4. Any sum paid by the employer by way of contribution towards a________ is deductible to the extent such contribution is permissible under income-tax law or any other law.
a. recognised provident fund
b. approved superannuation fund
c. approved gratuity fund
d. All of the above
Correct answer: (d)
Justification of the correct answer: As per section 40A(9), any sum paid by the employer by way of contribution towards a recognised provident fund, approved superannuation fund, pension scheme, or approved gratuity fund is deductible to the extent such contribution is permissible under income-tax law or any other law for the time being in force.
However, no deduction is allowable for the employer’s contribution towards a fund (for the benefit of employees) that is otherwise not required by any law.
Q5. As per ICDS-VIII (Securities), listed securities held as stock-in-trade shall be valued at _______ .
a. The actual cost initially recognised
b. The net realisable value at the end of the previous year
c. lower of (a) or (b)
d. None of the above
Correct answer: (c)
Justification of the correct answer: As per ICDS-VIII (Securities), listed securities held as stock-in-trade shall be valued at the lower of the actual cost initially recognised or the net realisable value at the end of the lower of the actual cost initially recognised or the net realisable value at the end of the previous year.
(Republished with amendments)
