Running Business: Be Careful About Claiming Payments Made To Relatives

Updated on: May 8th, 2024

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9 min read

If you are running a business or a profession, you are allowed to claim its expenses from your income. However, these expenses may not be allowed if you make payments to specified persons who are listed in the Income Tax Act. Where payment made to them is excessive or unreasonable and not according to the fair market value of goods or services provided, you may not be able to claim it. The assessing officer may not allow you to claim expenses for payments made to specified persons (as per Section 40A(2) of the Income Tax Act) if :

  • Payment is to be made to certain specified persons

                               AND

  • Income Tax Officer believes that such expenditure is excessive or unreasonable in relation to the fair market value of the goods, services or facilities provided.

If both the above conditions are fulfilled, the Income Tax Officer can disallow the expenditure to the extent he considers it excessive or unreasonable.

Who Is Specified Person?

The Income Tax Act mentions a list of specified persons, including relatives. But before we discuss the list of specified persons, we should know the meaning of substantial interest.

Substantial Interest

A  person will be considered to have a substantial interest in the business or profession in satisfying the conditions below.

  • In the case of a company carrying on business or profession, the person owning at least 20% voting power at any time during the year shall be called someone who has a substantial interest in the company.

For example, if in ABC Pvt Ltd, X1 firm holds 23% equity shares of ABC Ltd, then X1 firm shall have Substantial Interest in the company.

  • In any other case, such as a firm, an association of persons and a sole proprietorship, the person entitled to at least 20% of profits made by the business or profession during the year shall deemed to have Substantial Interest in such business or profession.

The list of specified persons in case of different categories of taxpayers for imposing the provisions of section 40A(2) are as follows:

Individuals

  • Relatives of an Individual include spouse, brother, sister, lineal ascendant or descendant of the individual, like parents, grandparents, son, daughter, etc.
  • Any person in whose business or profession the individual himself or his relative has a substantial interest.

For instance
Mr Ashok, who is running a business, has 22 % shares in X Ltd. Now any amount paid/payable by Mr Ashok to X Ltd will be subject to the category of specified person under Section 40 A(2)(b).

Company, Firm Or HUF

  • Director(s) of the company, partners in a firm, members of HUF or association of persons. Also the family member or relative of such director, partner or member will be considered as specified persons.
  • Any person in whose business or profession, such as director, partner, member himself or relative of such person, has a substantial interest.

For instance
If the relative of the director of X1 Ltd is entitled to a 22% share of profits in ABC firm, then ABC firm Ltd will be considered as a specified person to X1 ltd in case of any business transaction between the two

In Any Other Case Of Taxpayer

  • An individual who has a substantial interest in the business or profession run by the taxpayer.

For instance
Mr Puneet is entitled to 25% share of Abc firm , then he shall deemed to be specified person to ABC firm in case of any business transaction between the two.

  • A company, firm, AOP or HUF which has a substantial interest in the business or profession run by the Also the director of the company or partner of the firm or member of HUF and AOP along with their relatives which has a substantial interest in the business or profession run by the taxpayer shall be deemed to be specified persons.

For instance
if director ABC ltd is entitled to 25% of the profits in the business run by Mr Rahul.Then ABC ltd shall deemed to be specified person to Mr Rahul in case of any business transaction between the two.

In short specified Persons are as follows:

In Case of

Specified Person

Individual


 

Relatives of lineal ascendant or descendant such as spouse, brother, sister etc. A relative or the individual himself who has substantial interest in business or profession run by self.

Company, firm or HUF

Director(s) of the company, partners in a firm, association members or family or relative of people in these positions. A relative or the individual himself who has substantial interest in the business or profession the assessee holds such a position.

All Assessees

An individual who has substantial interest in the business or profession run by the assessee. A company, firm, AOP or HUF which has substantial interest in the business or profession run by the assessee or directors, partners or association members of such members or relative of the person holding such a position.

Conclusion

Section 40A(2) of the Income Tax Act is designed to empower authorities who assess income tax. It enables them to disallow certain expenditures (made to specific persons) to be claimed as tax deductions.

Yet, there are several legal ways for individuals to save their taxes such as by investing in health insurance plans, donating to charity, earning from savings accounts, etc.

Frequently Asked Questions

Who are relatives under section 40A (2)?

Lineal descendents or ascendents such as spouse, brother, sister etc. of the individual is considered as relatives under the section 40A (2).

What is the payment allowed under section 40A(2)?

Any sum paid by an assessee to a resident for professional or technical services provided is disallowed as deduction under this section 40A(2).

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