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.
The question under consideration is whether the transaction of loans, advances or similar nature which are not deductible from Income of the assessee will be reported under Section 40A(2)(b) of the Act, Clause-23 of Tax Audit Report? Hence to understand it one needs to refer the different provisions of Income Tax Act, 1961 which is stated below in this study.
Our advice has been sought under Income Tax Act 1961 on the below query:
Analysis and Facts:
In order to further analyze the query, it is imperative to quote the relevant provisions of law under
Income Tax Act, 1961 at this juncture-
Therefore, it may be necessary to restrict the scrutiny only to such payments in excess of certain monetary limits depending upon the size of the concern and the volume of business of the assessee.
Chart of persons specified in Section 40A(2)(b)- (Refer Paragraph 40.1)
Part-I
Individual | Firm | Association of persons | HUF | Company |
1.His relatives | 1.Its partners 2.Their relatives | 1.Its members 2.Their relatives | 1.Its members 2.Their relatives | 1.Its directors 2.Their relatives |
Part-II
Where person having substantial interest in the business or profession of the assessee is | |||
Individual | Association of persons | HUF | Company |
1. His relatives | 1.Its members 2.Their relatives | 1. Its members 2.Their relatives | 1.Its Directors 2.Their relatives 3.Any other company carrying on business or profession in which the first mentioned company has substantial interest. |
Note: Where one or more of the persons falling in any of the above categories (i.e. individual and his relatives, firm, its partners and their relatives, etc.) have substantial interest in the business or profession carried on by any person – that person is also covered under section 40A(2)(b).
Part-III
Director | Partner | Member of AOP | Member of HUF |
Companies in which he is a Director | Firms in which he is a partner | AOP of which he is a member | |
All other Directors of such Companies | All other partners of such firms | All other members of such AOP | All other members of such HUF |
Their relatives | Their relatives | Their relatives | Their relatives |
40A. (1) The provisions of this section shall have effect notwithstanding anything to the contrary contained in any other provision of this Act relating to the computation of income under the head “Profits and gains of business or profession”.
(2)(a) Where the assessee incurs any expenditure in respect of which payment has been or is to be made to any person referred to in clause (b) of this sub-section, and the Assessing Officer is of 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 the 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 a deduction :
[Provided that [for an assessment year commencing on or before the 1st day of April, 2016] no disallowance, on account of any expenditure being excessive or unreasonable having regard to the fair market value, shall be made in respect of a specified domestic transaction referred to in section 92BA, if such transaction is at arm’s length price as defined in clause (ii) of section 92F.]
Explanation.—For the purposes of this sub-section, a person shall be deemed to have a substantial interest in a business or profession, if,—
| (a) | 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 shares (not being shares entitled to a fixed rate of dividend whether with or without a right to participate in profits) carrying not less than twenty per cent of the voting power; and |
| (b) | in any other case, such person is, at any time during the previous year, beneficially entitled to not less than twenty per cent of the profits of such business or profession. |
mode as may be prescribed], exceeds ten thousand rupees, no deduction shall be allowed in respect of such expenditure.
(3A) Where an allowance has been made in the assessment for any year in respect of any liability incurred by the assessee for any expenditure and subsequently during any previous year (hereinafter referred to as subsequent year) the assessee makes payment in respect thereof, otherwise than by an account payee cheque drawn on a bank or account payee bank draft,[or use of electronic clearing system through a bank account [or through such other electronic mode as may be prescribed]], the payment so made shall be deemed to be the profits and gains of business or profession and accordingly chargeable to income-tax as income of the subsequent year if the payment or aggregate of payments made to a person in a day, exceeds ten thousand rupees:
Provided that no disallowance shall be made and no payment shall be deemed to be the profits and gains of business or profession under sub-section (3) and this sub-section where a payment or aggregate of payments made to a person in a day, otherwise than by an account payee cheque drawn on a bank or account payee bank draft, [or use of electronic clearing system through a bank account [or through such other electronic mode as may be prescribed], exceeds ten thousand rupees,] in such cases and under such circumstances as may be prescribed, having regard to the nature and extent of banking facilities available, considerations of business expediency and other relevant factors :]
[Provided further that in the case of payment made for plying, hiring or leasing goods carriages, the provisions of sub-sections (3) and (3A) shall have effect as if for the words “[ten] thousand rupees”, the words “thirty-five thousand rupees” had been substituted.]
(b) Nothing in clause (a) shall apply in relation to any provision made by the assessee for the purpose of payment of a sum by way of any contribution towards an approved gratuity fund, or for the purpose of payment of any gratuity, that has become payable during the previous year.
Explanation.—For the removal of doubts, it is hereby declared that where any provision made by the assessee for the payment of gratuity to his employees on their retirement or termination of their employment for any reason has been allowed as a deduction in computing the income of the assessee for any assessment year, any sum paid out of such provision by way of contribution towards an approved gratuity fund or by way of gratuity to any employee shall not be allowed as a deduction in computing the income of the assessee of the previous year in which the sum is so paid.]
| (i) | to claim that so much of the amount paid by him as has not been laid out or expended by such fund, trust, company, association of persons, body of individuals, society or other institution (such amount being hereinafter referred to as the unutilised amount) be repaid to him, and where any claim is so made, the unutilised amount shall be repaid, as soon as may be, to him; |
| (ii) | to claim that any asset, being land, building, machinery, plant or furniture acquired or constructed by the fund, trust, company, association of persons, body of individuals, society or other institution out of the sum paid by the assessee, be transferred to him, and where any claim is so made, such asset shall be transferred, as soon as may be, to him.] |
No deduction or allowance shall be allowed in respect of any marked to market loss or other expected loss, except as allowable under clause (xviii) of sub-section (1) of section 36.]
This section was inserted by the Finance Act, 1968 (19 of 1968), with effect from 1 April, 1968, with a view to taking measures for countering tax evasion.
In the course of business or profession, the assessee has to incur expenditure involving payments made from time to time to different persons under various circumstances. The legislature found from experience that the existing provisions of the Act were inadequate to deal with the evasion of tax under the cloak or guise of permissible deductions.
Section 40A was added by the Finance Act of 1968 and it came into force with effect from 1 April 1968. While introducing the Bill in the Lok sabha for its consideration, the Finance Minister made a speech on 29 April, 1968, in which he pointed out that the provision in question was intended to serve the objective of checking tax evasion.
The following are broadly the types or classes of payments in respect of the deductibility of which this section imposes restrictions and limitations:
An overriding provision:
As pointed out in Shree Sajjan Mills v CIT [(1985) 156 ITR 585 (SC)] section 40A, which contains a non- obstante clause in sub-section (1), is an overriding provision which operates in spite of anything to the contrary contained in any other provision of the Act relating to the computation of income under the head ‘Profits and gains of business or profession’. In other words, the legislature has made it clear that the provisions of section 40A will apply in supersession of other contrary provisions of the Act relating to the computation of income under the aforesaid head [Hasanand Pinjomal v CIT (1978) 112 ITR 134 (Guj).
Legislative History (1968):
This sub-section continues unamended except that a proviso to clause (a), which was there originally was omitted subsequently. The proviso read as under:
“Provided that the provisions of this sub-section shall not apply in the case of an assessee being a company in respect of any expenditure to which sub-clause (i) of clause (c) of section 40 applies.”
“Expenditure incurred in business and profession involving payment to relatives and associate concerns”-
The term “relative”, as defined in section 2(41) means, in relation to an individual, the husband, wife, brother or sister or any lineal ascendant or descendant of that individual. A person will be deemed to have a substantial interest in a business or profession if, in a case where the business or profession is carried on by a company the person beneficially owns shares in the company (other than preference shares), carrying not less than 20 per cent of the voting power and in any other case, where the person is beneficially entitled to not less than 20 per cent of the profits of business or profession.
One of the serious concerns of the revenue in the matter of computation of the business income was the avoidance or evasion of tax by claiming deduction of liberal payments made or benefits granted by an assessee to closely connected persons ostensibly for services rendered by them. To curb the practice, the legislature initially introduced a restriction in the case of companies and gave the department a power to investigate into the reasonableness of the payments made to such persons in the light of the business needs of the company and the benefit obtained by making such payments (Section 10(4A) of the 1922 Act, re- enacted as section 40(c)(i) and (ii). The starting point of this development was Newton Studios v CIT (1955) 28 ITR 378 (Mad). A ceiling was introduced later). This power extended to remuneration, benefit or amenity provided to a director or a person having a substantial interest in the company (The 1961 Act added also
the benefits given to a “relative of such director or other person”) either directly or in the form of enjoyment of assets belonging to the company. In 1963, the legislature conceived of the idea of a ceiling on the remuneration allowable to an employee of a company but modified it in 1964 by imposing a ceiling on the perquisites (which is so widely prevalent that it has come to be known, affectionately by the recipients as ‘perks’) allowed to its employees (later restricted to those drawing Rs. 7,500 or more per month as salary). The present section, inserted in 1968, has extended the curb, with modifications, to the case of all assessees.
An analysis of this section discloses the following constituent elements in the scheme of disallowance:
If the above conditions are fulfilled, the officer can disallow the expenditure to the extent he considers it excessive or unreasonable by the above objective standards or otherwise [For the three considerations mentioned are not exhaustive. See- Synpro Industries v CIT (1984) 146 ITR 176 (MP); Ganesh Soap Works v CIT (1986) 161 ITR 876 (MP); Anandji Shah v CIT (1990) 181 ITR 171 (Ker)].
The opening words of section 40 indicate that the amounts enumerated therein shall not be deducted in computing the income chargeable under the head “profits and gains of business or profession”, notwithstanding anything to the contrary in sections 30 to 38.
Clause (a) contemplates an assessee incurring any expenditure in respect of which a payment has been or is made to any person referred to in clause (b). Where no such expenditure is incurred, obviously, the provisions of this sub-section cannot be invoked. In the case [CIT v Subbaraya Chetty & Sons (AK) (1980) 123 ITR 592 (Mad); CIT v Udhoji Shri Krishnadas (1983) 139 ITR 827 (MP)], the assessee sold goods to another with whom it had a close connection, i.e., it charged a lower sale rate in effect. The bona fide nature of the transaction was not in dispute. It was held that all that had happened was that a certain portion of the normal sale price was given up. As there was nothing which was paid out or away by the assessee from the sale price or the income that had accrued to it, there was no expenditure which could be disallowed by reference to section 40A(2)(a).
In Upper India Publishing House (P) Ltd v CIT [(1979) 117 ITR 569 (SC). Also CIT v Skyline Industries Pvt Ltd (1985) 154 ITR 373 (MP); CIT v Orissa Cement Ltd (1988) 171 ITR 72 (Del); CIT v Kumar Engineers (1989) 178 ITR 630 (P&H); CIT v Northern India Iron & Steel Co Ltd (1989) 179 ITR 599 (Del); Trinity Pharmaceuticals India Ltd v CIT (1994) 206 ITR 431 (Ker)], it has been held by the Supreme Court that whether a particular expenditure is excessive and reasonable or not is essentially a question of fact and does not involve any issue of law. It was pointed out that in order to invoke clause (a), it has first to be held that a particular expenditure is excessive or unreasonable.
– Trib.) Payment of high incentives to directors was not justifiable, merely because assessee-company had earned high profits in current year.
requirements need not exist simultaneously. Coronation Flour Mills v. Asstt. CIT [2009] 314 ITR 1/[2010] 188 257 (Guj.).
TRANSACTIONS NOT COVERED
Income-tax Law is concerned only with reduction of tax liability by an assessee by diverting business profits to relatives and associate concerns in the form of excessive payments for goods, services, etc. In order to curb such evasion, section 40A(2) was inserted by the Finance Act, 1968, with effect from April 1, 1968 which empowers Income-tax Authorities to disallow an expenditure or payment to the extent it is considered excessive or unreasonable, for the purpose of computing profits and gains of a business or profession.
The payment should be in the nature of expenditure to qualify for reporting in Section 40(A)(2)(b) of the Act. If there is no expenditure then the provisions of Section 40A(2)(b) of the Act cannot be invoked. The understanding based on facts, provisions of law quoted above is that even if there is expenditure which is capital in nature (not debitable to profit and loss account) shall not necessitate reporting in Clause 23 of Tax Audit report for Section 40(A)(2)(b) of the Act. Further the expenditure to be reported in Clause 23 of Tax Audit report for Section 40(A)(2)(b) of the Act should lead to tax evasion.
The transaction of loans, advances or similar nature which are not deductible from Income of the assessee are outside the purview of Section 40A(2)(b) of the Act. The intention of legislature is clear and unambiguous since separate sections i.e. Section 269SS & 269T read with Section 2(22)(e) of the Act are separately defined in the provisions of the Act along with its reporting requirements in Tax Audit Report.
Our conclusions are based on the completeness & accuracy of the facts stated therein & assumptions, which if not entirely complete or accurate, should be communicated to us, as the inaccuracy or incompleteness could have a material impact on our conclusions. The conclusions reached & views expressed in the note are based on our understanding of the law & regulations prevailing as of the date of this note as well as our past experience with the tax and / or regulatory authorities. However, there can be no assurance that the tax authorities or regulators will concur with our views.
Legislation, its judicial interpretation & the policies of the tax and / or regulatory authorities are subject to change from time to time & these may have a bearing on the advice that we have given. Accordingly, any change or amendment in the law or relevant regulations would necessitate a review of our comments & recommendations contained in this note. Unless specifically requested, we have no responsibility to carry out any review of our comments for changes in laws or regulations occurring after the date of this note.
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