Payments to relatives and associates under expenses or payments not deductible in certain circumstances [Section 40A] :

Sub-section (2) of section 40A provides that where the assessee incurs any expenditure in respect of which a payment has been or is to be made to a relative or to an associate concern so much of the expendi ture as is considered to be excessive or unreasonable shall be disallowed by the Assessing Officer. While doing so he shall have due regard to:

(a) the market value of the goods, service of facilities for which the payment is made; or

(b) the legitimate needs of the business or profession carried on by the assessee; or

(c) the benefit derived by or accruing to the assessee from such a payment.

The word “relative” as defined in the section 2(41) means, in relation to individual, the spouse, brother or sister of any lineal ascendant or descendant of that individual. Whether the assessee is a firm, H.U.F. or an association of persons the relationship will have to be reckoned for the purpose, with reference to the partners of the firm and the members of the family or association. Similarly, where the assessee is a company the relationship will have to be reckoned with reference to the directors or persons having substantial interest in the company.

The related person as mentioned in section 40A(2) includes, inter alia, a company, firm, association of persons or Hindu undivided family having a substantial interest in the business or profession of the assessee or any director, partner or member of such company, firm, association or family, or any relative of such director, partner or member. Further, the related person in relation to a company shall include any other company carrying on business or profession in which the first mentioned company has substantial interest.

A person shall 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, 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% the profits of such business or profession.

No adjustment to expenditure under section 40A(2) if the transaction is a specified domestic transaction which is carried out at arm‘s length price No disallowance on account of any expenditure in respect of payment which has been made or is to be made to a related person, 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 i.e., no adjustment shall be made under section 40A(2) in relation to the specified domestic transaction in case the same is carried out at arm‘s length price even though the arm‘s length price so determined may be at variance with the fair market value.

Note – For details regarding the meaning of specified domestic transaction, please refer to Chapter 16 on Transfer Pricing.