Section 40A2 of the Income Tax Act, 1961 is a crucial measure that prevents the owners or majority shareholders of any organisation from claiming excessive benefits for themselves or any parties associated with them. 

This Section comes into effect whenever an assessing income tax officer believes that the owner/s of a business have made unreasonably excessive payments to a list of parties explained below. The Act serves various purposes, including profiteering, siphoning off money that belongs to the organisation’s corpus and claiming excessive deductions.

Note that individuals who run businesses are certainly entitled to claim expenses from their income under existing tax laws. It is only when large sums of money are transferred to ‘specified persons’ that Section 40A2 is put into effect.

The list of ‘specified persons’ is mentioned explicitly in the Income Tax Act; there are several listed entities, including close relatives, that attract the scrutiny of IT officials.

When is Such a Deduction Disallowed?

Under Section 40A2 of Income Tax Act, such a deduction is disallowed if the transaction fulfils 3 objectives –

  • When the payment is made to cover expenditures of any nature.
  • When such payment has already been made or is in the pipeline to the ‘specified persons’ for the latter’s expenses.
  • When the payment made or scheduled to be made is significantly more than the fair value of such a service, facility or goods. This assessment is carried out by Income Tax officials.

Note that any such exorbitant pay-outs may be investigated by the concerned IT officer suo moto. If the officer determines that excessive or unreasonable sums have been paid in lieu of services provided, the transaction can be disallowed or prohibited.

Terminologies Explained

There are 2 pertinent terms in this Act which need clarification. The first is the assessee of the organisation, which is paying exaggerated amounts as determined by the IT Officer. This individual must have ‘substantial interest.’ 

The second is a longer list of all ‘specified persons.’

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1. Defining ‘substantial interest’

The following scenarios reflect the policy of ‘substantial interest’:

  • Any person who holds more than 20% of the total voting throughout the year is someone who possesses ‘substantial interest’ under Section 40A2 of Income Tax Act. This instance applies mostly to businesses or companies where the person usually has a majority stake.
  • Secondly, any individual who receives at least 20% of all the profits generated by such a business is also classified as someone with substantial interest. This Section also takes into account sole proprietorship businesses and Association of Persons (AOPs) plus Body of Individuals (BOIs).

2. Defining ‘specified persons’

Section 40A2 lists all parties who together form ‘specified persons’. They may either be individuals or enterprises. Let us take a look at these different categories of taxpayers.

a. Any firm, company, enterprise or HUF

  • Under this heading, Section 40A2 plays a seminal part. The assessee company’s director/s, individuals who come together as partners of a firm, any member of a HUF or ‘Hindu Undivided Family’ and all AOPs or BOIs belong to this taxpayer category. 

Any close family member of such a director, a full-time or part-time partner or a member of a HUF will automatically be deemed to have ‘substantial interest.’

  • Furthermore, if any relative of the aforementioned parties has a stake or business interest in any other firm that may benefit from the assessee’s company, the concept of ‘substantial interest’ is present.

Examples: To cut through the legal jargon and understand the laws in simple language, 2 examples should suffice. 

  • Assume that the director of Firm ‘A’ controls around 40% of the stake in Firm ‘B’; there are also major financial transactions between the 2 firms. In such an instance, Firm ‘B’ is considered to be a ‘specified person’. 

If the IT Officer determines that any payment made by Firm ‘B’ to Firm ‘A’s director is considerably high and do not represent fair market value, investigations may be launched.

  • Assume that a sibling of a director of Firm ‘A’ is entitled to more than 20% of the profits generated by another firm, ‘XYZ’. Whenever there is any business transaction between these 2 entities, Firm ‘XYZ’ will always be considered as a ‘specified person’.

b. Individuals

‘Relatives’ of a company’s promoter or primary stakeholder are not mentioned in detail in Section 40A2. Drawing from Section 2(41) of the IT Act, relatives constitute:

  • Spouse of the primary shareholder
  • Siblings, if any, and
  • Parents, grandparents and children, all of whom are classified as ‘lineal relations’

The provisions of Section 40A2 are activated if these relatives have a significant stake or interest.

Example: Mr Sharma has his own business; he also holds around 22% shares of a firm owned by a close relative. In such a case, if Mr Sharma pays a sum to the latter firm, that amount is deemed a payment to a ‘specified person’, and Section 40A2 (b) kicks in. 

c. For all other taxpayers

Any individual who displays an extremely significant connection or interest in an organisation managed, owned and run by a taxpayer is also considered a ‘specified person’.

Besides, any other business, AOP/BOI, or even a HUF that professes to have a serious interest in a third-party organisation is also a ‘specified person.’ 

Real-Life Instances of this Section at Work

The primary aim of Section 40A2 is getting rid of the nepotism which has plagued Indian industries for several decades. In 2018, Chanda Kochhar, the then-MD and CEO of ICICI Bank and one of India’s most high-profile women business honchos, was accused of nepotism. 

The charge was favouritism in disbursing loans to relatives.

While the case is still sub judice, the names of Videocon Group’s promoters and her husband, Mr Deepak Kochhar came up in public. ICICI Bank had to remove Ms Kochhar from her position.

This is merely a prominent example. Taxation specialists believe that the ambit of this Section must be widened to stop all such allegations. Any changes may be introduced in 2021’s budget session.