Detailed Analysis of Disallowable Expenses under Section 40A of the Income-tax Act

Section 40A of the Income Tax Act 1961 functions as an overriding provision that curbs abuse of deductions relating to business and professional expenditure. It targets situations where:

  • Payments are made to related parties at inflated values,
  • Large outflows are settled in cash rather than through banking channels,
  • Provisions are created for gratuity without meeting statutory conditions,
  • Employers divert funds to non-statutory employee welfare schemes, and
  • Unrealised “marked-to-market” notional losses are booked on certain securities.

This section essentially ensures that only genuine, properly routed and legally compliant business expenses reduce the taxable income of an assessee.

1. Objective and Scope of Section 40A

Section 40A operates “notwithstanding anything to the contrary” contained in other deduction provisions. Thus, even if an expense otherwise qualifies under Section 30 to Section 37 or Section 36, it can still be disallowed if it falls foul of Section 40A.

Broadly, the section covers:

  • Excessive or unreasonable payments to specified persons – Section 40A(2)
  • High-value cash payments – Section 40A(3) and Section 40A(3A)
  • Provisions for gratuity – Section 40A(7)
  • Employer’s contribution to non-statutory funds – Section 40A(9)
  • Notional marked-to-market losses or gains on certain securities – Section 40A(13)

The underlying policy is to:

  • Discourage cash dealings and promote traceable banking transactions,
  • Prevent profit shifting to related parties through inflated expenses, and
  • Block artificial or contingent expenditures from being claimed as deductions.

2.1 Core Principle

Where an assessee incurs any expenditure and makes payment to a “specified person”, the portion of such payment which is considered excessive or unreasonable may be disallowed.

The Assessing Officer (AO) examines:

  • Fair market value of the goods, services or facilities,
  • Legitimate business needs of the assessee’s business, and
  • The benefit actually derived or accruing to the assessee.

Only the amount that exceeds what is commercially justifiable is disallowed; the reasonable part may still be allowed as a deduction.

Important: For a specified domestic transaction relating to an assessment year starting on or after 01-04-2016, no disallowance shall be made under Section 40A(2) if the transaction is at arm’s length price as defined in Section 92F(ii).

2.2 Who Are “Specified Persons”?

The definition of specified persons varies depending upon the type of assessee.

(A) Where the assessee is an Individual

Payments made to the following are covered:

  • Any relative of the individual;
  • Any person in whose business or profession the individual or any of his relatives has a substantial interest.

(B) Where the assessee is a Company

The following fall within the ambit:

  • Any director of the company;
  • Any relative of such director;
  • Any person in whose business or profession the company or any of its directors or their relatives has a substantial interest.

(C) Where the assessee is a Firm

Specified persons include:

  • Any partner of the firm;
  • Any relative of such partner;
  • Any person in whose business or profession the firm or any of its partners or their relatives has a substantial interest.

(D) Where the assessee is an AOP or BOI

The following are specified:

  • Any member of the AOP/BOI;
  • Any relative of such member;
  • Any person in whose business or profession the AOP/BOI or any of its members or their relatives has a substantial interest.

(E) Where the assessee is an HUF

The following persons are covered:

  • Any member of the HUF;
  • Any relative of such member;
  • Any person in whose business or profession the HUF or any of its members or their relatives has a substantial interest.

For any assessee (other than those specifically covered above), the following connections are relevant:

  1. Individuals with interest in assessee’s business

    • Any individual having a substantial interest in the business or profession of the assessee;
    • Any relative of such individual.

  2. Companies with interest in assessee’s business

    • Any company having a substantial interest in the business or profession of the assessee;
    • Any director of such company;
    • Any relative of such director;
    • Any other company carrying on business or profession in which the above company has a substantial interest.