Section 40A (2) of the Income Tax Act – Everything You Need to Know:

Individuals engaged in specific professions can claim a tax deduction of their work-related expenditures from their income, as per the Income Tax Act. But can your claims be denied or restricted if not found reasonable by the assessing officer? Read further to know about Section 40A (2) that empowers the assessing authority to deny such claims under specific conditions.

The taxpayers sometimes try to exploit or take undue advantage of the provisions that have been made to benefit them under the Income Tax Act. They provide invalid or misleading information during income tax filing to claim a higher deduction or use other tactics to lower their taxable income and hence the tax liability.

To curb such practices, the government of India added Section 40A (2) to the Income Tax Act. The Section ensures that only valid deduction claim requests from the taxpayers are accepted.

Section 40A (2) of the Income Tax Act

Section 40A (2) empowers and authorises the assessing officer to reject or limit the deduction on expenditure claimed by the assessee if the payment is made to specified persons and found unreasonable or of a higher value than the expected market value.

Let’s understand who may be these “Specified Persons” under section 40A (2):

  • Individuals

It includes relatives of the assessee such as siblings, spouse, parents, children, etc. Also, any person whose business the assessee or a relative of the assessee has a substantial interest can be considered under “Specified Persons”.

  • Companies, Firms, or HUFs

It includes the director of a company, partner in a firm, member of HUF or AOF (Association of Persons), and their family members or other relatives. Also, it includes any person in whose profession or business the director, partner, or member and their relatives have a substantial interest.

  • Others

It includes any individual, company, firm, HUF/AOP, or their relatives holding a substantial interest in the business or profession of the assessee.

Please note that the relatives of an individual here include only the relatives and not the relatives of their spouse (Section 2 (41)).

The Term “Substantial Interest”

If the assessee is a company, any person owning at least 20% voting power at a given point during the year can be referred to as someone with a substantial interest in the company. Also, in the case of sole ownership, firm, AOPs, a person entitled to a minimum of 20% profits in the business/profession can be considered having a substantial interest in that business or profession.

Let’s understand this with an example:

Mr Rajiv runs a business and has 25% shares in ABC Ltd. Company. Now any payment made by Rajiv to ABC Ltd. will fall into the category of specified person as per section 40A (2). This payment will be subjected to the judgment of the assessing officer and may be disallowed if found unreasonable.

Be Careful with Your Payment Claims

To avoid unnecessary scrutiny by the assessing officer and chances of claim rejection, you must try to keep away from claiming unrealistic amounts, especially including payments to your relatives and other close business acquaintances.

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