Any expenditure incurred by an assessee in respect of which payment has been made to the persons is liable to be disallowed in computing business profit to the extent such expenditure is considered to be excessive or unreasonable, having regard to the fair market value of goods or services or facilities, etc.
Before, understanding the implication of section 40A(2), it is imperative to understand the meaning of terms “relative” and “persons having substantial interest”—
WHO IS RELATIVE [SEC. 2(41)] –
The term “relative” in relation to an individual, means the husband, wife, brother or sister or any lineal ascendant or descendant of that individual [sec. 2(41)].
“SUBSTANTIAL INTEREST” - MEANING OF –
A person is deemed to have substantial interest in the business or profession if such person is the beneficial owner of at least 20% of equity capital (in the case of a company) or if such person is entitled to 20% profits of a concern (in any other case) at any time during the previous year.
PAYMENT TO PERSONS COVERED BY SECTION 40A(2) –
If a payment is made by a taxpayer in respect of an expenditure to the persons mentioned in column (2) of the table given below, section 40A(2) is applicable and, consequently, to the extent such expenditure is considered to be excessive or unreasonable having regard to the fair market value of goods, services, facilities, etc., it shall be disallowed.t In other words, if the following conditions are satisfied, then to the extent the payment is excessive, it will be disallowed—
Condition 1 - Expenditure is incurred for goods, services or facilities.
Condition 2- For the above expenditure, payment is made to a person mentioned in column 2 of the table infra.
Condition 3- Such expenditure is considered as excessive or unreasonable having regard to the following—
i. fair market value of the commodity or service or facility; or
ii. legitimate business needs of the business of the assessee; or
iii. benefit derived by or accruing to assessees as a result of the expenditure.
For Condition 3, the Assessing Officer is required to record a finding as to whether expenditure is excessive or unreasonable in relation to any one of the three requirements [ i.e., (i) or (i or (iii), given above], which are independent and alternative to each other. All the three requirements need not to exist simultaneously. In a given case, if any one of the requirements [i.e., (i) or (ii) or (iii), given above] along with Condition 1 and Condition 2 is satisfied, the provisions of section 40A(2) can be invoked and applied. If the Assessing Officer finds (cogent reasons should be assigned by the Assessing Officer) that a part of the expenditure (payment made to a relative or inter-connected person, given in the Table infra) is excessive having regard to the legitimate needs of the business, the disallowance provisions of section 40A(2) will be applicable, even if, the amount paid is not more than the fair market value of goods supplied, or services rendered, by the recipient
If the payer and recipient are in the same tax bracket and pays tax at the same rate, there is no question of diversion of funds to avoid tax and disallowance under section 40A(2) may not be attracted.