Income Tax and Related Party Transactions: A Comprehensive Overview

Introduction

Section 40A(2) of Income Tax Act, 1961 deals with payments to relatives and associated persons.

It provides that where the assessee incurs any expenditure in respect of which payment is to be made to a specified person and the Assessing Officer is of the opinion that such expenditure is excessive or unreasonable having regard to the fair market value of the goods, services or facilities for which the payment is made or legitimate needs of the business or profession of the assessee or the benefit derived by or accruing to him therefrom, so much of the expenditure as is so considered by him to be excessive or unreasonable shall not be allowed as deduction.

List of specified persons

• Section 2(41) of Income Tax Act states "relative", in relation to an individual, means the husband, wife, brother or sister or any lineal ascendant or descendant of that individual.
• Section 40A (2) (b) of Income Tax Act states that, a person shall be deemed to have a substantial interest in a business or profession, if, -

(a) 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 shares carrying not less than twenty per cent of the voting power; and

(b) in any other case, such person is, at any time during the previous year, beneficially entitled to not less than twenty per cent of the profits of such business or profession.

Case Study:

A) Balani Infotech (P.) Ltd. v. ACIT - Section 40A (2) (b)

SAC ‘997171’ - Services Of Holding Equity Of Subsidiary Companies.

Fore Ground:

Assessee is a company stated to be engaged in the business of dealing in sale and purchase of e-journals. Assessee filed its return of income for A.Y. 2015-16 on 29.09.2015 declaring total income at Rs.3,82,51,540/-. The case was taken up for scrutiny and thereafter assessment was framed u/s 143(3) of the Act vide order dated 30.12.2017 and the total income was determined at Rs.4,08,93,800/-.

During the course of assessment proceedings, AO noticed that assessee had made following salary payments to the Directors:

The assessee was asked to justify the payment of salary u/s 40(A)(2)(b) of the Act to which assessee made the submissions which was not found acceptable to AO. AO noted that in the case of Bina Balani and Kailash Balani there was hike in salary of more than 125% and 50% respectively whereas the increase in turnover of the assessee was only to the extent of 30% and therefore the increase in salary was not justifiable. He thus held the increase in salary of the Directors aggregating to Rs.16,20,000/- cannot be allowed and accordingly made its disallowance.

AO was of the view that the nature of the business of the assessee was of trading in nature and did not require any consultancy services. He accordingly held the amount of consultancy charges paid to Megha Balani of Rs.9,00,000/- including service tax aggregating to Rs.10,11,240/- to be not justifiable. He accordingly disallowed the aggregate of Rs.26,31,240/- (Rs.16,20,000 + Rs.10,11,240).

Proceedings of the case:

The assessee submitted that Megha Balani is daughter in law of one of the Director and is therefore not covered within the definition of relative u/s 2(41) of the Act.

There was no increase in salary from A.Y. 2012-13 to 2014-15 in case of salary of both the Directors and only in the year under consideration, the salary has been increased. He further pointed to the table of turnover of different years.

He therefore submitted that the observation of AO that there is no corresponding increase in sales as compared to increase in salary is misplaced. He thereafter submitted that it is a settled law that the businessman is a right person to take decision about the expenses which he has to incur for the purpose of business and the AO cannot sit in the chair of the assessee to determine the reasonableness of an expenditure.

Judgement:

The issue in the present ground is with respect to the disallowance made u/s 40(A)(2)(b) of the Act. Section 40A(2) of the Act, puts a curb on expenditure in respect of which payment has been made to close associates having substantial interest in the company for goods, services and facilities.

Under this section, the AO can disallow only that portion of the total expenditure, which in his opinion, is excessive or unreasonable. The duty is on the AO to form an opinion that the expenditure claimed as excessive/unreasonable having regard to the fair market value for which the payment is made. This opinion of the AO cannot be arbitrary but must be on the basis of determining the fair market value for which payment is made. The AO must establish that the payment is excessive or unreasonable which should be on the basis of material on record and cannot be based on incomplete information.

The reasonableness of the expenditure is to be seen from the viewpoint of the businessmen and not from the view of Revenue authorities.

In the present case the AO has only compared the salary payment made by the assessee in the year under considered with that of earlier year to come the conclusion of excessive salary payment. The aforesaid conclusion is not based on any material on record as contemplated u/s 40(A)(2)(b) of the Act.

Considering the totality of the previously mentioned facts, AO was not justified in disallowing the expenditure by invoking the provisions of Section 40(A)(2)(b) of the Act. Accordingly set aside the addition made by AO and CIT(A). Thus, the ground of assessee is allowed.

Section 13(2):

If charitable trust is created and any part of its income ensures directly or indirectly for the benefit of specified persons, then the entire income of such trust is not eligible for exemption under section 11 or 12. The interested persons can be, for example, the author of the trust or the founder of the institution or any relative of such author, founder, substantial contributor, member, trustee or manager.

B) Agappa Child Centre. v. CIT - Section 13(2)

Foreground:

The assessee - public charitable trust had purchased a refrigerator for Rs. 5,445. The trust had not commenced any of its operations. It was also noticed that the refrigerator was used in the residential house of Sri K.M. Joseph, managing trustee, at Kottayam. As the trustee was enjoying the user of the property of the trust, provisions of Section 13(2)(b) are attracted.

Assessee statement:

It was stated that the fridge was purchased in the interest of the trust in as much as to cater to the needs of the donors who are Swedish citizens.

Additional Information:

The trust had not adduced any proof to prove the visit of the donors. Moreover, the donors staying in the house of the trustee is only a very remote possibility. It is also stated that the office of the trust was for some time functioning in the house of the trustee. This is also not true. Even if this is true, refrigerator is not an essential item required in an office.

Judgement:

The Tribunal considered the language of the provision in the context. It is observed "we fail to understand as to why, when the building of the trust was not ready, the refrigerator had to be purchased at all". Considering the provisions of Section 13(2)(b) of the Act it is clear that the fridge was purchased for the use of the managing trustee and he was using it. The provisions of Section 13(2)(b) are attracted.