Section 40A(2) of Income Tax Act, 1961 curbs unreasonable payments businesses make to their stakeholders or related parties, preventing tax evasion, profiteering, and financial mismanagement. It applies when an income tax assessing officer suspects that an organization’s owners or shareholders have directed unreasonably high payments to certain individuals or entities known as “specified persons.” The act scrutinizes such transactions to prevent organizations from improperly siphoning funds and claiming excessive deductions.
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According to Section 40A(2), deductions are disallowed under these conditions:
Under these conditions, the income tax officer has the authority to investigate and disallow such payments if they are deemed excessive or unreasonable.
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Section 40A(2) highlights its preventive role in cases like that of ICICI Bank’s former CEO, Chanda Kochhar, who allegedly favored a related entity. While the case is ongoing, it underscored the importance of scrutinizing transactions that may benefit insiders at the expense of fairness.
All payments falling within Section 40A(2) must be disclosed in the tax returns if such expenses are claimed for deductions. Taxpayers should ensure that transactions with specified persons align with fair market value to avoid disallowances and additional tax liabilities.
Section 40A(2) reinforces financial integrity by ensuring that payments to related entities or individuals are fair and justifiable. It underscores the importance of compliance, preventing companies from diverting funds improperly and enabling fair tax practices.
Section 40A(2) prevents taxpayers from claiming excessive deductions through unjustified payments to related parties.
Specified persons include directors, partners, members of HUFs, and relatives with substantial interest in the business.
A person holding over 20% of voting rights or receiving 20% of the profits is considered to have substantial interest.
Yes, if payments to specified persons exceed fair value, they may be disallowed or investigated.
Yes, close relatives, including spouses, parents, and siblings, are classified as specified persons if they have a financial interest in the business.
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