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Last updated on: July 29, 2025
Section 40A(2) of the Income Tax Act, 1961 deals with disallowance of certain business expenditure incurred by an assessee if such expenses are considered excessive or unreasonable, particularly when payments are made to specified persons with whom the assessee has a close relationship (such as relatives, associated firms, or companies having substantial interest). The Assessing Officer has the authority to scrutinize these transactions and disallow the excess payment over the fair market value, to prevent tax avoidance through inflated expenses. However, normal commercial arrangements and transactions at arm’s length are generally not affected. Taxpayers are advised to document and justify such payments with appropriate evidence to ensure compliance. This provision acts as a check against profit diversion by way of unreasonable payments to related parties.
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Read BioSection 40A2 of the Income Tax Act has grown increasingly important in 2025 for Indian businesses, chartered accountants, and individual taxpayers. This section primarily governs the disallowance of certain expenditures for tax deduction claimed with related parties. Understanding its relevance can help businesses optimise tax planning, remain compliant, and avoid costly penalties. In this comprehensive guide, we will unravel all key aspects, recent updates, practical examples, and tips for strategic compliance.
Section 40A2 is a crucial provision in the Indian Income Tax Act that regulates transactions with related parties, called “specified persons”. It stops businesses from inflating their expenses artificially by making payments in excess of fair market value, usually to associates or family members. These excess amounts are disallowed as business expenditure while calculating taxable profits.
Payments covered under Section 40A2 include all expenditures (like salary, commission, rent, professional fees) made by a business to specified persons, where such payment could potentially reduce the taxable profits unfairly.
Due to ongoing digitisation of financial records and data sharing between authorities, scrutiny around related party transactions has increased. The tax department is actively using analytics to flag suspicious transactions, especially with connected persons. Section 40A2 ensures a business claims only reasonable expenditure to maintain tax integrity.
Expert insight: Many startups and family-run businesses have seen increased queries from the Income Tax Department around related party payments after the implementation of updated e-Verification processes in 2025.
A specified person generally means individuals or entities closely connected to the taxpayer, where there is a scope for personal or family interest to influence business decisions.
If a person is entitled to at least 20 percent of company shares or profits of a concern during the previous year, substantial interest is considered established.
Did you know? The scope of ‘specified persons’ was expanded in recent Budget amendments to cover indirect shareholding structures to check tax leakage.
Section 40A2 does not outright disallow all related party expenses. Instead, it targets only those which are higher than what might be paid to a third party for similar services or goods.
The tax officer compares:
Any excess over FMV or what would have been paid to an unrelated party is NOT ALLOWED as a deduction.
There are no fixed thresholds. The Assessing Officer (AO) has powers to determine and disallow excess amounts after giving the taxpayer an opportunity to be heard.
Suppose XYZ Pvt Ltd pays consulting fees of ₹1200000 in 2025 to its director’s brother, while prevailing market rates are about ₹800000 for similar services. The excess ₹400000 will be disallowed as business expense under Section 40A2.
Expert’s take: Businesses are increasingly using online B2B service marketplaces in 2025 to benchmark current market rates before finalising agreements with related parties.
Yes, Section 40A2 applies to all taxpayers with business or professional income regardless of the size of operation. It includes sole proprietors, partnerships, LLPs, and companies.
Sometimes, premiums are justified for expertise, location, or other reasons. Proper documentation is key to proving these to the tax officer. Arm’s length evidence from industry portals or online rating sites is increasingly accepted as proof.
People also ask:
Q: How do online service portals help comply with Section 40A2?
A: These platforms publish real-time price bands for goods and services, which you can use as evidence of market value during tax assessments.
Did you know? Leading tax experts suggest maintaining a file of peer-reviewed rate cards or online quotations for third party services to avoid future disputes under Section 40A2.
Yes, ERP or cloud accounting systems in 2025 let users flag, track, and attach evidence for every related party payment. Many Indian firms rely on these tools to produce compliance-ready reports for tax audits.
People also ask:
Q: What is the role of tax auditors in Section 40A2?
A: Tax auditors must specifically report all payments to specified persons, with comments on their reasonableness, under Clause 23 of Form 3CD.
Expert insight: In 2025, online marketplaces can help small businesses satisfy Section 40A2 requirements, making it easier to gather market evidence and fair pricing.
| Feature | Section 40A2 | Section 40A3 | Section 40(a)(ia) |
|---|---|---|---|
| Focus | Related party payments | Payments above cash limit | TDS (Tax deduction at source) |
| Trigger point | Unreasonable excess expense | Cash payment above Rs 10000 | Failure to deduct & pay TDS |
| Deduction disallowed | Excess over FMV | 100 percent of the expense | 30 percent under non compliance |
| Compliance proof | Documentation, benchmarking | Mode of payment | TDS filing and payment |
I run a medium scale consulting business in Mumbai. Last year, we paid substantial rent to a relative for our new office, since their location suited our needs. We also engaged a cousin for a few key projects.
Our CA advised us to:
During the tax audit, the Assessing Officer asked for justifications. Since our records matched market rates, the expenses were accepted without disallowance.
Real tip: Always overprepare your documentation for related party payments, even for one-time deals.
People also ask:
Q: Is salary paid to spouse allowable under Section 40A2?
A: Yes, but only to the extent that it matches what a third party would receive for the same role.
Did you know? In 2025, many online marketplaces offer automated benchmarking tools that help businesses instantly generate rate comparisons for compliance reporting.
Section 40A2 of Income Tax Act prevents businesses from reducing taxable profits by making excessive payments to related parties. Only amounts up to fair market value are allowed as expense; excess is disallowed. Cover all related parties, justify with market evidence, disclose in tax filings, and keep digital records to avoid penalties or disputes.
Q1: Is Section 40A2 applicable to all businesses, including sole proprietorships?
A: Yes, it applies to all businesses and professionals claiming tax deductions for expenses.
Q2: What is substantial interest under Section 40A2?
A: Substantial interest usually means holding at least 20 percent shares in a company or 20 percent profit share in a partnership or concern.
Q3: How do I prove payment value is reasonable for Section 40A2?
A: Compare with prevailing rates for similar services, save quotes, or refer to prices published on online portals.
Q4: What is required in the tax audit report for Section 40A2?
A: You must disclose all payments to specified persons and report on their reasonableness in Form 3CD Clause 23.
Q5: Does 40A2 apply to payments made before the due date of filing returns?
A: Section 40A2 applies to amounts paid or payable for the previous year, regardless of payment date.
Q6: How are genuine business needs judged under Section 40A2?
A: Genuine needs are respected, but you must show with proper documents why the related party’s fee or rent matches the market value.
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Written by Prem Anand, a content writer with over 10+ years of experience in the Banking, Financial Services, and Insurance sectors.
Prem Anand is a seasoned content writer with over 10+ years of experience in the Banking, Financial Services, and Insurance sectors. He has a strong command of industry-specific language and compliance regulations. He specializes in writing insightful blog posts, detailed articles, and content that educates and engages the Indian audience.
The content is prepared by thoroughly researching multiple trustworthy sources such as official websites, financial portals, customer reviews, policy documents and IRDAI guidelines. The goal is to bring accurate and reader-friendly insights.
This content is created to help readers make informed decisions. It aims to simplify complex insurance and finance topics so that you can understand your options clearly and take the right steps with confidence. Every article is written keeping transparency, clarity, and trust in mind.
Based on Google's Helpful Content System, this article emphasizes user value, transparency, and accuracy. It incorporates principles of E-E-A-T (Experience, Expertise, Authoritativeness, Trustworthiness).
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