Section 40A provides that certain expenses or payments are not deductible in certain circumstances while computing income under the head “Profits and gains of business or profession”. 

Section 40A(2)(a) provides disallowance in case where the assessee incurs any expenditure in respect of which payment has been or is to be made to any person referred to in 40A(2)(b) (“Relative”). 

For making the disallowance, the AO should form an opinion that such expenditure is excessive or unreasonable.  While coming to this conclusion the AO should have regard to:

  1. the fair market value of the goods, services or facilities for which the payment is made; or
  2. the legitimate needs of the business or profession of the assessee; or
  3. the benefit derived by or accruing to him therefrom. 

Based on above consideration, so much of the expenditure as is considered by AO to be excessive or unreasonable shall not be allowed as a deduction.

In this context, the issue that needs to be considered is on whom is the burden of proof to demonstrate that expenditure is excessive or unreasonable.  The language of the section casts the obligation on the AO.  This aspect is discussed in the following cases:

Nat Steel Equipment (P.) Ltd. v. DCIT [2018] 195 TTJ 796 (Mumbai – Trib.) – The assessee had made payments to its related parties towards of commission/legal and professional charges. However, the assessee had failed to place on record any documentary evidence in support thereof. The AO concluded that the assessee had paid commission to its related parties at an exorbitant rate of 10 per cent of the sale value and therefore considered the payments made to its related parties as unreasonable and excessive.  The AO accordingly disallowed 30 per cent of such payments.

The ITAT observed that the Legislature had in all its wisdom in order to avoid any arbitrary exercise of powers by the AO in the garb of the aforesaid statutory provision, specifically provided that such formation of opinion on the part of the AO had to be arrived at having regard to the fair market value of the goods, services or facilities for which the payment was made by the assessee.

The ITAT held that the AO has made disallowance u/s. 40A(2)(a) on an ad hoc basis (30 per cent of the payments) without placing on record any material which could prove to the hilt that the payments were excessive or unreasonable, having regard to the fair market value of the services for which the same were made or keeping in view the legitimate needs of the business of the assessee or the benefit derived by or accruing to the assessee therefrom.

In the absence of satisfaction of the basic condition for invoking of section 40A(2)(a), the Tribunal held that the disallowance of 30 per cent of the related party expenses made u/s. 40A(2)(a) could not be sustained.

ACIT vs. Grew Industries Pvt. Ltd (2018) 66 ITR (Trib.) 116 (Mumbai) – The ITAT observed that the AO had not established on record what was the fair market value of the services rendered to the assessee.  The AO merely made a vague statement that the remuneration paid by the assessee to the Directors was unreasonable, without bringing any corroborative evidence on record. Neither did he establish the actual fair market value of the services rendered.  Hence, the ITAT held that the disallowance was merely on the basis of conjectures and surmises and could not be sustained.

IKEA Trading (India) (P.) Ltd. v. DCIT – [2021] 123 taxmann.com 129 (Delhi – Trib.) – During the scrutiny proceedings, the AO held that assessee failed to justify the nature of services rendered by the directors to command such a huge remuneration. Accordingly, AO made addition under section 40A(2)(b) forming an opinion that the payment made to the director was excessive and unreasonable.  The assessee preferred an appeal before CIT(A).  The CIT(A) observed that the employees were professionally qualified employees and were not interested parties.  The CIT(A) further held that the AO had failed to bring on record or substantiate that how such salary payments were actually excessive. Accordingly, additions made by AO were deleted.

On revenue’s appeal, Delhi ITAT held that AO had not brought any comparable case to demonstrate that the payments made by assessee were excessive or unreasonable. A plain reading of Section 40A(2) shows that onus has been cast upon AO to bring on record comparable cases to demonstrate that the transactions made by assessee with the related parties were unreasonable and excessive. The ITAT further observed that the payees were also assessed to tax at the same rate of tax and CBDT vide Circular No. 6-P, dated 06-07-1968, stated that no disallowance is to be made under Section 40A(2) in respect of the payments made to the relatives and sister concerns where there is no attempt to evade tax.  The ITAT upheld the CIT(A) Order deleting the additions.

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