Section 40A of ITA, 1961 : Section 40A: Expenses Or Payments Not Deductible In Certain Circumstances

Explanation using Example

Imagine a scenario where a business owner, Mr. Sharma, runs a textile manufacturing company. He decides to contract his cousin's company to provide certain specialized machinery maintenance services. The market rate for such services is generally around INR 50,000. However, Mr. Sharma agrees to pay INR 1,20,000 for the same services to his cousin's company.

During the tax assessment, the Assessing Officer (AO) notes this transaction and considers the payment excessive compared to the fair market value. Since the payment is made to a relative of Mr. Sharma, which falls under the category specified in Section 40A(2)(b)(i) of the Income-tax Act, 1961, the AO can invoke Section 40A(2)(a) and disallow the deduction of the excess amount of INR 70,000 (INR 1,20,000 - INR 50,000) when calculating Mr. Sharma's business income. This is because the AO views the expenditure as unreasonable and not wholly for the legitimate needs of the business.

Furthermore, if Mr. Sharma had made the payment in cash exceeding INR 10,000, as per Section 40A(3), the entire payment could be disallowed for deduction, not just the excess amount. This encourages businesses to make payments through banking channels for better transparency and accountability.