Section 40A(2) of the Income Tax Act

Sec 40A 2 of the ITA enables an assessing income tax officer to not allow an individual or an entity to claim certain expenditures as tax deductions.

• This act comes into effect when the authority believes that those payments that have been made to a specific individual or entity are either excessive or unreasonable of the fair market value of the respective services, facilities or goods.

• Before rejecting the deduction of the assessee, the following conditions must be met:

• The payment made must pertain to an expenditure

• The payment is either made or scheduled to be made to a specific individual

• The assessing officer believes that the payment is unreasonable

When claiming deductions for business expenses under Sec 40A 2B, two things must be kept in mind. Firstly, if one is paying more than the fair market value for availing of goods and services, then this payment is likely to be scrutinised by the tax authorities.

Secondly, the IT Act has mentioned a list of persons or businesses that cannot be paid from the company funds and later claimed as business expenses. These are referred to as “specific persons” and it is important to know who they are to steer clear of raising any red flags with the tax officials.

Now, let’s understand the important terms associated with Section 40A(2) of the Income Tax Act:

Substantial Interest: This is when an individual holds a majority share and has more than 20% of voting rights in a company. Or when an individual who receives at least 20% of the profits made by the company and therefore holds substantial interest. This second scenario applies in case an individual is the sole owner of a business, or if they are part of a group of people running a business together.

Specified Persons: The IT Act enlists “specified persons” which can either be an enterprise or an individual. These include:**

Any Enterprise, Company, Firm, or HUF: These include the director/s of the company, partners in a firm, members of a Hindu Undivided Family (HUF), and all Association of Persons (AOPs) or Bodies of Individuals (BOIs) fall under this classification.

If you are a close relative of any of these or if you're a full or part-time partner or part of a family business, you are automatically regarded to have “substantial interest.”

Moreover, if any member of the above-mentioned categories has a business interest or stake in any other company that can benefit from the assessee’s organisation, the concept of “substantial interest” would apply.

Here are two examples to understand this better:

If the director of Company “ABC” also owns 40% of Company “XYZ” and there are significant money dealings between the two, then Company “XYZ” will be viewed as “specified persons”

If the sibling of a director of Company “ABC” gets more than 20% of the profit from Company “XYZ” then whenever these two firms engage in business together, Company “XYZ” will always be categorised under “specified persons”

Individuals: The ‘relative’ definition as per income tax as the promoter of a company or a primary stakeholder has not been specified in detail under Section 40A (2).

However, the relative definition as per income tax Section 2(41) includes the spouse of the primary shareholder, siblings, as well as grandparents, parents, and children – who are all classified as ‘lineal relations.’

If any of these related parties, as per the Income Tax Act, have a significant interest or stake the provisions of Section 40A(2) will come into effect.

All Other Taxpayers: If an individual has a prominent role or a significant interest or connection in a company owned by a taxpayer, then they will be viewed as a “specified person.”

Additionally, any other business, AOP, BOI, or HUF that claims to have an interest in a third-party company/organisation is also a “specified person.”

Instead of worrying about hassles such as identifying a related party as per the Income Tax Act, there are several other tax-saving instruments at citizens’ disposal.

These can be categorised into two sections: investing money in tax-saving instruments such as ELSS, PPF, premiums paid towards health insurance plans, etc., or claiming tax benefits from the deducted amount. Here are some ways to legally save tax in India:

Home Loan Tax Deduction: There are two components of a home loan: the principal amount and the interest. The income tax law enables tax deductions on the repayment of both these components.

For instance, under Section 80C, one can avail of a benefit of ₹1.5 lakhs, whereas Section 24 enables deductions up to ₹2 lakhs on the interest payable.

Money Received from Life Insurance: Under Section 10 of the IT Act if the premiums towards life insurance are below 10% of the sum assured, then the bonus or the maturity amount is tax-free. However, this only applies to policies purchased after the 1st of April, 2012. For policies purchased before this date and the premium is 20% of the sum assured, then the maturity is tax-free.

Medical Insurance Premiums: To promote investment in a health insurance plan, the Government of India has introduced several tax benefits. Section 80D of the IT Act enables tax deductions of up to ₹25,000 every financial year for premiums paid toward medical insurance. This overall deduction will also include the ₹5,000 limit for annual expenses incurred towards preventative health checkups.

Section 40A(2) of the Income Tax Act is designed to empower authorities who assess income tax. It enables them to disallow certain expenditures (made to specific persons) to be claimed as tax deductions.

Yet, there are several legal ways for individuals to save their taxes such as by investing in health insurance plans, donating to charity, earning from savings accounts, etc.

As seen, there are many other ways to legally save on your taxes other than Sec 40A 2B. A prominent example being, your annual health insurance plan premiums under Section 80D.

To ensure a streamlined process and to be eligible for this deduction, always ensure your chosen online insurer is IRDAI-approved and listed on their website as an insurance provider. For example, Tata AIG is listed as an authorised general insurer.

It is important to note, however, that the benefits of health insurance extend far beyond your tax savings. A health insurance plan is a great way to mitigate risks that are associated with any medical emergencies, should they arise.