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Feb 19, 2024

How to Save Tax by Avoiding Section 40A(2)(b) of the Income Tax Act, 1961

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Shebi Sharma

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Are you looking for ways to save tax on your income? If yes, then you need to be careful about one provision that can increase your tax liability significantly: Section 40A(2)(b) of the Income Tax Act, 1961.

Section 40A(2)(b) is a provision that deals with the disallowance of certain expenses in case the taxpayer has failed to deduct tax at source as required by law. This section applies to any entity or person that is subject to taxation under the Income Tax Act in India, such as individuals, companies, partnership firms, etc.

The section disallows the related expenses while calculating the taxable income of the taxpayer, if the taxpayer has incurred any expenditure in respect of which payment is to be made to a specified person and the Assessing Officer believes that such expenditure is excessive or unreasonable having regard to the fair market value of the goods, services or facilities for which the payment is made or the legitimate needs of the business or profession of the taxpayer or the benefit derived by or accruing to the taxpayer therefrom.

In simple words, if you pay more than the market value for something to a person who is related to you or your business, the tax authorities can disallow the excess amount as an expense and increase your taxable income.

This can harm your tax calculation, as it reduces your allowable expenses and increases your taxable income. This means that you will have to pay more tax on your income, which can affect your cash flow and profitability.

But don’t worry, there are ways to avoid Section 40A(2)(b) and save tax on your income. In this blog post, we will show you how to do that by following some simple steps.

We will cover:

  • How to deduct tax at source as per the applicable rates and rules, whenever you make a payment to a specified person.
  • How to maintain proper documentation of the transactions and payments made to a specified person, such as invoices, receipts, contracts, agreements, etc.
  • How to avoid transactions with related parties or persons having a substantial interest in your business or profession, unless it is necessary and beneficial for your business or profession.
  • How to compare the market prices of the goods, services or facilities for which you make a payment to a specified person, and ensure that you pay a fair and reasonable price, which is in line with the industry standards and practices.

By following these steps, you can avoid Section 40A(2)(b) and save tax on your income.

Let’s get started.

Step 1: Deduct tax at source as per the applicable rates and rules, whenever you make a payment to a specified person

To avoid Section 40A(2)(b), start by deducting tax at source according to applicable rates and rules whenever paying a specified person.

Tax deduction at source (TDS) ensures the government collects taxes directly from income sources, reducing evasion. The Income Tax Act, 1961 outlines various payments subject to TDS, like salary, interest, commission, rent, and professional fees.

Failing to deduct tax at source leads to penalties and disallowance of expenses. Ensure accurate deduction by:

  1. Verifying the payee's residency and PAN.
  2. Deducting tax upon payment or credit.
  3. Timely depositing the deducted tax with the government.
  4. Filing TDS returns and issuing certificates to the payee promptly.

By adhering to these steps, you comply with regulations, mitigating Section 40A(2)(b) risks.

Also Read: Section 194R of the Income Tax Act: What You Need to Know

Step 2: Maintain proper documentation of the transactions and payments made to a specified person, such as invoices, receipts, contracts, agreements, etc.

To avoid Section 40A(2)(b), maintain thorough documentation of transactions and payments to a specified person, including invoices, receipts, contracts, etc. Documentation serves as evidence to justify expenditure, preventing disallowance under Section 40A(2)(b) during audits.

Key tips include:

  1. Record details of the specified person, transaction, and payment, including name, address, PAN, date, mode, and amount.
  2. Preserve invoices, receipts, contracts, etc., demonstrating the nature and amount of the transaction.
  3. Ensure documents are properly signed, stamped, and contain relevant details like description, quantity, quality, price, and tax.
  4. Compare prices with market rates or prices paid to other parties for similar goods or services, documenting any variations.
  5. Regularly review and update documents to reflect changes in transaction terms and conditions.

Adhering to these practices helps support expenditure claims and mitigates Section 40A(2)(b) risks.

These transactions are closely monitored by tax authorities due to potential tax avoidance tactics, such as income or asset transfer, price manipulation, or conflicts of interest. Engaging in such transactions poses risks like:

  • The need to prove transactions' genuineness and arm's length nature.
  • Mandatory disclosure of transaction details and relationships in tax filings.
  • Exposure to disallowance of expenses under Section 40A(2)(b) if deemed excessive.

Tips to Avoid Related-Party Transactions:

  1. Evaluate the necessity and benefits of such transactions, avoiding them if not essential.
  2. Seek independent professional advice to ensure compliance with laws and best practices.
  3. Maintain transparent records of related-party transactions and disclose them in tax filings.
  4. Follow prescribed methods for determining arm's length prices, documenting the rationale.
  5. Cooperate with tax authorities, providing necessary information and evidence during scrutiny or audits.

Following these guidelines helps steer clear of related-party transactions and minimizes Section 40A(2)(b) risks, ensuring tax savings.

Step 4: Compare the market prices of the goods, services or facilities for which you make a payment to a specified person, and ensure that you pay a fair and reasonable price, that is in line with the industry standards and practices

Compare market prices of goods, services, or facilities to ensure fair payment aligned with industry standards. Exceeding market rates can lead to unnecessary expenditure, scrutiny by tax authorities, and disallowance under Section 40A(2)(b). Follow these tips:

  1. Obtain quotes from multiple vendors for comparison.
  2. Negotiate competitive prices with the specified person.
  3. Document the selection process and rationale.
  4. Regularly review and update prices to reflect market changes.

By adhering to these guidelines, you can ensure fair pricing, mitigate risks, and avoid Section 40A(2)(b).

Also Read: Tips and Best Practices to Comply with Section 194J

Final words

Section 40A(2)(b) of the Income Tax Act, 1961 poses potential risks to your tax calculation and savings if expenses and payments are not carefully managed. Following the discussed steps can help you avoid Section 40A(2)(b) and save on taxes:

Deduct tax at source according to applicable rates and rules for payments to specified persons. Maintain proper documentation of transactions and payments to specified persons. Avoid transactions with related parties unless absolutely necessary and beneficial. Compare market prices to ensure fair and reasonable payments.

By sidestepping Section 40A(2)(b), you can enhance tax savings, optimize expenses, improve cash flow, and avoid penalties or litigation stemming from non-compliance or disallowed expenses.

FAQs:

Q: What does Section 40A(2)(b) of the Income Tax Act entail?

A: Section 40A(2)(b) of the Income Tax Act disallowed deductions for expenses incurred by a taxpayer concerning payments made to related parties unless the taxpayer can substantiate that the payment was made at arm’s length and for legitimate business purposes.

Q: Which payments fall under the purview of Section 40A(2)(b)?

A: Section 40A(2)(b) contains various payments to related parties, spanning goods, services, rent, interest, and royalties.

Q: What penalties accompany violations of Section 40A(2)(b)?

A: Violations of Section 40A(2)(b) incur penalties equivalent to the amount of the payment made to the related party, in addition to any tax payable on the income that was inadequately deducted.

Q: Are there exceptions to the disallowance of deductions under Section 40A(2)(b)?

A: Yes, exceptions to the disallowance of deductions exist under Section 40A(2)(b), such as payments made to related parties residing in foreign countries subject to taxation therein. However, these exceptions are subject to specific conditions and constraints.

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