SECTION 40A(2) AND TAXAUDIT REPORT 'payment' to related persons only are required to be reported.

[C.A. Uma Kothari]

Related links and provisions:

S.40A(2).

Form 3CD paragraph 18

Section 40A(2) and requirement of reporting in  Tax audit report:

Certain information which have concern with allowabilty of certain items covered u/s 40A(2)  are required to be given in para 18 of the Form 3CD which is annexure to the  TAR in form no. 3CA or 3CB, as the case may be. The section is under the heading expenses or payments not deductible in certain  circumstances.  Said paragraph no.18  reads as follows (with highlights for the purpose of this write-up):-

       18. Particulars of payment made to persons specified under section 

             40A(2)(b).

Relevant part of S. 40A reads as follows with relevant highlights:

Expenses or payments not deductible in certain circumstances.

40A. (1) The provisions of this section shall have effect notwithstanding anything to the contrary contained in any other provision of this Act relating to the computation of income under the head "Profits and gains of business or profession".

 (2)(a) Where the assessee incurs any expenditure in respect of which payment has been or is to be made to any personreferred to in clause (b) of this sub-section, and the [Assessing] Officer is of opinion 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 assessee or the benefit derived by or accruing to him there from, so much of the expenditure as is so considered by him to be excessive or unreasonable shall not be allowed as a deduction.

(b) The persons referred to in clause (a) are the following, namely :—

(i) where the assessee is an individual	any relative of the assessee;
(ii) where the assessee is a company, firm, association of persons or Hindu undivided family	any director of the company, partner of the firm, or member of the association or family, or any relative of such director, partner or member;

(iii) any individual who has a substantial interest in the business or profession of the assessee, or any relative of such individual;

(iv) a company, firm, association of persons or Hindu undivided family having a substantial interest in the business or profession of the assessee or any director, partner or member of such company, firm, association or family, or any relative of such director, partner or member;

(v) a company, firm, association of persons or Hindu undivided family of which a director, partner or member, as the case may be, has a substantial interest in the business or profession of the assessee; or any director, partner or member of such company, firm, association or family or any relative of such director, partner or member;

(vi) any person who carries on a business or profession,—

(A) where the assessee being an individual, or any relative of such assessee, has a substantial interest in the business or profession of that person; or

(B) where the assessee being a company, firm, association of persons or Hindu undivided family, or any director of such company, partner of such firm or member of the association or family, or any relative of such director, partner or member, has a substantial interest in the business or profession of that person.

Explanation.—For the purposes of this sub-section, a person shall be deemed to have a substantial interest in a business or profession, if,—

          (a)  in a case where the business or profession is carried on by a company, such person is, at any time during the previous year, the beneficial owner of shares (not being shares entitled to a fixed rate of dividend whether with or without a right to participate in profits) carrying not less than twenty per cent of the voting power; and

          (b) in any other case, such person is, at any time during the previous year, beneficially entitled to not less than twenty per cent of the profits of such

Critical analysis:

The above highlighted wordings leave no doubt that the sub-section (2) is concerned with payment to  specified persons. As per heading of the section 40A which contains words  'expenses' or 'payments' it is clear that  two different varieties of items are   under consideration.  On reading of various sub-sections of section 40A it is clear that some provisions applies to 'expenses' like expenses paid in cash in excess of specified limits under subsection (3) and provision for gratuity under sub-section (7), and some apply to certain 'payments' like sub section (2) and sub section (9). Therefore, there is a clear distinction between 'expenditure' and 'payment'

Section 40A(2) is regarding certain expenses incurred by assessee in respect of which payment has been made or is to be made to any person referred to in clause (b) of section 40A(2).

An analysis - An analysis of this provision shows that it relates to any expenditure incurred by the assessee, it may be any   expenditure on capital account or on revenue account.

It relates to an expenditure of which payment has been made or is to be made to any person referred to in clause (b) (for short related person).  Thus, we find that this provision will apply only when a payment is to be made to a related person and not in other situation.

In tax audit report, however, only payment made to related persons is required to be reported. There is no need to report, payment which are to be made to related persons.

Care required by tax-auditors:

The list of all related persons should be obtained and examined if it is complete or not, thereafter an exercise should be made to find out if any payment has been made to related person or not. The meaning of related person itself is quite complex and ignorance of accountants of the client is a common feature, therefore, the auditor must clarify the scope of related person to obtain complete list. 

In the course of review of returns of clients and in course of preparation of appeals it has come to the notice of author that sometimes mistakes are committed by tax-auditors while reporting in relation to section 40A(2).  In many cases it was found that payment was made or to be made to a person who is not a related person within the meaning u/s 40A(2)(b)  still the tax-auditors have mentioned those payments in the tax-audit report.  For example -

Expenses in connection with traveling of related persons are paid to the airlines or railways who are not related persons but they were mentioned in report.

Payments made to hotels, for expenses incurred during traveling by directors, is not a payment made to the director but it was wrongly mentioned.

In this regard it need to be examine whether the payee - the airline or hotel is a related person or not.

Payments of fees made to university or other institutes for attendance of course by director or a related person was a payment made to the university or institute and not to a related person but it was wrongly mentioned in TAR.

Certain re-imbursements made to related persons were shown in the reports.

What should be reported?

As discussed above a  reading of the provision shows that only the payments, which has been made is required to be reported and not payments made  to an unrelated person though the expenses may be in connection with a related person.  Therefore, it appears that only the direct payments to related persons made on account of the related person will be covered, for example, any salary, interest, commission, rent, or charges for supplies and services provided by a related person will have to be reported.

Payments made to related persons even if they are on capital account are to be reported. However, the auditor can mention that the expenses have been capitalized in the accounts.

Payment made to a related person on account of an unrelated person needs to be mentioned. For example if rent is paid to a  relative of a director (related person) for providing accommodation to an employee of company (not a related person), the payment of rent is required to be mentioned.

What is not required to be reported?

Payments made to any party which is not a related party is not required to be mentioned though it may be in connection with a related person.  For example, contribution to providend fund, gratuity fund, Superannuation fund, house rent for accommodation of related person paid to owner of house who is not a related person, payments made to airlines or railways for booking tickets for a related person, payments made to universities, college or schools on account of assessee, for sponsored education of director or employee or relative of director or  employee (though related person) in the course of business etc. are not required to be reported under the clause.

Reimbursement are not covered:

While working for the assessee a related person may incur expenditure on behalf of the assessee.  While making payments the related person is making payment for and on account of the assessee and not on his personal account and therefore, when the assessee makes a reimbursement to the related person it does not amount to payment to a related person.  For example, suppose a director has incurred expenses on account of traveling for making payment to airlines and hotels on his credit card or he has deposited certain appeal fees and then the company reimburses the same to the director.  In this case it cannot be said that the company has made payment to the directors.  The fact is that the director made payment to airlines and hotels or revenue departments or courts on account of Assessee Company and he gets reimbursement.  Therefore, such reimbursements are not required to be reported.   

Reporting about reasonableness of payments is desirable though not necessary:

The purpose of TAR is to assist the A.O. in framing assessment. Therefore, relevant information with observation or opinion of auditor is desirable as to reasonableness of payment made to related persons. Though as per para 18 of form 3CD it is not specifically required to report whether the payments are reasonable or not. The auditor can easily have access to all relevant information available with the assessee. Therefore, on consideration of available material the tax auditor can very well mention suitable note that the payments are reasonable having regard to the market rates, payments made to other persons for similar supplies or services, and having regard to legitimate needs of business or profession of the assessee etc. 

In case the auditor finds excessive payments, he should draw attention of the A.O. by giving suitable note. It is found that many companies are paying hefty remuneration to directors or their relatives which is not commensurate with the education, qualification and experience of such persons. On comparison of such payments with payments made to other equally qualified officers of the assessee itself or in other companies it is found that excessive remuneration has been paid. In such circumstances the tax auditor can justifiably mention his view in the report to draw attention of the A.O. If the auditor do not do so the author feels that the auditor will be failing in his onerous duty because the purpose of section 40A (2)  will not be achieved.

By making sufficient disclosure about excessive payments made to related persons, tax auditors will assist the A.O. in a meaning full manner, besides it will also protect interest of shareholders of assessee company, as it may put a check in siphoning of company funds by making hefty payments to related persons.

{But … off course the auditor must be ready to sacrifice the job. The author believe that most of auditors are not fool like the author who has to discontinue audit functions for the lack of independence- how one can be independent when he gets good remuneration, and a tool of bargain and do not wish to sacrifice the same.}

Assessment and TAR:

It is noticed that usually auditors do not give any remarks about reasonableness of payments to related person. As a result many times the A.O. makes  full or partial disallowance by simply stating payments made to related persons u/s 40A(2)(b)  as per TAR. To avoid such situation it is desirable that the auditor should give suitable note as to reasonableness or otherwise of the sum paid to related persons.

The clause 18 of the Tax Audit Report may be amended on the following lines:

18. Particulars of payment made or to be made to persons specified under section 40A(2)(b) in the following form:

Name of recipient/ or beneficiary in case of credit

Relationship

Nature of payment

Amount

Auditors opinion about reasonableness or otherwise with reasons.

When the auditor has to express his opinion with reasons, he will be governed by principles of reasoning, logic and surrounding circumstances and evidences. Thus arbitrariness of the A.O. while considering allowabilty of such expenses will be avoided.

A list of all related persons may be required to be furnished irrespective of whether any payment has been made or not to any of such persons.

Legislative Intention:

In case legislative intention is to consider not only payments directly made to related persons but also to others in relation to related person, then it is desirable that Section 40(A) (2) should first be amended and then only  para 18 of form 3CD can be amended to cover payments made or to be made to non related persons in relation to related persons. 

Discussions to this article

[vinay mehta]

What is the defintion of Relative here??