Every business incurs expenses to earn income — salaries, rent, commissions, professional fees, and so on. Under normal circumstances, these outflows are deductible from the company’s profits to arrive at taxable income. But what if a company pays an unreasonably high salary to a relative of the owner or pays excessive commission to a partner’s family member?
To prevent such profit shifting tactics, the law introduced Section 40(2)(b). This section acts as a filter — it ensures that only genuine & reasonable business expenses are allowed as deductions, while those inflated through related-party arrangements are partly or fully disallowed.
Meaning and Purpose of Section 40(2)(b)
Section 40(2)(b) is a sub-clause under Section 40 of the Income Tax Act which lists specific payments that cannot be deducted while calculating taxable profits. It disallows deductions for any expenses incurred by a taxpayer that are found to be unreasonable when paid to a related party.
Simply put, it prevents a business from reducing its taxable income by making excessive payments to relatives, partners, or entities controlled by them. It is a classic anti-avoidance measure that keeps transactions transparent & fair for tax purposes.
Scope of the Provision
The section applies to any assessee carrying on a business or profession who makes payments to specific persons defined under clause (b). The intent is to ensure that when payments are made to connected individuals — such as relatives of directors or partners — they are within a reasonable limit for the services rendered or goods supplied.
If the Assessing Officer finds that the amount paid is excessive in relation to the market value or business benefit derived, that excess portion can be disallowed as an expense.
Who Are ‘Specified Persons’ Under Section 40(2)(b)?
The section lists certain people and entities that are considered related parties for this purpose. These include:
- Relatives of an individual assessee (such as spouse, brother, sister, lineal ascendant or descendant).
- Partners of a firm & their family members.
- Directors of a company & their relatives.
- Any person who has a substantial interest in the business (20% or more ownership or voting rights).
- Entities in which the assessee or its related persons hold a significant stake.
This wide definition ensures that no form of indirect payment escapes scrutiny.
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What Kind of Payments Are Covered?
Section 40(2)(b) only covers expenditure — not income.
That means it does not tax the recipient of the payment but merely restricts the payer from claiming it as a deduction.
Payments under this section may include:
- Salaries, bonus, commission, or remuneration to partners or relatives.
- Rent for property taken from a related person."
- Interest on loans taken from connected individuals.
- Payments for goods or services purchased from related entities.
In essence, the law targets disallowance of certain expenses that appear inflated or artificial.
The Logic Behind Disallowance
The idea is simple — no one should be allowed to artificially reduce taxable income through payments made to family members or related companies at unjustified rates.
For example, if a business owner pays ₹5 lakh monthly rent to his own relative for a small shop, the Assessing Officer can disallow a portion of it as being unreasonable. The section does not stop the payment itself — it simply refuses to allow the excess amount as a deductible business expense.
Reasonableness — The Core Test
The most important word in this section is “reasonable.” It is a subjective term but usually tested on the basis of:
- Market value of goods or services involved.
- Legitimate business need for incurring the expense.
- Benefit derived by the assessee from the payment.
If the Assessing Officer believes the payment is higher than what an independent party would charge, they can disallow the excess amount.
Example Scenario
Let’s understand this with an example.
Suppose ABC Traders pays ₹10 lakh as annual commission to Mr. Ravi, the brother of its managing partner, for sales support services. If similar services in the market normally cost ₹5 lakh, the Income Tax Officer may allow ₹5 lakh as a valid deduction & disallow the remaining ₹5 lakh under Section 40(2)(b).
Thus, the section does not punish the relationship but ensures that the payment is in line with market standards.
Section 40(2)(b) Only Covers Expenditure, Not Income
It is crucial to note that this section does not deal with income received by the related party. The recipient must still declare the amount as income in their return & pay tax accordingly. The provision operates only from the payer’s side — restricting what they can deduct from profits.
Hence, Section 40(2)(b) only covers expenditure not income, and serves as a guardrail against misuse of deductions.
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Judicial Interpretations
Courts and tribunals have repeatedly clarified that not every payment to a related party is automatically disallowed. The Assessing Officer must first prove that the amount is indeed excessive or unreasonable compared to market rates.
Judgments such as CIT v. Shankar Sugar Mills Ltd. & CIT v. Indo Saigon Industries Ltd. have emphasized that commercial expediency should be respected — the officer cannot substitute their business judgment for that of the assessee without clear evidence of inflation.
Practical Challenges in Implementation
While the objective of the section is noble, its application can be complex. Determining “reasonable value” is not always straightforward, especially in niche industries where price benchmarks don’t exist. Businesses sometimes face unnecessary scrutiny even for genuine transactions.
Hence, maintaining proper documentation — agreements, comparative quotes, and proof of services — is critical to defend claims under this section.
Documentation Tips for Taxpayers
To avoid additions during assessment, every business should:
- Maintain written contracts or agreements with related parties.
- Collect market comparisons or price justifications.
- Keep proof of actual service rendered or goods delivered.
- Disclose related-party transactions transparently in tax filings.
This not only ensures compliance with Section 40(2)(b) but also strengthens corporate governance.
Difference Between Section 40(2)(b) and Transfer Pricing Rules
While both provisions deal with related-party transactions, they operate differently.
- Section 40(2)(b) applies to domestic transactions within India."
- Transfer Pricing (Section 92 onwards) applies to international transactions between associated enterprises.
Essentially, Section 40(2)(b) is the domestic counterpart of transfer pricing — ensuring that Indian related-party transactions also reflect fair value.
Tax Planning vs. Tax Evasion
The law recognizes that businesses have freedom to plan their affairs efficiently. However, when that planning crosses into manipulation — such as using relatives or connected entities to shift profits — Section 40(2)(b) steps in.
The fine line between tax planning & tax evasion is drawn by the reasonableness of the expense. If it reflects genuine commercial value, the law permits it; if it appears designed to reduce tax liability, it is curtailed.
Also Read: Disallowance of Related Party Payments
Recent Trends and Scrutiny
With digitization and AI-based tax assessments, the Income Tax Department can now compare transactions across sectors to detect outliers. Payments to related parties that deviate from industry norms are flagged for review. This makes Section 40(2)(b) more relevant than ever in India’s current compliance landscape.
Key Takeaways
- Section 40(2)(b) is a provision that restricts the deduction of certain expenses from taxable income.
- It disallows deductions for any expenses incurred by a taxpayer if paid to a related party at an unreasonable rate.
- The section applies only to expenditure & not to income.
- The disallowance depends on whether the payment is excessive compared to market value.
- Proper documentation & disclosure can help taxpayers defend genuine transactions.
Conclusion
Section 40(2)(b) of the Income Tax Act is not a punitive provision — it is a rational check on how business expenses are booked and deducted. It reminds taxpayers that business expenses are not allowed as deductions unless they reflect commercial reality & arm’s-length pricing. By placing this responsibility on the assessee, the law promotes transparency and protects the tax base from erosion through family or group transactions.
If you want expert guidance on how to justify your business expenses, draft contracts, or defend disallowances under Section 40(2)(b), our CA team is here to assist. Visit CallMyCA.com to get personalized advice & optimize your tax filings without stress.
