Section 40A(2)(b) does not automatically prohibit payments to relatives or connected businesses. It identifies the people and entities whose business or professional transactions can be examined under section 40A(2)(a) of the Income-tax Act, 1961. The Assessing Officer may disallow only the portion of an expense considered excessive or unreasonable after considering market value, legitimate business needs and the benefit received by the assessee.
For tax year 2026, the Income Tax Department’s current statutory text places the corresponding rule in section 36 of the Income-tax Act, 2025. Section 40A(2) remains the relevant reference for legacy years governed by the 1961 Act, so the tax year and governing Act must be identified before applying the rule.
As an Amazon Associate I earn from qualifying purchases.
What section 40A(2)(b) does
Section 40A(2)(b) is a definition provision. It lists “specified persons” whose transactions with an assessee can come within the excessive-payment rule in section 40A(2)(a). The relationship itself is not a finding that the price is inflated, the service is unnecessary or the expense is disallowable.
Recommended Free Tools
When a payment falls within the provision, the Assessing Officer examines the expenditure in context. Under the 1961 Act, section 40A(2)(a) permits disallowance of the part considered excessive or unreasonable by reference to:
#1 Best Overall
- the fair market value of the goods, services or facilities for which the payment is made;
- the legitimate needs of the assessee’s business or profession; and
- the benefit derived by, or accruing to, the assessee.
The same core test appears in section 36 of the Income-tax Act, 2025, which the department identifies for tax year 2026. The current statutory wording states: “so much of the expenditure as considered excessive or unreasonable by him shall not be allowed as a deduction.” The words “so much” matter: the rule targets the amount judged excessive or unreasonable, not necessarily the whole payment.
Who counts as a related or specified person
The direct categories depend on the legal form of the assessee. The following table summarizes the relationships identified in the statutory text.
| Assessee | Persons directly covered |
|---|---|
| Individual | Any relative of the assessee |
| Company | Any director, or the director’s relative |
| Firm | Any partner, or the partner’s relative |
| Association of persons | Any member, or the member’s relative |
| Hindu undivided family | Any member, or the member’s relative |
This is why describing section 40A(2)(b) as a “family-member rule” is incomplete. The list includes directors, partners and members themselves, and the provision extends to ownership and control relationships involving other businesses and companies.
Businesses and entities with substantial interest
The provision also reaches a person or entity that has a substantial interest in the assessee’s business or profession. It can cover that person or entity’s directors, partners or members, as well as their relatives. It further covers an entity whose director, partner or member has a substantial interest in the assessee’s business.
Rank #2
- Ideal for Gifting
- Ideal for a bookworm
- Compact for travelling
Additional limbs address specified businesses in which the assessee, or a person connected with the assessee under the provision, has a substantial interest. Another company can also be covered where the first-mentioned company has a substantial interest in it. These connected-entity rules are separate from the direct family and office-holder categories and should be checked whenever ownership, profit participation or common control is present.
How “substantial interest” is measured
The threshold differs according to the type of business. The statutory test is generally 20 percent, but the interest is measured differently for a company and for other businesses or professions.
| Business form | Substantial-interest test in the 2025 Act text | Timing |
|---|---|---|
| Company | Beneficial ownership of shares carrying at least 20% of the voting power, excluding shares entitled to a fixed dividend | At any time during the tax year |
| Other business or profession | Beneficial entitlement to at least 20% of the profits | At any time during the tax year |
The corresponding 1961 Act provisions use the same 20 percent concepts by reference to the previous year. That difference in the relevant period can change who is covered, particularly where ownership or profit rights changed during the year. Do not carry the 2025 Act’s “tax year” wording into a legacy-year calculation without checking the 1961 Act text that governs that filing.
Free tools Windows power users keep installed
One-click scans. No signup required.
What payments can be examined
Section 40A(2) is concerned with expenditure claimed in computing business or professional income. A payment for goods, services or facilities can be examined when it is made to a specified person. Common examples include:
- purchase of goods or raw materials from a related business;
- rent, lease charges or use of property connected with a director, partner, member or relative;
- professional, management, technical or administrative services;
- interest, commission or other charges paid for business facilities; and
- salary, fees or other remuneration where the recipient falls within a specified relationship.
These are examples of transaction types, not an automatic list of disallowances. The payment must be examined against its commercial circumstances, and the statute does not say that every transaction with a specified person is excessive.
The three questions the Assessing Officer applies
1. What is the fair market value?
The first comparison is the price or value that comparable goods, services or facilities would command in the relevant market. Useful evidence can include quotations, independent comparable transactions, price lists, valuation material and the terms actually delivered. A higher price is not automatically excessive if the transaction includes additional scope, urgency, specialist expertise or other features that make the comparison appropriate.
2. Was the expense a legitimate business need?
The question is whether the business or profession had a genuine commercial reason to incur the expense. A written agreement can help show the purpose, but the underlying business requirement and what was actually done are more important than the label placed on the payment. A transaction may be needed even when the recipient is connected to the assessee; conversely, a formally documented arrangement can still be challenged if the business need is not demonstrated.
3. What benefit did the assessee receive?
The officer can consider the benefit derived by, or accruing to, the assessee. Evidence may include completed deliverables, increased capacity, access to premises or equipment, avoided costs, sales support or another identifiable business result. The benefit should be evaluated in relation to the payment and the period in which it was incurred.
Rank #4
These factors are contextual. The statute gives the Assessing Officer the judgment; it does not prescribe a universal percentage markup, a fixed price ceiling or a guaranteed deduction merely because paperwork exists.
How to document a related-party payment
Good records allow the assessee to explain why the transaction was entered into and why its amount was commercially justified. For each material payment, assemble evidence that addresses the three statutory comparisons.
- Identify the relationship. Record the recipient’s role, ownership, profit interest and any family or control connection that places the transaction within section 40A(2)(b) or the corresponding section 36 definition.
- Describe the transaction. Keep the contract, purchase order, lease, engagement letter or other terms showing what was to be supplied, for which period and at what price.
- Show performance. Preserve invoices, timesheets, reports, delivery records, correspondence, work product and proof that the goods, services or facilities were actually provided.
- Support market value. Retain comparable quotations, prior unrelated transactions, published rates or another reasoned basis for the price. Comparisons should account for differences in scope, quality, location and timing.
- Explain business need and benefit. Make a contemporaneous note of the business problem addressed, alternatives considered and the benefit expected or obtained.
- Reconcile the accounting and tax claim. Ensure the ledger, payment trail, withholding records where applicable and tax computation describe the same transaction.
This is a practical evidence framework, not an exhaustive statutory checklist and not a promise that a deduction will be accepted. The strength of the explanation depends on the facts and the records for the particular year.
What a disallowance looks like
Suppose a firm pays a partner’s separate company for administrative support. The relationship places the transaction within the review rule, but the entire charge is not automatically denied. The officer may compare the scope and quality of the support with independent market prices, consider whether the firm needed the work and assess the benefit actually received. If only part of the charge is judged excessive, only that part is disallowed under the statutory test.
Best Value
- It can be a gift option
- Comes with secure packaging
- Helpful in various ways
The same reasoning applies to rent paid to a relative, goods bought from a company in which a connected person has a substantial interest, or professional fees paid to a director’s relative. The relationship opens the door to scrutiny; it does not decide the result.
Independent reader supportYour contribution helps us test, update, and keep practical guides available for everyone.Section 40A(2) and the 2026 transition to section 36
The title of this topic comes from the Income-tax Act, 1961. Use section 40A(2), including clause (b), when analyzing a year governed by that Act. For tax year 2026, the Income Tax Department’s current text identifies the corresponding excessive-expenditure rule and specified-person definitions in section 36 of the Income-tax Act, 2025.
Before preparing a return, notice response or tax opinion, establish:
Do these 3 things before closing this tab:
1Fix the driver behind crashes, sound loss and screen glitches2Repair Windows errors before they cause bigger problems3Scan for outdated or missing drivers - takes under a minute- the tax year or assessment year being examined;
- which Act and statutory text apply to that period;
- whether ownership or profit interests changed during the relevant year or previous year; and
- whether a transitional rule changes the period or definition used.
Using the section 40A wording without qualification for a 2026 filing can obscure the current section number and the applicable timing test. Conversely, using section 36 for a legacy year can misstate the governing law.
Specified domestic transactions and arm’s-length rules
The department’s tutorial material describes arm’s-length treatment for specified domestic transactions under section 92BA for assessment years commencing on or after 1 April 2016. That statement belongs to the specified-domestic-transaction framework and should be applied only after confirming that the transaction and assessment year fall within it.
Arm’s-length treatment in that context should not be presented as a universal safe harbor under every version of section 40A(2). A transaction can still require analysis under the law applicable to its year, and the relevant compliance, transfer-pricing and reporting rules should be checked separately.
Common mistakes to avoid
- Assuming every related-party payment is illegal. The rule is a reasonableness test, not a blanket prohibition.
- Disallowing the whole invoice automatically. The statute targets the portion considered excessive or unreasonable.
- Checking only family relationships. Directors, partners, members, substantial-interest holders and connected entities can also be covered.
- Using a 20 percent threshold without checking the denominator. Companies use voting power and exclude fixed-dividend shares; other businesses use profit entitlement.
- Ignoring the relevant period. The 2025 Act text refers to any time during the tax year, while the 1961 Act uses the corresponding previous-year framework.
- Relying on a contract alone. The agreement should be supported by proof of performance, market comparables, business need and benefit.
- Treating section 92BA as a universal defense. Its arm’s-length treatment is tied to the specified domestic transaction rules and the assessment years to which they apply.
A practical decision path
- Fix the governing law. Mark whether the file concerns a legacy year under the 1961 Act or tax year 2026 under the 2025 Act’s section 36 text.
- Map the recipient. Check the assessee’s form, the recipient’s office or family connection, ownership, voting power, profit entitlement and connected entities.
- Confirm substantial interest if relevant. Apply the 20 percent test using the correct business form and time period.
- Describe what was purchased. Separate goods, services, facilities, rent, finance charges and remuneration rather than treating a mixed invoice as one unexplained amount.
- Build the three-part comparison. Set out market value, legitimate business need and benefit in a file that a third party can follow.
- Quantify only the challenged excess. If an adjustment is proposed, distinguish the supported portion from the amount alleged to be excessive.
- Check related compliance regimes. Where section 92BA or another rule may apply, verify the year-specific reporting and arm’s-length requirements instead of assuming section 40A(2) resolves them.
Section 40A(2)(b) therefore answers a threshold question—who can bring a payment into the specified-person review—not the final question of deductibility. The final result turns on the applicable Act and year, the transaction’s market value, its business purpose and the benefit the assessee can demonstrate.
Quick wins for a faster PC:
Fix the driver behind crashes, sound loss and screen glitchesFind Drivers →Repair Windows errors before they cause bigger problemsFix Now →Quick Recap
Product prices and availability are accurate as of the date/time indicated and are subject to change. Any price and availability information displayed on Amazon at the time of purchase will apply.
