Section 40A2: A Step-by-step Guide 2025

The 40A2 section of the Income Tax Act has become more significant in 2025 to Indian businesses, chartered accountants and individual taxpayers. The main provision of this section is the denial of specific expenditure to claim tax deduction made with the related parties. Knowing its relevance can assist businesses in optimising tax planning, complying and evading hefty penalties. In this ultimate guide, we are going to untangle all the main points, recent changes, practical examples, and strategy tips to be compliant.

Section 40A2 and Why Does it Matter?

Section 40A2 is an important section under the Indian Income Tax Act that governs the transactions with the related parties which are referred to as the specified persons. It stops businesses which have artificially high expenses, through overpaying to partners or relatives, who are usually partners, usually to partners or relatives. Such surplus figures cannot be utilized as business expenses during the determination of taxable profits.

What Payments are Section 40A2 Payments?

Payments covered under Section 40A2 include all expenditures (like salary, commission, rent, professional fees) made by a business to specified persons, where such payment could potentially reduce the taxable profits unfairly.

Why Section 40A2 is More Relevant in 2025?

The curiosity over related party transactions has grown with the requirements of the continued digitisation of financial records and sharing of data among the authorities. Analytics is also being actively used by the tax department to find suspicious transactions, particularly with connected persons. Section 40A2 makes sure that a business can claim only a reasonable amount of expenditure to uphold the integrity of tax.

Insider Tip: There are a lot of startups and family-owned businesses that have been receiving more queries by the Income Tax Department regarding related party payments following the introduction of new e-Verification procedures in 2025.

What are so-called Specified Persons of Section 40A2?

Specified person is usually people or other entities that are closely related with the taxpayer, and there is some degree of personal or family interest that can interfere with business decision-making.

What is a specified person in this section?

• To individuals: family members such as spouse, brother, sister, lineal ancestor or descendant
• The companies or firms: directors, partners, or any relative of such persons
• For Hindu Undivided Family (HUF): any member of the family
• In the case of other entities: any individual who is a substantial interest holder or in other words, owns at least 20 percent of the voting power or share of profits
• All the entities, where the taxpayer or their relatives/associates have significant interest in

How is “substantial interest” determined?

When an individual has a right to receive not less than 20 percent of company shares or profits of a concern in the last year, then substantial interest is assumed.

You know what? Indirect shareholding structures were brought under the scope of the term of specified persons in the recent amendments in the Budget to prevent tax leakage.

What does the Section 40A2 refer to by Excessive or Unreasonable Expenditure?

The section 40A2 does not explicitly disallow the whole related party expenses. Rather, it only targets those that are above what could be paid to a third party to get the same services or goods.

What is too much or too unreasonable payment?

The comparison made by the tax officer is:

• The real price paid to the associated party
• The fair market value (FMV) of the goods, services, or facilities

Any amount more than FMV or the amount that would have been paid to an unrelated party is NOT ALLOWED as a deduction.

Do authorities have special limits or does it go case to case?

There are no set limits. The Assessing Officer (AO) has powers to determine and disallow excess amounts after giving the taxpayer an opportunity to be heard.

Practical Example (2025):
XYZ Pvt Ltd may be paying consulting charges of 1200000 to its director brother in 2025 whereas market rates are around 800000 in similar services. The 400000 extra will not be allowed as business expense under Section 40A2.

Expert opinion: In 2025, online B2B service markets are becoming very common with businesses using them as a way of benchmarking the current rates in the market before concluding deals with the concerned parties.

What Are the Costs That Are Scrutinised under Section 40A2?

The most popular challenged heads of expenses

• Salaries or consulting fees to directors/partners or their families
• Rent of property rented to relatives or group companies
• Interest to those around
• The group concerns purchase of raw material or stock
• Contract outsourcing or support services charged by associated bodies

Do small businesses and professionals also fall under it?

Yes, Section 40A2 is applicable to all taxpayers whose business/professional earnings are not subject to any limit in terms of size of operation. It has sole proprietors, partnership, LLPs and companies.

Do companies have the right to pay more in special circumstances?

There are occasions when a premium can be justified on expertise, place, etc. These can be proved with good documentation to the tax officer. Industry portal or online rating site arm length evidence is becoming more and more accepted as evidence.

Another question that people pose is:

Q: What role do online service portals play in meeting the Section 40A2?
A: These platforms post real prices bands of goods and services and you can use them as evidences of market value in tax valuation.

What Will Be the Major Characteristics of Section 40A2 in 2025?

• All forms of businesses/professions are applicable
• Covers all kinds of payments: salary, fees, commission, rent, interest, purchases, etc.
• Analysis is centered on inappropriate reduction of taxable income by use of related party payments
• Only the excess amount which has been found unreasonable can be disallowed by tax authorities
• Needs a written documentation so as to show market justification and reasonableness
• Small enterprises or startups are not exempted
• Needs correct disclosures in tax audit form or ITR form

So what has changed in the last few years?

• E-Assessment Scheme and e-Verification in 2024-2025 have facilitated the regular electronic requests in benchmarking data on related party payments
• All major related party transactions are supposed to be recorded by businesses and justified using notes in a digital format
• Failure to disclose attracts risk of penalty, fines and re-opening of assessments

What do you know? The top tax minds advise that one should keep a file of peer-reviewed rate cards or Internet based quotations of third party services to prevent future disputes under Section 40A2.

Examples of How to be Compliant with Section 40A2

What can a company do to keep itself in compliance?

• Find out all the dealings with related parties
• Documentation of the reasons of why certain individuals were chosen to the exclusion of third party should be done systematically.
• Seek price quotations individually or issue rates lists via internet markets
• Have arm length pricing evidence in case of large or recurring payments
• Make full disclosures in tax filings and under Tax Audit (Form 3CD)
• Give briefing to the board of directors or the partners on the importance of transparent documentation in a short form

Is compliance possible with tech and software?

Yes, ERP or cloud accounting systems in 2025 allow users to flag, track, and add evidence to each related party payment. A lot of Indian companies use such tools to generate tax audit-ready reports.

The other question is also asked by people:

Q: Whose responsibility is the role of tax auditors under Section 40A2?
A: The clause 23 of the form 3CD requires the tax auditors to report all payments to the mentioned persons with comments on their reasonableness.

What are the advantages and disadvantages of the Section 40A2 to small businesses?

Pros

• Makes sure it is fair so that the profit does not shift to their relatives
• Encourages free and market oriented business conducts
• Shields bona fide taxpayers against the tax evasion by others
• Promotes documentation and keeping of records and reduces conflict

Cons

• Increases the compliance costs especially of new and small companies
• The “reasonableness” is subjective and gives rise to controversies and lawsuits
• Continued administrative expenses in monitoring, benchmarking and reporting to related party transactions
• Threat of legitimacy of real transactions being opposed or refused

Professional advice: By 2025, online markets will be able to assist small businesses to meet the Section 40A2 requirements, simplifying the collection of market evidence and fair prices.

Comparison Table 40A2 and other Disallowances

First-Hand Experience: Section 40A2 in Action (2025)

I am a medium scale consulting businessman in Mumbai. We had to pay a high amount of rent last year to one of our relatives in order to have a new office as their place was what we required. We also contracted one of the cousins in some of the core projects.

Said our CA:

• Get at least three rental offers of the surrounding commercial premises
• As evidence of market rent, take screen shots of online real estate websites
• Note down the professional credentials and fee of the like-minded consultants

The tax audit involved Assessing Officer who demanded explanations. The costs were not disallowed since we recorded market rates.

Real tip: Overdocument the payments to related parties, even in case of a single transaction.

The other questions being asked by people are:

Q: Can salary to spouse be paid under 40A2?
A: Yes, but only to the extent that it corresponds with what a third party would be paid to do the same job.

Key Points to Remember for Section 40A2 (2025 Onwards)

• Record all the payments that have been made to said parties with respect to goods, services, rent, interest or fees
• In comparison to market prices; have separate quotations, internet samples and past contracts
• All such transactions to be disclosed in tax returns and audit reports
• Bring in a knowledgeable CA or tax consultant when it comes to a difficult or important transaction
• Keep track of changes through CBDT circulars and amendments to Finance Act every year

Did you know? By 2025, there are numerous online marketplaces, which provide automated benchmarking services, enabling a business to create rate comparisons in a few seconds to report compliance.

TL;DR (Quick Recap)

Section 40A2 of Income Tax Act denies businesses the ability to lower the amount of taxable profits by over-paying related parties. Expense is only allowed to amounts up to fair market value; more than that is disallowed. Indicate all the involved parties, support them with market facts, report in tax returns and store records in a digital format to prevent penalties or conflicts.

People Also Ask: Questions and Answers

Q1: Can Section 40A2 apply to any business such as sole proprietorships?
A: Yes, it is applicable to any business and professional who is taking tax deductions on expenses.

Q2: What is substantial interest of section 40A2?
A: Substantial interest is normally a holding of more than 20 percent shares in a company or 20 percent profit share in a partnership or concern.

Q3: What do I do to prove that Section 40A2 payment value is fair?
A: Compare to the prevailing rates of similar services, save quotes or consult prices published on the Internet portals.

Q4: What is the content expected in the tax audit report section 40A2?
A: You need to reveal all the payments to the mentioned persons with the report on their reasonableness in the Form 3CD Clause 23.

Q5: Does 40A2 apply to the payments prior to the due date of submitting returns?
A: The section 40A2 is applicable on amounts paid or payable in the previous year irrespective of the date of payment.

Q6: What is the criteria of Section 40A2 to judge genuine business needs?
A: Bonafide needs are not ignored, but you have to demonstrate using the necessary paperwork why the fee or rent of the related party is in tandem with the market value.

Sources:

• Bombay Chartered Accountants Society, Income Tax Act
• Official Portal of Income Tax Department
• The Taxsutra Current Compliance Practices 2025, Taxsutra
• CBDT Circulars on Transfer Pricing and related party Transactions