[Opinion] Income Tax and Related Party Transactions | A Comprehensive Overview

Meenakshi Subramaniam – [2023] 152 taxmann.com 127 (Article)

A man said to another:

“I have become a poet, because of income tax.”

His friend quizzed:

“How?”

The man said:

“This is my poem:-If I don’t help my saala, I won’t get nivala (food) but if I help my saala, the income tax department would show me a bhaala (spear).”

Related party transactions are an extremely favourite subject of the income tax department. If A and B are related, the tax authorities think there is a mysterious X element.

Related Parties & Income Tax

What are the sections, related to related party transactions and their implications ?

Section 13(2)

If charitable trust is created and any part of its income enures directly or indirectly for the benefit of specified persons, then the entire income of such trust is not eligible for exemption under section 11 or 12. The interested persons can be, for example, the author of the trust or the founder of the institution or any relative of such author, founder, substantial contributor, member, trustee or manager.

The income or the property or any part is deemed to be used or applied, under Section 13(2) for the benefit of the interested person in giving interest free loans, no charging of adequate rent, purchase of property at very high price and sale at very low price.

In the extremely interesting case of Agappa Child Centre v. CIT [1997] 92 Taxman 327/226 ITR 211 (Ker.), the trust had purchased a refrigerator and kept it at the residence of its managing trustee. As the trustee was enjoying the use of fridge, without compensation the ITO held that section 13 was attracted. The Kerala High Court held that the Managing Trustee was one of the prohibited persons as per section 13(3). Therefore, the Court held that the entire exemption of the trust was to be denied.

Section 40A (2) (b)

This Section is an over-riding provision which provides that even if an expenditure or allowance comes within the purview of any other section, their treatment should only be done as laid down in this section.

Mr. Raj is a lawyer and makes payment for office rent to his wife Mrs. Raj. Section 40A(2)(b)(i) states this is related party transaction.

Mr. Rakesh is a director of A Ltd. and the company made payment for office rent to Mrs. Rakesh. Under section 40A(2)(b)(ii) this is a related party transaction.

Mrs Bani holds 10% of equity shares of ABC Pvt. Ltd. Mr Poshak holds 25% of equity shares of ABC Pvt. Ltd. Mrs Bani is mother of Mr Poshak. The company purchased goods from Mrs Bani. Section 40A(2)(b)(iii) calls it a related party transaction.

ABC Private Ltd. has made payment for office rent to XYZ Ltd. which holds 21 percent of shares of ABC Private Ltd. Mr. Rakesh is a director of XYZ Ltd. This is a ‘related party transaction’ under 40A(2)(b)(iv) for ABC Private Ltd.

Y Ltd. paid rent to X Ltd. and purchased certain consumer items from Z. The rent transaction between Y Ltd. and X Ltd. is a related party transaction under Section 40A(2)(b)(v) since the payee’s director holds substantial interest in Y Ltd.

Under, section 40A(2)(b)(vi), two more related party transactions occur:

(A) Where payment for expenditure is made to person having business or profession and the individual or his relative has a substantial interest, then a related party transaction occurs.

(B) Where assessee company makes payment to any person having business or profession and the company or any director of the assessee company or relative of such director has a substantial interest, then related party transaction takes place.

There is one amusing case where a daughter-in-law of director was held by income tax department to being paid excessive salary. Section 40A(2)(b) rolled into action. In Balani Infotech (P.) Ltd. v. ACIT [2023] 146 taxman.com 410 Delhi Tribunal held that as per Section 2(41) of the Act, “Relative” means the husband, wife, brother or sister, or any lineal ascendant or descendant of the individual. The daughter in law cannot be considered to be a relative.

The assessee should remember not to compare rates of previous years but see the prevailing market rate [CIT v. Denso Haryana (P.) Ltd. [2010] 190 Taxman 389/328 ITR 14 (Delhi)]

Payment made by assessee (holding company) to its subsidiary company cannot be disallowed.

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