Disallowance u/s 40A(2)(b)-Excess over FMV to be seen as per legitimate needs of business

Disallowance u/s 40A(2)(b) AO has to form opinion if expenses more than FMV according to legitimate needs of business.

ABCAUS Case Law Citation:
ABCAUS 3344 (2020) (07) ITAT

Important case law relied upon by the parties:
Flour Mills Vs. ACIT (2009) 314 ITR 1 (Guj.)
CIT Vs. Shatrunjay Diamonds (2003) 261 ITR  258

The assessee had preferred the appeal against the order passed by the learned CIT(Appeals) in confirming disallowance u/s 40A(2)(b) of the Income Tax Act, 1961 (the Act).

The case was selected for scrutiny and statutory notices were issued and complied with. The scrutiny assessment was completed u/s 143(3) of the Act, after making certain additions/ disallowances.

One of the disallowance made was under section 40A(2)(b) of the Act on account of the excessive royalty payment made to related party.

The Tribunal noted that the disallowance under section 40A(2)(b) of the Act can be made by the Assessing Officer, if he is of the opinion that such expenditure is excessive or unreasonable having regard to:

(i) the fair market value of the goods, services or facilities for which payment is made or;

(ii) the legitimate needs of the business or profession of the assessee or;  

(iii) the benefit derived by or accruing to him therefrom.

The Tribunal further observed that the Hon’ble High Court has held that AO is required to record a finding as to whether the expenditure is excessive or unreasonable in relation to any of the three requirements prescribed, which are independent and alternative to each other. 

Disallowance u/s 40A(2)(b) for unregistered agreement

One of the ground taken by the AO for invoking section 40A(2)(b) was that the agreement between the parties had not been registered.

The Tribunal opined that an unregistered agreement cannot be a ground for invoking provisions of section 40A(2)(b) of the Act in absence of requirement of law. If the expenses are not incurred wholly and exclusively for the purpose of the business, then disallowance could be made under section 37(1) of the Act.

Excess of expenses over FMV to be seen as per legitimate needs of the business

The Tribunal noted that the CIT(A) had dismissed the appeal on the ground of assessee having not furnished any justifiable reason for increment in expenses as compared to the previous year.

Further, the Assessing Officer had only questioned the fair market value of the expenses and not questioned to the legitimate need of the expenses or the benefit derived from the expenses.

The Tribunal stated that for invoking the provision of section 40A(2)(b) of the Act, the Assessing Officer has to form an opinion if expenses are more than the fair market value or not according to the legitimate needs of the business or no benefit was derived?

The Tribunal observed that the Assessing Officer had only  compared expenses of  the preceding assessment year and no  efforts had been made for identifying the fair market value of such expenses during relevant period, which is one of the requirement  for invoking the provisions of section 40A(2)(b) of the Act.

The Tribunal opined that though the provisions of section 40A(2)(b) of the Act are general provision as compared to the specific provisions of the transfer pricing, the Assessing Officer was required to compare the expenses paid in case of the similar product by other companies during the relevant period. The Assessing Officer instead of that and only made basis of expenses paid in earlier years.

Accordingly, the ITAT deleted the disallowance made and allowed the appeal.

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