Where a business incurs expenditure by way of payment to certain specified categories of related persons — relatives of the assessee, or persons having a substantial interest in the business, along with their relatives and related entities — and the Assessing Officer forms the opinion that the expenditure is excessive or unreasonable having regard to the fair market value of the goods, services or facilities provided, or having regard to the legitimate business needs of the assessee, the excess portion of the payment (though not necessarily the whole payment) can be disallowed.

This provision is aimed specifically at related-party transactions that may be structured to shift profits between connected entities through inflated payments, rather than at ordinary arm's-length dealings with related parties. The burden generally falls on the Assessing Officer to first establish that a payment is, in fact, excessive by reference to fair market value or genuine business need, before any disallowance can be sustained — mere relationship between payer and payee, without more, is not itself sufficient ground for disallowance.

Relevant Case Laws

CIT v. Indo Saudi Services (Travel) Pvt. Ltd. (2009) 310 ITR 306 (Bombay HC) — emphasised that the burden lies on the Assessing Officer to demonstrate, with reference to comparable fair market value or genuine business considerations, that a payment to a related person is excessive or unreasonable, and that a disallowance cannot be sustained on a mere assumption of relationship between the parties without objective evidence of unreasonableness.

Frequently Asked Questions

Q. Is every payment to a relative or related company automatically at risk of disallowance?

A. No — the mere fact of a relationship does not itself justify disallowance; the Assessing Officer must demonstrate that the specific payment is excessive or unreasonable by reference to fair market value or genuine business need.

Q. What kind of evidence helps defend a related-party payment as reasonable?

A. Comparable market rates for similar goods or services from unrelated parties, documented business justification for the specific arrangement, and evidence that the related party genuinely rendered the service or supplied the goods in question.

Q. Is the entire payment disallowed, or only the excessive portion?

A. Only the portion found to be excessive over the fair market value or genuine business requirement is disallowed; the reasonable portion of the payment remains deductible.

Q. Does this provision apply to salary paid to family members working in the business?

A. Yes, where the family member is a specified related person — salary or remuneration paid must be reasonable and commensurate with the services genuinely rendered, and an unreasonably high salary relative to the role and market rates is vulnerable to partial disallowance.

Precautions to Be Taken

1.      Benchmark all significant related-party payments — rent, salary, professional fees, commission — against comparable market rates for similar arrangements with unrelated parties, and retain that benchmarking as contemporaneous evidence.

2.      Maintain clear documentation of the actual services or goods provided by the related party, since disallowance risk increases sharply where the underlying substance of the transaction is thin or poorly evidenced.

3.      Review related-party remuneration and payment arrangements periodically (at least annually) to ensure they remain aligned with the individual's actual role, responsibilities and market comparables as the business evolves.

4.      Where a related-party arrangement changes materially in terms or amount, document the business rationale for the change at the time it occurs, rather than only when queried in assessment.

5.      Distinguish this provision clearly from broader transfer-pricing rules that may separately apply to specified domestic or international related-party transactions, since the compliance and documentation requirements differ.

 Disclaimer

This content is shared strictly for general information and knowledge purposes only. Readers should independently verify the information from reliable sources. It is not intended to provide legal, professional, or advisory guidance. The author and the organisation disclaim all liability arising from the use of this content. The material has been prepared with the assistance of AI tools.