Whether payment made to relatives is disallowed under Income Tax Act?

1. Relevant Provisions in the Income Tax Act:

• Section 40A(2)(a) – Disallowance of excessive or unreasonable payments to related parties (including relatives)

• Explanation (b) to Section 40A(2) – Defines “related persons”

• Section 64 – Clubbing of income if remuneration is paid to spouse without substantial contribution

2. Can Payment to Relatives Be Allowed as Deduction?

Yes, payment to relatives is not automatically disallowed, but subject to scrutiny under Section 40A(2) of the Act.

The law only disallows the portion of payment which is “excessive or unreasonable” having regard to:

• Fair Market Value (FMV) of the goods/services

• Legitimate needs of the business

• Benefit derived by the business

So, if the payment is at arm’s length and justifiable, it is allowed.

3. Bare Act Text: Section 40A(2)(a)

“Where the assessee incurs any expenditure in respect of which payment has been or is to be made to any person referred to in clause (b) of this sub-section, and the Assessing Officer is of the opinion that such expenditure is excessive or unreasonable… so much of the expenditure as is so considered by him shall not be allowed as a deduction.”

4. Who Are Treated as “Relatives” for This Purpose?

As per Explanation (b) to Section 40A(2):

The term includes (but is not limited to):

• Spouse of the individual

• Brother or sister of the individual

• Brother or sister of the spouse

• Any lineal ascendant or descendant of the individual or spouse

• Any individual having substantial interest in the business or profession of the assessee

Also includes entities in which such relatives have substantial interest.

5. Example Case:

Let’s say a sole proprietor pays ₹40,000/month salary to his brother for doing clerical work.

• If the market salary for such work is ₹20,000/month, then ₹20,000 may be considered excessive.

• The Assessing Officer (AO) can disallow ₹20,000/month as unreasonable expenditure under Section 40A(2).

6. What to Keep in Mind:

✅ Maintain proper documentation (appointment letter, qualification proof, work scope)
✅ Justify payment amount based on industry rates or FMV
✅ Avoid cash payments – use banking channels
✅ Make sure the relative actually works for the business

7. Clubbing of Income (Section 64): A Separate Concern

Even if salary paid to a spouse is reasonable, under Section 64(1)(ii):

If no technical or professional qualification is held by the spouse and she/he does not contribute substantially, the income is clubbed with the assessee’s income.

This is not a disallowance of expense, but clubbing of income for taxation.

✅ Conclusion:

💡 Payments to relatives are not outright disallowed, but only the unreasonable or excessive portion is disallowed under Section 40A(2).

Proper business justification, recordkeeping, and arm’s length payment are essential to ensure deduction is allowed.