There is an involvement of so many people when you start up your own work as a Freelancer. Your Financial Independent goal is mostly supported by Family and Friends. The assistance may be in the form of giving a place on rent, providing services at low cost or without any cost. All these have an impact on Income Tax. Let’s see how to treat these expenses for Income Tax. Know about the Treatment of Business Expenses related to Relative or person with substantial Interest.
In Income Tax, deductions of only reasonable and Justifiable expenses are allowed from our Income. But when payments are made towards some expenses to a person having a substantial interest or to relatives in your profession or business, such expenses may not be allowed as a deduction from our Income if it seems to be unreasonable or excessive.
Treatment of Business Expenses related to Relative or person with substantial Interest in Detail
A relative has been defined under section 2(41) of the Income Tax Act – as a spouse, sister or brother or any descendant or ascendant. A person having substantial interest means a person who is entitled to 20% of profits or has a minimum of 20 % of equity share out of the total capital of the company. For example, Divyanka, a freelance Journalist takes premises for running her freelancing business from her married sister on monthly rent. This rent is an expense and allowed as a deduction from Divyanka’s freelancing business. Now as the premises is owned by Divyanka’s sister, Divyanka wants to divert some of her income to her sister by paying her rent, higher than the market rent. Divyanka wants to claim such rent payment as a business expense and cleverly want to reduce her overall income – whereas her sister, the recipient of rent and who has no other source of income, ends up by just paying 10% tax on her rental income.
In such circumstances, an Assessing Officer may not allow such rent payment as a deduction, which is not according to the fair market value of the premises and where the recipient of the tax is also a relative.
Hence, the situations in which payment as expenses made to a person having a substantial interest or to a relative may be disallowed are as follows:
• Any expenses which are incurred towards services, goods, or facilities.
• Any Payment which has been made to a person having a substantial interest or relative.
• Any expenses which are unreasonable or excessive, not according to fair market value or may not be genuine needs of your profession or business or it benefits you indirectly.
Some examples –
The Recipient Example
Relative – Mr. X purchases goods from his sister.
Relative of a director – A, B and C are directors in XYX Ltd. XYZ Ltd hires Mrs. C and XYZ Ltd makes her payment.
The company in which Relative has a substantial interest Mrs. Priya holds 20% equity in K Ltd and Priya purchases from K Ltd.
Note: –The AO has the power to disallow the entire expense or a portion which is considered excessive. Hence, while arranging for facilities and goods, one should take utmost care so that these expenses are allowed to be deducted from the freelancing income and help save tax.