Why Is My Related Party Payment Being Disallowed?

You paid the founder-CEO a director’s remuneration of Rs 45 lakh for FY 2025-26. It sat in the Board minutes since April 2025, went through the audit committee, and reflected in every quarterly Ind AS financial. Then the tax auditor’s draft Form 3CD lands on the twentieth of August with clause 23 flagging Rs 12 lakh as excessive under Section 40A(2)(b) — benchmarked against three comparable-industry salary studies that put the fair-market range at Rs 30 to Rs 36 lakh.

The disallowance is not the whole Rs 45 lakh. It is the Rs 12 lakh above the mid-point of Rs 33 lakh. At the 30 per cent marginal tax rate that is roughly Rs 3.6 lakh of additional tax. But the disallowance is only the surface. Behind that Rs 12 lakh flag sit five other regimes — Section 92BA specified domestic transaction reporting, Ind AS 24 disclosure, SEBI LODR Regulation 23 (for listed entities), Companies Act Section 188 audit-committee and shareholder approvals, and the TDS layer that Section 393(1) coding migration touches from FY 2026-27 onwards. What do you do next?

The quick answer

A related-party payment in an Indian company’s books passes through six overlapping regimes. Section 40A(2)(b) is the income-tax disallowance on the excess portion. Section 92BA is the transfer-pricing overlay if aggregate related-party transactions cross Rs 20 crore for the year. Ind AS 24 is the financial-statement disclosure. SEBI LODR Regulation 23 is the listed-entity audit-committee and shareholder-approval framework. Companies Act Section 188 is the Board-resolution requirement. And the TDS layer under the applicable section (192/194C/194H/194I/194J/194R) continues to apply with its own coding cross-era from 1 April 2026.

The Rs 12 lakh Section 40A(2)(b) disallowance is the visible symptom. The escalation-first regime is Section 92BA — because SDT documentation obligations run for eight years, penalties for non-maintenance under Section 271AA are two per cent of the SDT value, and the Form 3CEB filing is due with the tax audit report on the same date the Form 3CD is being signed.

Regime 1 — Section 40A(2)(b) disallowance on the excess

Section 40A(2)(a) of the Income-tax Act 1961 empowers the Assessing Officer to disallow so much of any expenditure paid to a specified related party as is excessive or unreasonable, having regard to (i) the fair market value of the goods, services or facilities for which the payment is made, (ii) the legitimate needs of the business or profession of the assessee, and (iii) the benefit derived by or accruing to the assessee. Section 40A(2)(b) defines the specified persons. For a company assessee, this includes any director of the company, any relative of such director, any person who has a substantial interest in the business of the assessee (holding beneficially at least twenty per cent of the equity shares or voting power), any relative of such person, and any company in which the director or the substantial-interest-holder has a beneficial equity interest.

The disallowance is on the excess only. A Rs 45 lakh remuneration benchmarked at a Rs 33 lakh mid-point gives a Rs 12 lakh disallowance — not a Rs 45 lakh disallowance. The Rs 33 lakh fair-market figure needs a defensible working paper: an industry salary survey (a Big Four consulting benchmarking study, an AON compensation survey, a Michael Page or Korn Ferry industry report), a comparable arm’s length transaction with an unrelated vendor, or a published price list where relevant. Extraction date, source citation, and comparable-selection rationale all need to sit in the working paper. Without it, the Assessing Officer’s own comparison prevails.

Illustrative arithmetic. Rs 45 lakh remuneration; Rs 30 lakh to Rs 36 lakh benchmark range with a Rs 33 lakh mid-point; Rs 12 lakh excess against the mid-point; Rs 3.6 lakh tax cost at the 30 per cent marginal rate. The auditor’s Form 3CD clause 23 draft carries the disallowance; the company’s benchmarking working paper — attached to the tax audit response — is the defence.

Regime 2 — Section 92BA specified domestic transaction (the escalation)

Aggregate the related-party payments for the year — director’s remuneration, professional fees to relatives, rent on leased property owned by related parties, purchases from and sales to related companies, inter-unit transfers under Section 80-IA(8), business between the assessee and other person under Section 80-IA(10). If the aggregate crosses Rs 20 crore, Section 92BA applies and the transfer pricing provisions of Sections 92 to 92F kick in.

Every specified domestic transaction has to be benchmarked at arm’s length under Rule 10B using one of six prescribed methods — Comparable Uncontrolled Price (CUP), Resale Price Method (RPM), Cost Plus Method (CPM), Profit Split Method (PSM), Transactional Net Margin Method (TNMM), or such other method as may be prescribed. Rule 10C requires contemporaneous documentation — the ownership structure of the group, the industry profile, the FAR analysis (functions performed, assets employed, risks assumed), the actual arm’s length working, the assumptions and price negotiations that critically affected the price. The documentation has to be preserved for eight years from the end of the relevant assessment year. Form 3CEB — a chartered accountant’s certificate covering every specified domestic transaction and the method applied — is filed with the tax audit report by the due date of the return.

Section 271AA penalises non-maintenance of the Rule 10C documentation at two per cent of the value of the international transaction or specified domestic transaction. On a Rs 24.6 crore aggregate SDT set, the Section 271AA ceiling exposure is Rs 49.2 lakh — an order of magnitude larger than the Section 40A(2)(b) Rs 3.6 lakh tax cost. This is why Section 92BA takes escalation precedence over Section 40A(2)(b).

The deeper treatment of the SDT regime is at what is a specified domestic transaction under Section 92BA.

Regime 3 — Ind AS 24 related-party disclosure in the notes

Ind AS 24 requires an entity that prepares Ind AS financials to disclose, in the notes to the financial statements, the nature of every related-party relationship, the amount of every related-party transaction during the year, the outstanding balances at year-end with their terms and conditions, provisions for doubtful debts on outstanding balances, and expense recognised in the period on bad or doubtful debts due from related parties. Key management personnel compensation is disclosed in total and separately for short-term employee benefits, post-employment benefits, other long-term benefits, termination benefits, and share-based payments.

The related-party register that supports the Ind AS 24 note is the same register that populates Form 3CD clause 23 and Form 3CEB. Reconciling the three surfaces at the statutory audit stage — the tax audit report, the transfer pricing certification, and the financial-statement note — is where a controller’s statutory audit reconciliation checklist closes the loop. A related-party payment that appears in Form 3CD but not in the Ind AS 24 note, or vice versa, is a reconciliation break that the statutory auditor’s management-letter comment will surface.

Regime 4 — SEBI LODR Regulation 23 (listed entities)

For a listed entity, Regulation 23 of the SEBI (Listing Obligations and Disclosure Requirements) Regulations 2015 sits on top of the income-tax and accounting layers. The audit committee’s prior approval is required on every related-party transaction (with an omnibus approval framework for recurring transactions inside defined parameters). A “material” related-party transaction — a transaction or transactions individually or taken together with previous transactions during the financial year that exceed Rs 1,000 crore or 10 per cent of the annual consolidated turnover of the listed entity as per the last audited financial statements, whichever is lower — requires prior approval of the shareholders through a resolution. No related party of the listed entity may vote to approve the resolution, whether or not that specific related party is a party to the transaction.

The half-yearly RPT disclosure to the stock exchange, in the standard SEBI-prescribed format, is a separate obligation that runs alongside the annual Ind AS 24 note. A listed manufacturing company with Rs 5,000 crore consolidated turnover has a Regulation 23 materiality threshold of Rs 500 crore (the lower of Rs 1,000 crore and 10 per cent of Rs 5,000 crore) — every transaction or transaction bundle above that figure needs shareholder approval before execution, not after.

Regime 5 — Companies Act Section 188 Board and shareholder approvals

Section 188 of the Companies Act 2013 requires a Board resolution for specified categories of related-party contracts — sale, purchase or supply of goods or materials; buying, selling or disposing of property; leasing of property; availing or rendering of services; appointment of related-party agents; related-party appointments to office of profit; related-party underwriting of securities. For a company above a prescribed paid-up-capital or transaction-value threshold, an ordinary resolution of the shareholders is also required. Related-party members may not vote on the resolution.

The ordinary-course-of-business exemption applies only where the transactions are on an arm’s length basis — the same arm’s length test that Section 92BA operationalises through Rule 10B. A transaction that fails the arm’s length test loses the ordinary-course exemption, which pulls it back into the Board-resolution and (if the threshold is crossed) shareholder-resolution requirement.

For the illustrative case — a Rs 45 lakh director’s remuneration to a founder-CEO of an unlisted Rs 200 crore manufacturing company — Section 188 typically covers the remuneration through the Board resolution route without a shareholder trigger, but the ordinary-course-of-business defence rests on the same arm’s length benchmarking that Section 40A(2)(b) uses. A single benchmarking working paper serves both regimes.

Regime 6 — the TDS layer and the Section 393(1) coding migration

Every related-party payment attracts the applicable TDS section — Section 192 on salary components of a director’s remuneration, Section 194C on contractor payments to related parties, Section 194H on commission, Section 194I on rent, Section 194J on professional fees or sitting fees, Section 194R on benefits or perquisites. The TDS deduction on the payment is unaffected by any Section 40A(2)(b) disallowance — the disallowance sits on the deduction claim, not on the TDS obligation. The full Rs 45 lakh remuneration attracts Section 192 TDS at the applicable slab rate, regardless of whether Rs 12 lakh is later disallowed under Section 40A(2)(b).

From 1 April 2026, every TDS deduction leg reported in Form 26Q from Q1 FY 2026-27 onwards carries the Section 393(1) successor payment code — code 1027 for Section 194J professional fees, code 1023/1024 for Section 194C contractor payments, code 1031 for Section 194Q purchases. The TDS payment codes 1001 to 1092 reference is the full cross-era mapping. A related-party payment split across salary (Section 192) and sitting-fee professional-services (Section 194J) needs the two legs coded separately in the successor register.

The one to escalate first — the Section 92BA aggregate register

The Section 40A(2)(b) Rs 12 lakh disallowance is a Rs 3.6 lakh tax cost. The Section 92BA Rs 24.6 crore SDT set carries a Section 271AA non-maintenance ceiling of Rs 49.2 lakh, a Form 3CEB filing obligation on the tax audit due date, and a documentation preservation obligation running for eight years. The Section 92BA exposure is an order of magnitude larger and it is time-bound to the same date as the Form 3CD signing.

The escalation ladder — the controller review that follows the auditor’s clause 23 flag — should therefore run in this order: first confirm the running aggregate of specified domestic transactions for the year; second, if the aggregate crosses Rs 15 crore (a 75 per cent early trigger), build the Rule 10C documentation contemporaneously through the balance of the year rather than reconstructing it at Form 3CEB filing time; third, address the Section 40A(2)(b) disallowance with a defensible benchmarking working paper for each flagged transaction; fourth, reconcile the Ind AS 24 note and the SEBI LODR (if listed) half-yearly disclosure to the same register.

When the manual register outgrows itself

For a company with under 30 related-party transactions in a year — a handful of key management personnel remunerations, a small set of intercompany service charges, one or two leases — the related-party register fits in a single spreadsheet that the tax executive maintains alongside the monthly close. One controller review per quarter, one comprehensive review at Form 3CD signing, and the six regimes reconcile cleanly.

Above 100 related-party transactions per year, or above three concurrent related-party categories (director’s compensation + intercompany service charges + inter-unit transfers under Section 80-IA(8)), the manual register starts to leak — a transaction miscoded against the wrong specified person, a benchmark that goes stale between the Board approval date and the Form 3CD signing date, an Ind AS 24 note that does not tie to Form 3CD because the two were maintained separately, a Form 3CEB SDT list that misses a payment coded outside the related-party filter. Each miss compounds the tax audit response and the transfer pricing documentation burden.

At that scale, moving the related-party register and the six-regime cross-reconciliation onto continuously refreshed detection — where Terra Insight’s reconciliation software treats the related-party ledger, the SDT aggregate, and the Ind AS 24 note as reconciled first-class outputs — is what keeps the tax audit close inside the statutory timetable rather than an open-ended firefight. Below that scale, the manual register and the statutory audit preparation kit template set are the right tools, and the discipline of running the six regimes by hand is what builds the reconciler’s judgement for when scale demands the shift.

Go deeper

• What is a specified domestic transaction under Section 92BA — the SDT threshold, arm’s length methods, and Form 3CEB filing
• The statutory audit reconciliation checklist — the six-regime cross-tie at Form 3CD signing
• TDS payment codes 1001 to 1092 — the Section 393(1) cross-era mapping for the TDS leg on every related-party payment
• Statutory audit preparation kit — the working-paper template set
• Reconciliation software for India

Frequently Asked Questions

What makes a payment excessive or unreasonable under Section 40A(2)(b)?

The test is the fair market value of the goods, services or facilities for which the payment is made, read against the legitimate needs of the business and the benefit derived by the assessee. The Assessing Officer compares the payment against an external benchmark — an industry salary survey, a comparable arm’s length transaction with an unrelated vendor, a published price list, or a Big Four benchmarking report — and disallows only the excess portion. A director’s remuneration of Rs 45 lakh where the fair-market benchmark for an equivalent role in an equivalent-sized business is Rs 33 lakh gives a Rs 12 lakh excess, and that Rs 12 lakh is the disallowance. The full Rs 45 lakh is not disallowed. The benchmarking working paper attached to the tax audit response — with source citations, date-stamped extracts, and a comparable-selection rationale — is what defends the Rs 33 lakh figure at scrutiny. Without a defensible benchmark, the Assessing Officer’s own comparison prevails.

Does Section 40A(2)(b) apply to salary payments to directors?

Yes — Section 40A(2)(b) includes any director of the company in the list of specified persons. A director’s remuneration whether structured as salary under Section 192, sitting fees, commission on profits, or professional fees under Section 194J is squarely within the scope of the disallowance. The disallowance test remains the same — the fair market value, the legitimate needs of the business, and the benefit derived. Where the director is also a substantial shareholder (holding at least twenty per cent equity or voting power), both limbs of Section 40A(2)(b) apply and the Assessing Officer scrutiny tends to be more granular. A director’s remuneration paid to a founder-CEO of a manufacturing company with Rs 200 crore turnover benchmarked against comparable industry data attracts a different tolerance band than the same figure paid to a non-executive director drawing sitting fees only. The benchmarking has to be role-specific, industry-specific, and size-adjusted.

If I cross the Rs 20 crore SDT threshold under Section 92BA, what changes?

The aggregate of all specified domestic transactions across the previous year — including Section 40A(2)(b) payments, Section 80-IA(8) inter-unit transfers, and Section 80-IA(10) group-company business transactions — crosses Rs 20 crore, the transfer pricing provisions of Sections 92 to 92F kick in. Every specified domestic transaction has to be benchmarked at arm’s length under Rule 10B using one of the six prescribed methods (CUP, RPM, CPM, PSM, TNMM, or other prescribed). Contemporaneous documentation under Rule 10C — the ownership structure, the industry profile, the FAR analysis, the actual arm’s length working, the assumptions and price negotiations — has to be maintained for eight years from the end of the relevant assessment year. Form 3CEB — a certificate from a chartered accountant covering every specified domestic transaction and the arm’s length method applied — is filed with the tax audit report by the due date of the return. Section 271AA penalises non-maintenance of the documentation at two per cent of the value of the international transaction or specified domestic transaction. The Section 40A(2)(b) disallowance becomes a Section 92CA transfer pricing adjustment — a fundamentally different tribunal-level challenge with a fundamentally deeper documentation burden.

Are related-party disclosures required in the financial statements?

Yes — Ind AS 24 mandates related-party disclosure in the notes to the financial statements for every entity that prepares Ind AS financials. The disclosure has to cover the nature of the related-party relationship (parent, subsidiary, associate, joint venture, key management personnel, close family members of KMP), the amount of transactions during the year, the outstanding balances at year-end and their terms and conditions, provisions for doubtful debts on outstanding balances, and expense recognised in the period in respect of bad or doubtful debts due from related parties. Key management personnel compensation has to be disclosed in total and separately for short-term employee benefits, post-employment benefits, other long-term benefits, termination benefits, and share-based payments. For a listed entity, the SEBI LODR Regulation 23 disclosure to the stock exchange every six months (in the standard disclosure format) runs in parallel with the Ind AS 24 annual disclosure — the two are not substitutes and the audit committee’s approval trail sits behind both. For an unlisted company preparing Indian Accounting Standards (AS-18) financials, a similar related-party disclosure obligation applies with a narrower disclosure set.

What is the difference between a Section 40A(2)(b) disallowance and a Section 92BA SDT adjustment?

Section 40A(2)(b) is the direct income-tax disallowance — the Assessing Officer forms an opinion that the payment is excessive against fair-market value, legitimate needs, and benefit derived, and disallows the excess as a deduction. The dispute plays out at the assessment level and any appeal follows the standard route through the Commissioner of Income Tax (Appeals) and the Income Tax Appellate Tribunal. Section 92BA read with Section 92C applies the transfer pricing arm’s-length-price framework — the Transfer Pricing Officer determines the arm’s length price under one of the six prescribed methods, the assessee has an opportunity to object, and any adjustment gets built into the assessment order. The two regimes can apply to the same payment. Where the aggregate SDT threshold of Rs 20 crore is not crossed, only Section 40A(2)(b) applies. Where the threshold is crossed, Section 92BA takes precedence for benchmarking and Form 3CEB reporting, but Section 40A(2)(b) remains available to the Assessing Officer as a separate disallowance ground for any payment inside the SDT set that fails the excessive-and-unreasonable test independent of the arm’s length pricing conclusion.

Terra Insight Editorial Team Reconciliation Infrastructure

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