Section 40A(2)(b) Specified Persons: Related Party List & 20% Test (AY 2026-27)
Updated: Sep 28
Section 40A(2)(b) specified persons are the related persons and connected entities whose business expenditure payments need special scrutiny under the Income-tax Act, 1961. For AY 2026-27, the key practical test is whether the payee falls within the statutory relationship categories—including relatives, directors, partners or members, and entities connected through a substantial-interest test. In most cases, “substantial interest” means at least 20% voting power in a company or at least 20% beneficial entitlement to profits in another concern.
This matters for two different reasons. First, Section 40A(2)(a) empowers the Assessing Officer to disallow only the portion of expenditure considered excessive or unreasonable by reference to fair market value, legitimate business needs or the benefit derived. Second, Clause 23 of Form 3CD requires particulars of payments made to persons specified under Section 40A(2)(b). A payment being reportable under Clause 23 does not automatically mean the whole payment is disallowed.
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Section 40A(2)(b) Specified Persons: Who Is Covered?
The list changes with the legal form of the assessee. Finance teams should therefore start with the assessee type, identify the direct relationship, and then test substantial-interest links.
1. If the assessee is an individual
A relative of the individual is a specified person. The statutory definition of “relative” for this purpose covers the husband or wife, brother or sister, and any lineal ascendant or descendant of the individual.
2. If the assessee is a company, firm, AOP or HUF
The list includes a director of the company, partner of the firm, member of the association or family, as applicable, and relatives of those persons. This means a vendor relationship can fall within Section 40A(2)(b) even where the payee is not itself a shareholder of the assessee.
3. Persons having substantial interest in the assessee
An individual who has a substantial interest in the business or profession of the assessee, and any relative of that individual, is covered. Certain companies, firms, AOPs and HUFs having substantial interest in the assessee are also covered, together with specified directors, partners, members and their relatives.
4. Connected concerns in which the assessee or its key persons have substantial interest
Section 40A(2)(b) also works in the other direction. It can cover a person carrying on business or profession where the assessee, or specified relatives/directors/partners/members, has substantial interest in that payee concern. This is why a simple vendor-master flag based only on common names is not enough.
What Is the 20% “Substantial Interest” Test?
Company payee or concern: the relevant person must beneficially own shares carrying not less than 20% of the voting power at any time during the previous year.
Other business or profession: the relevant person must be beneficially entitled to not less than 20% of the profits at any time during the previous year.
The phrase “at any time during the previous year” is important. A year-end shareholding snapshot can miss a relationship that existed earlier in FY 2025-26. Tax-audit working papers should therefore consider changes in shareholding, partnership ratios and beneficial ownership during the year, not only balances at 31 March.
Section 40A(2)(b) Is Not the Same as Every Accounting Related Party
A common compliance mistake is to copy the financial-statement related-party register into Form 3CD without a tax-law mapping. Accounting standards, the Companies Act and Section 40A(2)(b) have different purposes and definitions. There will often be overlap, but the lists are not automatically identical.
Start with the statutory Section 40A(2)(b) categories rather than the accounting label alone.
Check beneficial ownership and profit entitlement, not merely registered ownership or a common group name.
Review relatives where the statute expressly brings them into the relationship chain.
Reconcile the tax list with the Companies Act/financial-statement related-party list as a completeness control—not as a substitute for the tax test.
How Section 40A(2)(b) Connects With Clause 23 of Form 3CD
Clause 23 requires particulars of payments made to persons specified under Section 40A(2)(b). PGT’s detailed Form 3CD Clause 23 guide explains the tax-audit reporting and reconciliation process. The present article answers the narrower question: who should be on the specified-person master list before that reconciliation begins?
The Income Tax Department’s current tax-audit reporting material describes Clause 23 as requiring particulars such as the specified person’s name, PAN, relationship, nature of transaction and amount. ICAI guidance similarly recommends obtaining a complete specified-person list and then tracing expenditure and payments to those persons through contracts, ledgers and other records.
Four Practical Examples
Example 1: Company pays consultancy fees to a director
A director of the assessee-company falls directly within the specified-person category. The consultancy payment should be captured for Clause 23 review. Whether any amount is disallowable is a separate Section 40A(2)(a) question based on reasonableness.
Example 2: Company pays rent to its director’s spouse
The spouse is a relative of the director and therefore falls within the relevant relationship category. The rent should be identified for Clause 23 reporting review. Market-rent evidence is useful because Section 40A(2)(a) can apply if the expenditure is excessive or unreasonable.
Example 3: Company buys services from a vendor in which its director holds 25% voting power
Because 25% exceeds the 20% substantial-interest threshold, the connected-concern provisions need to be tested. The transaction should not be excluded merely because the vendor is a separate legal entity.
Example 4: Partner has only a 10% profit entitlement in another firm
A 10% entitlement by itself does not satisfy the statutory 20% substantial-interest test. However, the complete Section 40A(2)(b) relationship chain must still be checked before concluding that the payee is outside the specified-person list.
Does Clause 23 Reporting Mean the Expense Is Disallowed?
No. This distinction is critical. Clause 23 is a disclosure requirement for payments to specified persons. Section 40A(2)(a), by contrast, permits a disallowance only to the extent the Assessing Officer considers the expenditure excessive or unreasonable having regard to statutory benchmarks such as fair market value, legitimate business needs or the benefit derived.
Therefore, a properly priced and commercially justified related-party payment may still be reportable in Form 3CD while remaining fully deductible. The audit file should preserve the evidence supporting the amount rather than treating disclosure as an admission of disallowance.
AY 2026-27 Working-Paper Checklist
Prepare a legal-entity-wise Section 40A(2)(b) specified-person register for FY 2025-26.
Obtain director, partner, member and relevant relative declarations where appropriate.
Track shareholding and profit-sharing changes during the year because the 20% test can apply at any time in the previous year.
Review beneficial ownership, not only the registered name on the share certificate or vendor master.
Match the specified-person list with purchase, expense, rent, professional-fee, commission, interest and other relevant ledgers.
Capture PAN, relationship, transaction nature and amount needed for Clause 23 reporting.
Retain agreements, invoices, quotations or benchmarking evidence supporting commercial reasonableness.
Reconcile the tax list to the financial-statement and Companies Act related-party records to identify omissions.
Common Mistakes to Avoid
Using only the accounting related-party list without testing Section 40A(2)(b).
Applying a 20% shareholding test without checking voting power or beneficial ownership.
Checking relationships only at year-end instead of throughout the previous year.
Ignoring relatives of directors, partners or members where the statute expressly covers them.
Assuming every Clause 23 payment is automatically disallowable.
Reporting only cash payments—Clause 23 is about payments to specified persons, not a cash-payment threshold.
Frequently Asked Questions
Is a director automatically a specified person under Section 40A(2)(b)?
For a company assessee, a director is within the specified-person list. A separate 20% test is not required merely to bring that director into the direct director category.
What is substantial interest under Section 40A(2)(b)?
Broadly, it is beneficial ownership of shares carrying at least 20% voting power where the relevant concern is a company, or beneficial entitlement to at least 20% of profits in another business or profession, at any time during the previous year.
Are relatives covered?
Yes, in the relationship chains specifically listed in Section 40A(2)(b). “Relative” for the Act includes spouse, brother, sister, lineal ascendant and lineal descendant.
Should every related-party payment be disallowed?
No. Reporting and disallowance are separate. Section 40A(2)(a) targets only the excessive or unreasonable portion after applying its statutory tests.
Where does this appear in the tax audit report?
Payments to Section 40A(2)(b) specified persons are addressed in Clause 23 of Form 3CD. For the surrounding disclosures, see PGT’s Form 3CD clause-wise guide and Tax Audit AY 2026-27 forms and deadline guide.
Practical Takeaway
The safest approach is to build the Section 40A(2)(b) specified-person register before extracting Clause 23 transactions. The 20% substantial-interest test, relatives, beneficial ownership and changes during the year should all be documented. Once the population is complete, the tax auditor can reconcile payments and separately evaluate whether any pricing issue under Section 40A(2)(a) requires attention.
PGT & Associates assists businesses with tax-audit reconciliations, Form 3CD documentation and related-party compliance. The appropriate tax treatment depends on the facts, relationship chain and supporting records of each case.
Authoritative References
Income Tax Department — Section 40A of the Income-tax Act, 1961.
Income Tax Department — Items reportable in the Tax Audit Report (Clause 23 reporting fields).
ICAI — Guidance Note on Tax Audit under Section 44AB (Clause 23 guidance).
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