As a freelancer, when you take the first few steps towards financial independence and setting up your own work – it is common for family to help you get started. This help may be in the form of giving you a place on rent, providing a service and charging less or more or not at all or any other form of assistance.
Let’s find out how these expenses are treated for Income Tax.
The Income Tax allows us to deduct reasonable and justifiable expenses from our Income. However, when the payment for some expenses are made to relatives or persons who have substantial interest in your business or profession, such expenses may not be allowed to be deducted if they seem excessive or unreasonable.
A relative has been defined in section 2(41) of the Income Tax Act – A relative can be spouse, brother or sister or any lineal ascendant or descendant.
A person with a substantial interest means a person who has at least 20% of the equity or if such person is entitled to 20% profits.
Suppose Rohit, a freelance designer takes premises which are owned by his married sister for carrying on freelancing work. Rent is an expense which is allowed to be deducted from the freelancing income of Rohit. Since the premises are owned by Rohit’s sister he decides to divert some of his income to his sister by paying her higher than a reasonable market rent for such premises. Rohit wants to claim the rent payment as a business expense and reduce his overall income –the recipient, his sister, who has no other income, ends up paying only a 10% tax on the rental income. The Assessing Officer may not allow a rent payment which is not in line with fair market value of the premises and where the recipient is a relative.
Therefore, expenses for which payment has been made to a relative or a person with substantial interest shall be disallowed when –
- These expenses are incurred for goods, services or facilities.
- Payment has been made to a relative or a person with substantial interest as defined above.
- Such expenses are excessive or unreasonable. They are not in line with fair market value. Or they may not be a legitimate need of your business & profession. Or when you have incurred these expenses and they result in a benefit to you. Do note that an Assessing Officer can disallow expenses when they are not in sync with the needs of your business, even though these may have been paid as per the market value.
Here are some examples of transaction which may be under a scanner from the Income Tax –
|To a relative||Mr. A purchases goods from his brother.|
|Relative of a director||X, Y and Z are directors in ABC Ltd. ABC ltd hires Mrs. X and ABC Ltd makes her a payment.|
|Company in which Relative has a substantial interest||Mrs. A holds 20% equity in K Ltd and A purchases from K Ltd.|
Do note that the AO may disallow the entire expense or a portion which is considered excessive may be disallowed. Be careful while setting up your freelancing work and arranging for facilities and goods so that these expenses are allowed to be deducted from your freelancing income and they help you save tax.
Reach out to usif you have any questions!