Clause 23 of Form 3CD is a pivotal disclosure requirement under the Income Tax Act, 1961, applicable during a tax audit. It pertains to reporting of actual payments made to persons or entities covered under section 40A(2)(b) of the Act. The clause ensures transparency in transactions involving related parties and acts as a key tool for preventing tax evasion through inflated payments.
Scope and Applicability of Clause 23
Clause 23 is applicable to all taxpayers undergoing a tax audit under section 44AB of the Income Tax Act. The clause requires the auditor to disclose only the actual payments made to persons specified in section 40A(2)(b) during the financial year. It does not cover unpaid dues or mere book entries, thus narrowing the scope of what is reported.
Section 40A(2)(b) outlines who qualifies as a related party, including directors, partners, substantial shareholders, and their relatives. If a payment has been made to any of these individuals or entities, it must be disclosed under Clause 23.
Identifying Related Persons under Section 40A(2)(b)
The term related persons includes a wide range of individuals and entities who are presumed to have significant influence over the assessee’s business. These include:
- Directors of a company
- Partners in a firm
- Relatives of such directors or partners
- Individuals or entities with substantial interest in the business
- Any entity in which such individuals hold significant ownership or interest
A substantial interest is defined as holding at least 20 percent of equity shares or being entitled to 20 percent of profits in the business. It’s essential to thoroughly review shareholding and profit-sharing arrangements to ensure accurate identification.
Types of Payments Covered
Only actual payments made during the relevant financial year are required to be reported. These payments can be for goods, services, rent, salaries, commissions, consultancy fees, and other such business expenditures. If the amount is recorded in the books but has not been paid during the year, it falls outside the reporting requirement of Clause 23.
This distinction helps the tax department focus on actual cash outflows that may indicate potential shifting of profits or tax planning measures involving related parties. Reporting only real payments ensures that the data remains relevant and actionable.
What the Auditor Needs to Report
Under Clause 23, the auditor must report the following details:
- Name and address of the related party
- Permanent Account Number (PAN) of the related party
- Nature of relationship as per section 40A(2)(b)
- Amount of payment actually made during the year
- Nature of transaction
These disclosures form a part of the larger tax audit report and help the Assessing Officer in identifying payments that may warrant closer scrutiny.
Exclusions from Reporting
Certain transactions do not need to be reported under Clause 23:
- Payments that have been merely accrued but not paid
- Transactions that do not involve persons listed under section 40A(2)(b)
- Transactions not in the nature of revenue expenditure
- Capital expenditures unless later reclassified as revenue by the Assessing Officer
This clause focuses only on payments that can potentially influence taxable income due to the nature of relationship between the payer and the payee.
Auditor’s Responsibilities and Limitations
The auditor’s responsibility under Clause 23 is limited to factual reporting. The auditor is not required to assess the reasonableness or commercial justification of the payments. This role rests solely with the Assessing Officer, who may disallow payments deemed to be excessive under section 40A(2)(a).
While the auditor need not opine on whether a transaction is excessive, they must still apply professional judgment in ensuring the completeness and accuracy of the data provided. Any omissions or misclassifications can mislead the Assessing Officer and expose the auditor to compliance risks.
Importance of PAN Disclosure
PAN disclosure is a mandatory part of reporting under Clause 23. It enables the tax authorities to cross-check the reported transaction with the returns filed by the related party. Inaccurate or missing PAN details can trigger notices or even assessment proceedings.
Maintaining accurate records and verifying PAN details before submission helps reduce the likelihood of errors and ensures a smoother audit process. Businesses should make it a part of their internal financial controls to verify PANs at the time of onboarding vendors or service providers who are related parties.
Maintaining Adequate Documentation
Proper documentation is key for supporting the disclosures made under Clause 23. This includes:
- Invoices
- Payment vouchers
- Contracts or agreements
- Board resolutions, if applicable
- Ledger extracts
These records serve as evidence in case of scrutiny and should be readily available to the auditor. Inadequate documentation can lead to audit qualifications and even penalties.
Internal Controls for Compliance
To ensure compliance with Clause 23, businesses should:
- Periodically review all related party relationships
- Maintain an updated register of related parties
- Set up internal controls to track payments made to such persons
- Implement a system for verifying PAN details and payment records
These practices not only ease the audit process but also reduce the chances of accidental non-disclosure.
Common Mistakes to Avoid
There are several recurring issues businesses and auditors encounter with Clause 23:
- Reporting unpaid amounts as payments
- Missing out on identifying all related parties
- Providing incomplete PAN details
- Incorrect classification of payments
Such errors can compromise the integrity of the tax audit report and may lead to further investigation by tax authorities. Ensuring robust internal processes helps in avoiding these pitfalls.
Role of Assessing Officer
Once the auditor has reported the payments, the Assessing Officer examines them to determine whether they are excessive or unreasonable. If any part of the payment does not reflect fair market value or lacks commercial justification, it can be disallowed under section 40A(2)(a).
The Assessing Officer may use various metrics, including industry benchmarks and prior year data, to evaluate reasonableness. The auditor’s report under Clause 23 acts as a starting point for this assessment.
Ethical Considerations for Auditors
While auditors are not required to provide an opinion on the commercial rationale, they must act diligently. If a payment appears significantly out of line with industry norms, the auditor should inquire further or document the rationale provided by management.
Maintaining audit working papers that capture the thought process and basis of disclosures helps protect the auditor in case of later disputes.
Legal Implications of Non-compliance
Non-compliance with Clause 23 can lead to legal consequences. Penalties may be levied under section 271B for failure to file a correct audit report or under section 271J for furnishing incorrect information. Businesses can also face prolonged scrutiny and disallowance of expenses.
Ensuring accurate and complete disclosures helps avoid litigation and preserves the credibility of the tax audit report.
Introduction to the Checklist Approach
A structured checklist offers both tax auditors and businesses a practical way to ensure compliance with Clause 23 of Form 3CD. It provides clarity, minimizes oversight, and ensures that reporting obligations are fulfilled in alignment with statutory expectations. The checklist serves as a roadmap to identify, verify, and report payments made to persons covered under section 40A(2)(b) of the Income Tax Act.
Step 1: Compilation of Related Party Master List
The first and most critical step is identifying all related persons and entities under section 40A(2)(b). This master list forms the base for further analysis and must include:
- Full names of individuals and entities
- PAN details
- Nature of the relationship
- Ownership percentages, if applicable
- Entity type (individual, partnership, company, etc.)
This list should be updated annually, and cross-verified with shareholder registers, partnership deeds, and other legal documents.
Step 2: Extracting Payment Data from the Ledger
Once the master list of related parties is established, the next task is to extract payment information from the accounting ledgers. This includes:
- Vendor ledgers
- Expense accounts
- Journal entries and payment vouchers
- Bank transaction reports
Only payments that have been made during the relevant financial year should be included. This step filters out book entries or accrued liabilities.
Step 3: Filtering Transactions for Reporting
After extracting all payment data, identify those that qualify for Clause 23 reporting. Apply the following filters:
- Payments made to individuals/entities in the related party list
- Payments falling under revenue expenditure
- Payments supported by verifiable documents
This step ensures only relevant transactions move forward for disclosure.
Step 4: Verification of PAN and Documentation
Each payment selected for reporting must be supported by:
- Correct and valid PAN of the related party
- Supporting documents such as invoices, bills, and contracts
- Proof of payment such as bank advice or payment vouchers
Ensure consistency between books of accounts and documentary evidence to avoid any future discrepancy.
Step 5: Preparation of Reporting Format
Now, prepare the reporting format as per Form 3CD requirements. The following fields must be accurately populated:
- Name and address of the payee
- PAN of the payee
- Nature of relationship
- Amount paid
- Nature of transaction
Use accounting software or audit tools to automate data population where possible. Manual entries increase the chance of typographical errors.
Step 6: Internal Review and Reconciliation
Before finalizing the report, conduct an internal review of the data:
- Cross-verify total payments with trial balance and ledger reports
- Reconcile PAN details with the income tax database
- Match disclosures with previous years’ reports to detect unusual trends or omissions
This stage also allows for fixing errors and addressing any pending clarifications with the client.
Step 7: Client Confirmation and Sign-off
Present the draft Clause 23 disclosures to the management for review and confirmation. Obtain written acknowledgements to:
- Confirm that the payments were indeed made
- Validate that the disclosed relationships are accurate
- Certify that all necessary supporting documents are available
Documenting client sign-off adds a layer of responsibility and audit trail.
Step 8: Integration into Tax Audit Report
After client confirmation, incorporate the disclosures into the final Form 3CD submission. Ensure:
- Consistency across all clauses in Form 3CD
- Matching totals between financial statements and audit report
- Accurate annexures and digital formats, if applicable
Include working papers and backup schedules in your audit file to defend your reporting in case of future scrutiny.
Step 9: Final Compliance Review
Conduct a final checklist review before submission:
- Have all related parties been identified?
- Are the PAN and relationship fields filled in for every entry?
- Have only actual payments been included?
- Are the disclosures aligned with ledger balances and financials?
This final check acts as a safeguard against errors and omissions that could have compliance consequences.
Step 10: Post-Audit Documentation and Retention
After submission of the audit report, retain copies of:
- All working papers
- Communication with the client
- Payment proofs and invoices
- Ledger extracts and reconciliations
These records should be stored securely for at least eight years and may be needed during assessments or litigation.
Introduction to Practical Scenarios
Having explored the scope and audit checklist for Clause 23, the next phase involves examining how businesses and professionals apply these requirements in actual scenarios. This part highlights best practices, industry observations, and commonly encountered complexities. It offers actionable insights that help align compliance efforts with audit expectations and regulatory standards.
Best Practice 1: Creating a Year-Round Monitoring Mechanism
One key practice that simplifies Clause 23 compliance is maintaining a live register of related party transactions. Instead of collecting data at year-end, businesses can monitor and record payments to specified persons throughout the financial year.
This includes:
- Monthly reconciliation of payments made to related parties
- Tracking PAN validation status
- Linking each transaction with supporting invoices and documentation
A real-time tracking system helps avoid last-minute rush, omissions, or discrepancies when the tax audit season arrives.
Best Practice 2: Integrating Clause 23 Requirements into ERP Systems
Many businesses operate ERP systems that can be customized to tag related parties and flag any transactions with them. Integrating Clause 23-specific fields into the vendor master, invoice processing, and payment approval workflows can create a built-in alert mechanism.
This system should ideally support:
- Automatic identification of related parties based on master data
- PAN validation at the time of vendor creation
- Generation of Clause 23 payment reports on demand
Such technology integration reduces human error and enhances audit readiness.
Best Practice 3: Periodic Internal Audits and Cross-functional Reviews
Conducting periodic internal audits focusing on related party transactions helps ensure early detection of issues. Involving finance, compliance, and legal teams in reviewing payments to specified persons strengthens internal controls.
A structured internal audit process might include:
- Quarterly review of transactions flagged as related party payments
- Cross-functional meetings to assess reasonableness and documentation
- Updating the related party register with changes in shareholding or management
These reviews foster a culture of accountability and ensure that the final disclosures are accurate and defensible.
Practical Challenge: Determining the Nature of Transactions
In real-world situations, transactions are not always straightforward. For instance, payments might be routed through intermediaries, or the nature of a transaction may change over time. Identifying whether a particular payment falls under Clause 23 requires judgment.
Considerations include:
- Whether the payee is listed in the related party register
- The extent to which the related party influences the transaction
- Whether the transaction value has been negotiated at arm’s length
To resolve ambiguity, businesses should retain correspondence, agreements, and negotiation history that can demonstrate intent and control.
Real-World Example: Payments to Directors for Consultancy
In some cases, directors or their relatives may provide consultancy services to the business outside of their board duties. Payments for such services must be disclosed under Clause 23 if the individual qualifies under section 40A(2)(b).
To ensure proper reporting:
- Clearly segregate director fees and consultancy fees
- Ensure consultancy agreements are in writing
- Maintain evidence of service delivery
- Confirm PAN and relationship details match those disclosed under other tax filings
Failure to do so may result in inconsistent disclosures and possible audit objections.
Real-World Example: Rent Paid to Partners or Relatives
Many businesses operate from premises owned by partners or relatives of key persons. If rent is paid to these individuals, such payments are reportable under Clause 23.
Steps to manage this correctly include:
- Formal lease agreements
- PAN verification
- Reasonableness test by comparing with market rent
Though the auditor is not required to conduct the reasonableness test, it helps if management maintains documentation to justify the payment.
Observation: Growing Scrutiny from Tax Authorities
In recent years, authorities have intensified scrutiny of related party payments. Disclosures under Clause 23 often trigger further questions, particularly if there are large or unusual payments.
Auditors and businesses should be prepared to explain:
- Commercial justification for the payment
- Selection of the related party vendor or consultant
- Absence of similar services in the open market
These insights guide the assessing officer in evaluating whether the payments should be allowed or partially disallowed.
Practical Tip: Use Past Years as a Benchmark
Historical disclosures can be valuable references when preparing current year reports. Consistency in reporting helps establish credibility.
Auditors should:
- Compare current year disclosures with prior year filings
- Investigate any sharp increase or drop in related party payments
- Document reasons for variances
This proactive approach minimizes surprises and fosters transparent communication with tax authorities.
The continuation of this part will offer more case studies, additional audit documentation practices, and strategies for dealing with post-audit queries raised by the assessing officer under Clause 23.
Understanding the Boundaries of Auditor’s Responsibility
Clause 23 of Form 3CD serves a narrow but critical function—reporting actual payments to related persons defined under section 40A(2)(b). While the scope is limited, tax auditors often face gray areas in practice, especially when client records are unclear or relationships are not disclosed up front. The auditor’s primary obligation is to report factual data and not make judgments on reasonableness, but proper due diligence remains essential.
Challenges in Identifying Related Parties
One of the foremost difficulties in complying with Clause 23 is accurately identifying all related parties within the definition of section 40A(2)(b). This section covers a broad range of relationships, including:
- Relatives of the assessee (individual)
- Directors or partners in firms and companies
- Persons with substantial interest in the business
- Entities where such persons also hold a significant role
Businesses may not maintain a comprehensive or updated register of such relationships, leading to incomplete disclosures. In many closely held companies or family-run enterprises, inter-entity transactions and payments to relatives are common, but the extent of such relationships is often not well documented.
Importance of Management Representations
To bridge the information gap, it is prudent for auditors to obtain a signed management representation letter that clearly lists all parties falling under section 40A(2)(b). While this does not absolve the auditor from professional skepticism, it ensures that the management confirms and takes ownership of disclosures.
However, reliance on management representations should be supplemented with independent checks. For example, a review of company minutes, shareholding registers, or organizational charts may reveal additional related parties not listed initially.
Reporting Only Actual Payments
A recurring issue arises when clients provide details of debits in the profit and loss account, but actual payments have not yet been made. Since Clause 23 requires reporting of payments actually made during the financial year, auditors should filter out accrual entries and confirm payments through bank statements or cash books.
Care must also be taken when payments are made in kind or adjusted through journal entries. If the journal entry reflects actual settlement (such as offsetting liabilities), such cases may qualify as payments. Still, auditors must apply caution and document the rationale for including or excluding such entries.
Handling Multi-Year or Installment-Based Payments
Payments to related parties may be staggered across multiple financial years. For example, a lump-sum contract awarded to a related entity may be settled in quarterly or monthly installments. In such cases, only the actual amount paid in the relevant previous year should be reported under Clause 23.
This requires reconciling contract or service agreements with the books of accounts and payment schedules. Misreporting the total contract value instead of the year-specific payment amount can lead to incorrect disclosures and potential scrutiny.
Interplay with Other Clauses of Form 3CD
Clause 23 does not operate in isolation. It often intersects with other clauses in Form 3CD, such as:
- Clause 18: Reporting of depreciation, where asset purchases from related parties might be involved.
- Clause 21: Disallowable expenses under various sections, including 40A(2).
- Clause 31: Details of loans and advances, which may also include transactions with related parties.
Auditors must ensure consistency across these clauses. For example, a payment reported under Clause 23 to a related party should not conflict with disclosures made under Clause 31, especially if the payment also involves loan settlements.
Common Mistakes to Avoid
Several errors commonly arise during the reporting process, including:
- Reporting Outstanding Balances: Including amounts that are due but unpaid defeats the objective of Clause 23, which is focused on actual payments.
- Ignoring Non-Cash Payments: Assuming only cash or bank payments are relevant, while actual payments can also include set-offs and settlements.
- Overlooking Silent Relationships: Failing to include distant or indirect relationships that still fall under section 40A(2)(b).
- Duplicating Entries: Reporting the same transaction under multiple heads without reconciling totals.
Each of these errors can potentially mislead the Assessing Officer or raise unnecessary red flags during scrutiny assessments.
Impact of Incomplete or Incorrect Reporting
Incomplete or inaccurate reporting under Clause 23 can lead to the disallowance of expenses under section 40A(2)(a) by the Assessing Officer. While the auditor is not required to comment on excessiveness, the mere act of disclosure enables the AO to initiate an inquiry.
Moreover, inaccurate reporting can affect the credibility of the tax audit report and lead to professional liability risks for the auditor. In egregious cases, penalties may be levied on the assessee under section 271J or 271B for false or incorrect information.
Best Practices for Tax Auditors
To maintain compliance and minimize audit risks, the following best practices are recommended:
- Maintain a Standard Checklist: Include relationship mapping, payment verification, and document referencing as part of the Clause 23 audit checklist.
- Use Analytical Procedures: Compare related party payments year-on-year and assess significant variances.
- Document Judgments Clearly: Where ambiguity exists, such as with journal-based payments, the rationale for inclusion or exclusion should be documented in the working papers.
- Cross-Check with Financial Disclosures: Review board reports and notes to accounts in audited financial statements for disclosures of related party transactions.
- Seek Clarifications Early: Don’t wait until the final stages of audit to verify related parties. Early engagement with management reduces the risk of last-minute surprises.
Examples Illustrating Reporting Requirements
To better understand Clause 23 disclosures, consider the following examples:
Example 1: Payment to Director’s Spouse
A company makes a consultancy payment of INR 10 lakhs to the spouse of a director. The payment was credited to her account and cleared via bank transfer during the financial year. Since the spouse qualifies as a related person under section 40A(2)(b), and actual payment has been made, the auditor must report this under Clause 23.
Example 2: Payment Debited but Not Paid
A company records a professional fee of INR 5 lakhs to a firm where a director has substantial interest, but the payment is not made during the year. No disclosure is required under Clause 23, even though the expense is booked, since no payment occurred.
Example 3: Offset Entry for Loan Adjustment
A director owed INR 2 lakhs to the company as a loan, and the company adjusted this against consultancy fees payable to him. If the offset was final and no further payment is pending, the auditor may consider this a payment. However, appropriate supporting documents and authorizations should be reviewed and retained.
Maintaining Audit Trail and Documentation
As with any aspect of audit reporting, proper documentation is critical for Clause 23. Each reported payment should be backed by:
- Invoice or agreement
- Mode and date of payment
- Identification of the related party and relationship confirmation
- Verification of PAN
- Payment vouchers or bank statements
The audit file should also include a reconciliation of payments declared under Clause 23 with general ledger accounts and payment summaries. This not only aids in transparency but also helps defend the audit report in case of any inquiry.
Role of Technology in Clause 23 Compliance
Technology tools can assist auditors in managing the complexity of related party disclosures. For example, audit software with entity mapping features can flag potential related parties based on shareholding or director information.
Similarly, integrated accounting systems that allow tagging of related party transactions help in automated extraction of payment data. These solutions reduce manual errors and improve efficiency, especially for large firms with multiple inter-entity dealings.
Evolving Judicial Interpretations
Though the auditor is not responsible for determining the reasonableness of payments, judicial precedents have highlighted the importance of maintaining substance over form in related party dealings. Cases where artificial structuring of transactions to divert income or inflate expenses through related parties have faced strict judicial scrutiny.
While these rulings are primarily of interest to the assessing authorities, auditors must be aware of their implications. Suspicious or unusually structured payments, even if technically compliant, should be reported clearly and flagged internally for consideration.
Conclusion
Understanding and accurately reporting payments to specified persons under section 40A(2)(b) is a crucial aspect of tax audit compliance. Clause 23 of Form 3CD plays a pivotal role in ensuring transparency in transactions with related parties, helping the tax authorities identify potentially excessive or unreasonable expenditures. While the auditor’s responsibility is limited to factual reporting without making judgments on the reasonableness of the payments, the accuracy and completeness of these disclosures are essential for effective scrutiny by the Assessing Officer.
Throughout this series, we examined the underlying legislative intent, key definitions, reporting framework, and procedural steps involved in meeting the compliance requirements of Clause 23. We also explored the challenges, case laws, and practical considerations that auditors and businesses must navigate to avoid errors and omissions. Moreover, the detailed checklist and documentation approach presented offers a practical roadmap for executing this clause with due diligence.
As regulatory focus on related-party transactions continues to intensify, maintaining robust internal controls, timely reconciliations, and clear documentation becomes indispensable. Ensuring proper classification and transparent disclosures not only supports audit integrity but also builds credibility with tax authorities. Ultimately, aligning audit practices with statutory expectations under Clause 23 is not just a compliance exercise, but a step toward fostering greater financial accountability within the business ecosystem.