The fundamental principle under the GST regime, derived from the concept of value-added taxation, is that input tax credit is allowed only when tax is payable on outward supplies. When a registered person is engaged in both taxable and exempt supplies, only the proportionate input tax credit related to taxable supplies is eligible for credit.
This principle applies equally to input goods, input services, and capital goods. The statutory basis for this provision is laid out in section 17 of the CGST Act.
According to section 17(1), when inputs or services are used partly for business purposes and partly for non-business purposes, the input tax credit shall be limited to the portion used for business.
Further, section 17(2) states that if goods or services are used partly for effecting taxable supplies, including zero-rated supplies, and partly for exempt supplies, the credit must be proportionately attributed to taxable and zero-rated supplies.
Section 17(6) empowers the Central or State Government to prescribe, by notification, how the proportionate input tax credit is to be determined.
These provisions are conceptually similar to the apportionment mechanism under Rule 6 of the erstwhile Cenvat Credit Rules.
Definition of Taxable Supply and Non-Taxable Supply
Taxable supply refers to any supply of goods or services or both that is liable to tax under the CGST Act. In contrast, a non-taxable supply refers to a supply that is not leviable to tax under either the CGST Act or the IGST Act.
For example, the supply of alcoholic liquor for human consumption is not taxable under GST. Therefore, it is categorized as a non-taxable supply and is consequently treated as an exempt supply for input tax credit purposes.
In the case of a restaurant supplying both food and alcoholic beverages, a proportionate reversal of input tax credit is required due to the dual nature of the supply. This view has been affirmed in rulings where restaurant service providers supplying liquor were directed to reverse proportionate ITC.
Concept of Zero-Rated Supply
Zero-rated supply is defined in section 2(23) of the IGST Act. According to section 16(1) of the IGST Act, zero-rated supplies include the export of goods or services or both, and supplies to SEZ units or developers.
Even if such supplies are exempt, section 16(2) of the IGST Act allows credit of input tax for making zero-rated supplies. A registered person making zero-rated supplies can claim a refund through two options. They can either supply under a bond or Letter of Undertaking without payment of IGST and claim a refund of unutilized ITC, or supply on payment of IGST and claim a refund of the tax paid. The refund process is governed by section 54 of the CGST Act.
Calculation of the Value of Exempt Supply
Exempt supply includes supplies attracting a nil rate of tax, wholly exempt supplies under section 11 of the CGST Act or section 6 of the IGST Act, and non-taxable supplies. It is clarified that exempt supply should not include activities listed in Schedule III of the CGST Act except as specifically provided in section 17(3).
Section 17(3) includes the following items in the value of exempt supply for reversal of input tax credit. Supplies where tax is payable on a reverse charge basis, transactions in securities, sale of land, and sale of completed buildings are to be included.
The value of land and building is to be taken as per the stamp duty valuation, and the value of securities is taken as one percent of the sale value of such securities.
Basis of Apportionment for ITC in Real Estate Services
Section 17(3) generally envisages that the apportionment of input tax credit between taxable and exempt supplies should be based on value. However, for real estate services, especially those provided after April 1, 2019, the apportionment is based on the area of construction. This distinction was introduced through a Removal of Difficulties Order to ensure fair computation of eligible ITC in real estate projects.
Exclusion of Schedule III Activities from Exempt Supply
Activities and transactions under Schedule III are not deemed to be supplies of goods or services. Therefore, they are excluded from the calculation of exempt supplies for ITC reversal. The only exceptions are those mentioned in paragraph 5 and specified activities under paragraph 8(a) of Schedule III.
Paragraph 5 pertains to the sale of land or completed buildings. Paragraph 8(a) refers to the supply of warehoused goods to any person before clearance for home consumption. Effective from October 1, 2023, supplies from duty-free shops at arrival terminals to incoming passengers are included in the value of exempt supply under these provisions.
Inclusion of Supply from Duty-Free Shops as Exempt Supply
From October 1, 2023, the value of goods supplied from duty-free shops at arrival terminals is to be included in the value of exempt supplies. This inclusion affects the reversal of ITC under rules 42 and 43 of the CGST Rules.
Treatment of Electricity and Interest for ITC Reversal
Electricity is classified as an exempt supply. However, interest income from loans and deposits is not considered exempt fromm ITC reversal under rules 42 and 43. Interest is excluded from the computation of exempt supplies except when provided by banking companies or financial institutions.
This clarification was introduced with retrospective applicability from July 1, 2017. Therefore, taxpayers are not required to reverse ITC on account of interest income except in the specific cases mentioned.
Supply of Services to Nepal and Bhutan
Initially, services supplied to Nepal and Bhutan were treated as exempt supplies when payment was received in Indian currency. However, after February 1, 2019, services supplied to Nepal and Bhutan qualify as exports even when payment is received in Indian Rupees, provided the RBI allows such a transaction. Hence, they are now considered zero-rated supplies and no longer classified as exempt for ITC reversal purposes.
Inclusion of Outward Freight in Exempt Supply
Outward freight from India to locations outside India was excluded from exempt supply until September 30, 2023. From October 1, 2023, it is to be included in the value of exempt supply for ITC reversal.
Duty Credit Scrips Not to Be Included in Exempt Supply
Supplies involving duty credit scrips are not to be treated as exempt supplies for the purpose of rules 42 and 43. This position was confirmed in relevant rulings and ensures that no ITC reversal is required on account of such supplies.
Special Provisions for Banks, Financial Institutions, and NBFCs
Under section 17(4) of the CGST Act, a banking company or financial institution, including NBFCs, has the option to either comply with section 17(2) or avail fifty percent of the eligible input tax credit on inputs, capital goods, and input services. This option, once exercised, cannot be withdrawn during the financial year.
The fifty percent restriction does not apply to supplies made between branches of the same entity having the same PAN. This enables internal supplies between different states to be fully creditable without reversal.
For such entities, the fixed percentage ITC scheme is simpler and often more practical than proportionate reversal based on actual usage.
Eligibility of Co-operative Societies
Co-operative societies engaged in deposit-taking and lending activities are treated as financial institutions under the RBI Act. Therefore, they are also eligible to opt for the fifty percent ITC mechanism under section 17(4). In such cases, only fifty percent of the eligible ITC is claimed each month, and the rest lapses.
Reversal of Input Tax Credit in Special Circumstances
The Input Tax Credit mechanism under the Goods and Services Tax framework allows for seamless credit across the supply chain. However, under certain situations, the ITC already availed needs to be reversed. The law prescribes specific scenarios and conditions in which ITC reversal is mandatory. These include non-payment to suppliers within the prescribed time, use of inputs or capital goods for exempted or non-business purposes, cancellation of registration, and others. In such cases, the amount of ITC availed earlier must be reversed along with applicable interest.
One common scenario is when the recipient fails to make payment to the supplier within 180 days from the date of the invoice. As per GST rules, if payment is not made within the stipulated period, the ITC claimed must be reversed proportionately. Once the payment is eventually made, the taxpayer can re-avail the reversed credit. This requirement enforces compliance and ensures timely payments across the supply chain.
Another major ground for ITC reversal arises when the goods or services are used for both taxable and exempted supplies. Rule 42 and Rule 43 of the CGST Rules provide the method for such apportionment and reversal. These rules apply when inputs and input services are commonly used for both taxable and exempt supplies or business and non-business purposes. The taxpayer is required to compute the eligible credit and reverse the portion attributable to exempt or non-business usage. The reversal computation must be carried out monthly and adjusted at the end of the financial year.
Where capital goods are used for both taxable and exempt supplies, Rule 43 outlines the methodology to be followed for proportionate credit reversal over a period of five years. The total ITC availed on capital goods is divided equally over the useful life, and reversal is made accordingly if used for exempt purposes.
Another situation warranting reversal is the cancellation of registration. When a registered person’s GST registration is cancelled, all unutilised ITC lying in the electronic credit ledger must be reversed. If the taxpayer continues to hold stock and capital goods on which ITC has been availed, reversal is required based on the prevailing market value.
In cases where goods or services become wholly exempt, the taxpayer must reverse ITC related to the stock and inputs as of the date the exemption is notified. Similarly, if a person opts to pay tax under the composition scheme or switches from regular to exempt supply, ITC reversal is necessary.
Incorrect or excessive availment of ITC must also be reversed voluntarily or on detection by authorities. The GST portal allows for such reversals through GSTR-3B returns, and interest is payable on such excess credit from the date of availment until the date of reversal.
Timely and accurate ITC reversal is critical to avoid penalties and maintain GST compliance. Taxpayers must monitor their transactions regularly and apply the reversal provisions where applicable.
Input Tax Credit on Capital Goods
Capital goods under the GST framework refer to goods used in the course or furtherance of business and whose benefit extends over multiple tax periods. The GST law allows Input Tax Credit on capital goods if they are used for making taxable supplies. However, the rules for availing and utilising ITC on capital goods are more specific compared to inputs and input services.
The conditions for claiming ITC on capital goods are largely similar to those applicable for inputs and input services. The taxpayer must possess a valid tax invoice or document, have received the capital goods, and the tax charged must have been paid to the government. In case of construction of immovable property, ITC on capital goods used for such purpose is not available if the constructed property is not intended for further supply.
ITC on capital goods cannot be claimed if depreciation under the Income Tax Act is claimed on the GST component. If a taxpayer includes the GST portion in the cost of the capital asset while computing depreciation, ITC is not allowed. Therefore, businesses must carefully plan their accounting treatment of capital goods to ensure eligibility for ITC.
When capital goods are used for both taxable and exempted supplies or for business and non-business purposes, the ITC must be apportioned by Rule 43 of the CGST Rules. The ITC is spread evenly over the useful life of five years, and reversal is made proportionately for exempt usage.
For example, if a business purchases a machine worth a certain amount with GST, and it is used 40 percent for exempt supplies, then ITC for the exempt portion must be reversed over 60 months. The reversal must be done monthly and a final adjustment made at the end of the financial year.
If capital goods are sold or disposed of before completing their useful life, ITC reversal must be made. The reversal is calculated by reducing five percent of the input tax per quarter or part thereof for the period from the date of invoice to the date of sale or disposal. The remaining credit must be reversed, and output tax liability arises on such sale.
When capital goods are lost, destroyed, or stolen, and there is no further use for taxable supplies, ITC must be reversed. Even if goods are scrapped or obsolete and no output tax is payable, the ITC claimed earlier must be reversed.
Capital goods used exclusively for exempted supplies, personal use, or non-business activities are not eligible for ITC. If such goods are subsequently used for taxable supplies, ITC can be availed prospectively.
Capital goods purchased under the composition scheme are not eligible for ITC. If a taxpayer migrates from composition to the regular scheme, ITC on capital goods held in stock can be availed,, subject to specific conditions and limitations.
Capital goods play a significant role in manufacturing and service industries. Accurate tracking, documentation, and classification are essential to claim and retain ITC under the GST law.
Input Tax Credit in Case of Job Work
Job work is a vital part of many industrial processes, where inputs or capital goods are sent to another person for further processing. The GST law permits the principal to send goods to a job worker without payment of tax, and still be eligible to claim ITC on such goods. This provision enables businesses to maintain liquidity and continue availing credits while leveraging job work arrangements.
ITC can be claimed by the principal on inputs or capital goods sent to a job worker directly or from the principal’s place of business. The ownership of goods remains with the principal, and the job worker only carries out the specified process. The principal can avail of ITC on inputs or capital goods sent to the job worker, provided they are received back within the stipulated time.
As per GST provisions, inputs must be received back within one year and capital goods within three years from the date of dispatch. If the goods are not received back within the specified period, they are deemed to have been supplied by the principal to the job worker. This triggers liability to pay GST along with applicable interest. The ITC on such goods is reversed if tax is not paid on the deemed supply.
The job worker must maintain proper records of the goods received and returned, and the principal must ensure that Form ITC-04 is filed periodically to report the movement of goods. This form is crucial for tracking and validating the ITC claim on goods sent for job work.
If the job worker further processes or assembles the goods and supplies them directly from their premises, the principal must declare the job worker’s premises as an additional place of business unless the job worker is a registered person. This compliance is necessary to support the ITC claim and to avoid classification of the transaction as an unreported supply.
Waste and scrap generated during job work can be sold by the job worker if they are registered, and applicable tax must be paid. If the job worker is unregistered, the principal is liable to pay tax on such scrap. Proper documentation and invoice management are essential to substantiate ITC claims and to comply with audit requirements.
The job work provisions under GST aim to ensure an uninterrupted flow of credit and avoid cascading tax effects in outsourced manufacturing and service processes. Businesses must maintain strict control over timelines and documentation to avoid ITC reversal and potential tax liabilities.
Input Tax Credit Under Reverse Charge Mechanism
The reverse charge mechanism shifts the responsibility to pay tax from the supplier to the recipient of goods or services. Under GST, certain categories of supplies are subject to reverse charge, where the recipient must discharge tax liability and is eligible to claim ITC on the same.
Goods and services notified under section 9(3) of the CGST Act, such as supply by a goods transport agency or legal services by advocates, are covered under reverse charge. Additionally, supplies from unregistered persons to registered persons under section 9(4) were also initially covered but were later restricted to notified classes of registered persons.
When a registered taxpayer receives a supply subject to reverse charge, they must raise a self-invoice and pay the tax under reverse charge through the electronic cash ledger. Once the tax is paid, the recipient is eligible to claim ITC on such payment, provided other conditions for availing ITC are met.
The recipient must ensure that the reverse charge tax is paid in the same month in which the ITC is claimed. ITC cannot be availed if tax is not paid to the government. Unlike normal supplies, ITC under reverse charge is not subject to the 180-day payment rule, as the tax is paid by the recipient directly.
ITC under reverse charge is also available on capital goods and input services, provided they are used for business purposes and for making taxable supplies. However, if the goods or services are used for exempt or non-business purposes, ITC must be reversed in proportion to such usage.
The taxpayer must report reverse charge liabilities and corresponding ITC in their monthly GSTR-3B return. Mismatches or delays in payment may attract interest and penalties and lead to the denial of ITC.
Ineligible Input Tax Credit and Reversal Scenarios
Input Tax Credit under GST is not available in certain circumstances as prescribed under Section 17(5) of the CGST Act, 2017. These include ITC on motor vehicles (with some exceptions), goods or services used for personal consumption, goods lost, stolen, destroyed, written off, or given as free samples, and more. The logic behind disallowing ITC in these cases is to ensure that only those credits that contribute to taxable outward supplies are allowed, preventing misuse and revenue leakage.
Apart from these permanently blocked credits, there are other scenarios where ITC once availed must be reversed later. For example, if payment is not made to the supplier within 180 days from the date of invoice, the ITC claimed earlier must be reversed along with interest. This ensures that ITC is claimed only on genuine transactions backed by actual payment. Similarly, in the case of goods or services used partly for business and partly for non-business purposes, or for making exempt supplies, ITC must be reversed proportionally.
There are also cases where credit reversal is mandatory due to specific events such as cancellation of GST registration, sale of capital goods, or changes like supply (e.g., taxable to exempt). These reversals must be reported in GSTR-3B and adjusted in the electronic credit ledger accordingly.
Rule 42 and Rule 43 of the CGST Rules
Rules 42 and 43 of the CGST Rules, 2017, provide detailed mechanisms for the reversal of input tax credit on inputs and input services (Rule 42) and capital goods (Rule 43), respectively. These rules are applicable when the registered person uses goods or services for both taxable and exempt supplies or both business and non-business purposes.
Under Rule 42, the reversal of ITC is calculated every month using a specific formula. It involves segregating inputs used exclusively for taxable supplies, exclusively for exempt supplies, and those used commonly. The common credit is then apportioned between taxable and exempt supplies based on turnover. The amount attributable to exempt supplies and non-business use is added to output tax liability.
Rule 43 deals with capital goods and follows a similar principle, but the ITC on capital goods is spread over 60 months (or 5 years). The proportionate credit to be reversed each month is determined based on the exempt turnover to total turnover ratio. In case of disposal of capital goods before the expiry of 5 years, further adjustments are required.
These rules require meticulous record-keeping and regular compliance, as any shortfall in reversal or incorrect computation can attract penalties and interest. Businesses need to automate or streamline their accounting systems to ensure accuracy in ITC apportionment and reversal.
ITC Reversal on Non-Payment to Suppliers
Section 16(2) of the CGST Act provides that a recipient can claim ITC only if the supplier has been paid the value of supply along with tax within 180 days from the date of invoice. Failure to make this payment requires the recipient to reverse the ITC claimed earlier. This reversal is to be made in the month in which the 180-day period expires. The amount reversed must be added to the output tax liability,, and interest is payable from the date of availing the credit till the date of reversal.
Once payment is made to the supplier, the recipient is allowed to reclaim the ITC. This provision ensures that credits are not indefinitely held without actual payment, promoting prompt settlements and financial discipline between suppliers and recipients.
In case of part-payment to the supplier, ITC reversal is to be done proportionately. This rule is often a compliance challenge, especially in industries with long credit cycles or where disputes delay payments. Accounting systems must be able to flag invoices nearing the 180-day deadline so that reversals can be made timely to avoid interest and penalties.
ITC Reversal in Case of Credit Notes and Discounts
When a supplier issues a credit note to the recipient due to a reduction in the value of supply or return of goods, the tax portion is also adjusted. In such cases, if ITC has already been claimed by the recipient, the corresponding ITC must be reversed. This ensures that the recipient does not continue to hold excess credit that is no longer justified by the revised taxable value.
This reversal should be made in the return for the month in which the credit note is declared. Often, businesses miss these adjustments, leading to excess ITC balances, which may later be disallowed during departmental audits.
Additionally, in cases where post-supply discounts are given but not pre-agreed in the original contract or not linked to specific invoices, no reduction in output tax is allowed. Consequently, the recipient cannot reverse the ITC or reduce tax liability on such discounts. These nuances require clear contractual terms and accurate documentation.
Reversal of ITC on Capital Goods in Case of Sale or Deregistration
When a registered person sells capital goods or plant and machinery on which ITC was availed, the person must pay the higher of the ITC availed, reduced by 5 percent per quarter,, or the tax on the transaction value of such goods. This ensures that the benefit of ITC is not availed indefinitely and the government recovers an appropriate portion if the asset is disposed of before completing its useful life.
Similarly, when a taxpayer cancels their GST registration, all unutilized ITC must be reversed. This applies to both capital goods and other inputs held in stock. The reversal amount is computed based on the prevailing market value of such goods, and if capital goods are involved, depreciation is considered before reversal.
This provision ensures closure of tax liability upon deregistration and prevents leakage of credit benefits. Businesses must make these calculations correctly and pay the liability along with the final return in Form GSTR-10.
Reversal of Input Tax Credit in Case of Non-payment to Supplier Within 180 Days
As per Rule 37 of the CGST Rules, if the recipient fails to make payment to the supplier for the value of supply along with the tax amount within 180 days from the date of issue of invoice, the ITC availed on such supply will be added to the output tax liability of the recipient. Interest is also required to be paid from the date of availing such credit till the date when the amount is added to output liability. Once the payment is made to the supplier, the recipient can avail of the ITC. This provision ensures that ITC is available only when actual consideration is paid, preventing undue benefit to the recipient and ensuring fairness to the supplier.
Reversal of ITC on Capital Goods
When capital goods are used for both business and non-business purposes or both taxable and exempt supplies, ITC needs to be reversed proportionately over the useful life of the asset. The useful life is considered to be five years (i.e., 60 months) from the date of invoice. The amount of ITC to be reversed each month is calculated based on the total ITC divided by 60, and reversal is done accordingly for the months during which the capital goods are used for non-business or exempt purposes. Upon sale or disposal of capital goods, any balance ITC not yet reversed must be adjusted as per Rule 44(6) of the CGST Rules. Special provisions also apply where capital goods become obsolete or are lost, stolen, or destroyed, requiring full reversal of ITC.
Reversal of ITC on Input Services
Input services, when used for both taxable and exempt supplies, also require proportionate reversal under Rule 42. The rules consider the total input service credit and allocate it to business and exempt use based on turnover ratios. Input services that are directly attributable to taxable or exempt supplies are segregated accordingly. The balance common credit is then distributed on a pro-rata basis using the formula provided in Rule 42. The taxpayer is required to calculate these figures every tax period and carry out annual reconciliation to determine any excess reversal or short reversal of ITC. Any discrepancies found at the time of annual return filing must be rectified with interest liability.
ITC Reversal Due to Cancellation of GST Registration
When a registered person opts for cancellation of GST registration, either voluntarily or otherwise, they are required to reverse the ITC available in their electronic credit ledger. The reversal amount must be equivalent to the ITC related to inputs, semi-finished goods, finished goods, and capital goods lying in stock on the day immediately before the date of cancellation. This reversal is done through the filing of Form GSTR-10, the final return. This ensures that ITC is not misused once a person ceases to be a registered taxpayer. In the case of capital goods, the amount to be reversed is calculated based on the proportionate reduction in value over the useful life of five years, as per the prescribed formula.
ITC Reversal in Case of Change in Constitution of Business
When there is a change in the constitution of a registered person on account of sale, merger, demerger, amalgamation, or transfer of business with the specific provision for transfer of liabilities, the unutilized ITC can be transferred to the transferee. However, if the liabilities are not transferred or if there is a partial transfer, reversal of unutilized ITC may be required. The transfer of ITC is made through Form GST ITC-02. In the absence of a proper arrangement, the ITC may lapse or become subject to reversal. In the case of demerger, ITC is apportioned in the ratio of the value of assets transferred, as per Rule 41.
Annual Reconciliation and Final ITC Reversal
At the end of the financial year, the taxpayer must perform an annual reconciliation of the ITC claimed and reversed. This is done to ensure that the provisional reversals done during the year match with the actual use of inputs and services. The annual calculation must be done before filing the annual return in Form GSTR-9 and the reconciliation statement in GSTR-9C. Any excess reversal can be reclaimed, and any short reversal must be made good along with applicable interest. This process ensures transparency, accuracy, and compliance with GST law, preventing leakage of revenue and ensuring that ITC benefits are restricted to eligible claims only.
Impact of ITC Reversal on Output Tax Liability
Whenever ITC is reversed, it is added back to the output tax liability of the taxpayer in the relevant tax period. The taxpayer is required to declare such additions in Form GSTR-3B under the section about ITC reversal. This addition increases the net tax liability of the taxpayer, which must be discharged through a cash payment. Interest is also applicable on a delayed reversal. Proper maintenance of records and timely identification of ITC to be reversed is essential to avoid financial penalties and to ensure proper compliance with GST rules.
Documentation and Audit Trail for ITC Reversal
Maintaining proper documentation and audit trail for all ITC availed and reversed is essential. This includes retaining copies of tax invoices, payment proofs, reconciliations, working papers for apportionment, and correspondence in case of business reorganization. These records must be preserved for 72 months from the due date of filing of the annual return for that year. In the event of a departmental audit, scrutiny, or investigation, these documents serve as vital evidence of compliance and safeguard against penal consequences.
Conclusion
Input Tax Credit is a cornerstone of the GST framework, aimed at eliminating cascading taxes. However, to preserve the integrity of the system, the GST law mandates that ITC must be reversed under various scenarios such as use for exempt supplies, non-business purposes, non-payment to suppliers, cancellation of registration, and changes in the business constitution. The rules provide detailed formulas and procedures to carry out such reversals periodically and at year-end. Failure to adhere to these provisions can lead to increased tax liabilities, interest, penalties, and litigation. Therefore, businesses must implement robust systems for ITC tracking, apportionment, and reversal, supported by accurate record-keeping and compliance processes.