In the context of Goods and Services Tax (GST), the term Inverted Duty Structure refers to a situation where the rate of tax on inputs (raw materials or input services) is higher than the rate of tax on output supplies. This imbalance leads to an accumulation of input tax credit (ITC), which a registered taxpayer may find difficult to utilize fully. To address this issue, the GST law provides a mechanism for refunding the unutilized ITC under an inverted duty structure.
The refund mechanism ensures that businesses are not unnecessarily burdened with excess input taxes and maintain a neutral tax incidence across the supply chain. However, the eligibility, restrictions, conditions, and procedural requirements for claiming this refund are laid out in specific provisions of the Central Goods and Services Tax (CGST) Act, 2017 and the CGST Rules, 2017. This article delves into the foundational understanding of the inverted duty refund under GST, focusing on the legal framework, eligibility criteria, and the structure of relevant rules and notifications.
Understanding the Inverted Duty Structure
An inverted duty structure arises when the GST rate on inputs is higher than the rate on outputs. For example, if a manufacturer purchases raw material taxed at 18 percent and sells the finished product at 12 percent, the input tax credit on the 18 percent cannot be fully offset against the output tax liability of 12 percent. This results in the accumulation of excess ITC, which may eventually become refundable, subject to statutory conditions.
The inverted duty structure affects the working capital of taxpayers. Without a refund mechanism, businesses would bear the burden of excess taxes, making them less competitive. Therefore, allowing refunds in genuine cases is crucial for reducing the cascading effect of taxes and ensuring the credit chain remains intact.
Statutory Provisions Governing Inverted Duty Refund
Section 54(3) of the CGST Act, 2017
The main legal provision for refund under inverted duty structure is contained in Section 54(3) of the CGST Act, 2017. It allows the refund of unutilized input tax credit at the end of a tax period when:
- The credit has accumulated due to the rate of tax on inputs being higher than the rate of tax on output supplies (other than nil-rated or fully exempt supplies), or
- In cases of zero-rated supplies made without payment of tax under bond or letter of undertaking.
The second provision to Section 54(3) restricts refund in cases where the goods or services are subject to nil or exempt supply, or when the goods are notified by the government as not eligible for such refund.
Rule 89(5) of the CGST Rules, 2017
This rule prescribes the formula for computing the maximum refund amount in case of inverted duty structure. The rule has undergone several amendments, and its interpretation has also been subject to judicial scrutiny. As per the latest version, the formula is:
Refund Amount = {(Turnover of inverted rated supply of goods and services) × Net ITC ÷ Adjusted Total Turnover} – Tax payable on such inverted rated supply of goods and services
Where:
- Net ITC means input tax credit availed on inputs during the relevant period (excluding ITC on input services and capital goods)
- Turnover of inverted rated supply of goods and services is the value of output supply with inverted rate
- Adjusted Total Turnover is the total turnover in a State or Union Territory, excluding exempt supplies
This formula excludes input services and capital goods from the refund computation, which has been a contentious issue among taxpayers.
Notifications and Circulars
The government has from time to time issued various notifications under Section 54(3) to notify goods or services for which refund of unutilized ITC under inverted duty structure shall not be allowed. Some of the important notifications include:
- Notification No. 5/2017-Central Tax (Rate), dated 28.06.2017
- Notification No. 20/2018-Central Tax (Rate), dated 26.07.2018
- Notification No. 9/2022-Central Tax (Rate), dated 13.07.2022 (amending prior notifications)
These notifications list items like fabrics, edible oils, and others for which refund is restricted.
In addition, the Central Board of Indirect Taxes and Customs (CBIC) issues circulars to clarify ambiguities related to inverted duty refunds. For example, Circular No. 135/05/2020-GST dated 31.03.2020 addressed the scope of refund and treatment of input services in the refund calculation.
Conditions for Claiming Inverted Duty Refund
The refund under inverted duty structure is subject to fulfillment of certain conditions:
1. Accumulation Due to Inverted Duty
The accumulation of credit must be solely due to the inversion of GST rates (i.e., input rate being higher than output rate). If the accumulation arises for any other reason, such as exempt outward supply or zero-rated supply under LUT, the refund will not be admissible under the inverted duty provision.
2. Input Services and Capital Goods Not Considered
As per Rule 89(5), only ITC on inputs is eligible for refund. Input services and capital goods are excluded from the computation, even if their rate is higher than the output supplies.
3. Output Supplies Should Not Be Exempt or Nil-Rated
If the output supply is nil-rated or fully exempt, refund under inverted duty structure is not allowed. The output must be taxable at a lower rate than the input to qualify.
4. No Prohibition Through Notification
If the input goods or output supplies fall under any category notified under Section 54(3) for which refund is restricted, then no refund will be allowed despite inversion.
5. Proper Filing of Returns
The applicant must have filed all relevant GST returns (GSTR-1 and GSTR-3B) for the tax period in which refund is being claimed. Non-filing or delay in filing may lead to rejection or delay in processing.
6. Limitation Period
Refund application must be filed within two years from the relevant date. For inverted duty refund, the relevant date is the due date for furnishing the return under Section 39 (GSTR-3B) for the period in which the claim arises.
Sectors Commonly Affected by Inverted Duty
Several sectors frequently face the issue of input tax accumulation due to the inverted duty structure. These include:
- Textile industry (e.g., fabrics taxed at 5 percent while inputs may be taxed at 12 or 18 percent)
- Footwear industry
- Fertilizers and chemical manufacturers
- Renewable energy equipment suppliers
- Electric vehicle components
- Mobile handset assemblers
- Railways and metro rail supply sectors
In many of these cases, though inputs are taxed at 12 or 18 percent, the finished goods are taxed at 5 percent, causing a recurring ITC accumulation and creating the need for regular refund applications.
Case Law on Inverted Duty Refund
Over time, courts and tribunals have played a crucial role in interpreting the refund provisions under inverted duty structure. Some notable judgments include:
VKC Footsteps India Pvt. Ltd. v. Union of India (Gujarat HC)
The Gujarat High Court held that exclusion of input services from the refund formula under Rule 89(5) was ultra vires and violative of Article 14. It allowed refund of input services under the inverted duty formula.
Tvl. Transtonnelstroy Afcons Joint Venture v. Union of India (Madras HC)
Contrary to the Gujarat ruling, the Madras High Court upheld the validity of the formula under Rule 89(5) and supported the exclusion of input services.
Supreme Court in Union of India v. VKC Footsteps India Pvt. Ltd.
The Supreme Court overruled the Gujarat High Court and upheld the exclusion of input services from the refund formula. The court held that the legislative intent and delegated rule-making authority justified this exclusion.
This decision has settled the legal position on the refund of input services under inverted duty structure, limiting the scope of eligible ITC refund to inputs only.
Document Checklist for Refund Application
To apply for a refund under the inverted duty structure, the applicant needs to submit certain documents along with Form GST RFD-01:
- Statement of inward and outward supplies
- Self-declaration or CA certificate, if applicable
- Relevant invoices of purchases and sales
- GSTR-3B and GSTR-1 returns of the refund period
- Copy of challans evidencing tax payment
- Undertaking of no unjust enrichment, if applicable
- Declaration for non-prosecution (if required)
The documentation must be accurate and consistent with returns filed, as any mismatch may lead to rejection of the refund claim.
Legislative Framework Governing Inverted Duty Refund
The mechanism for refund under an inverted duty structure is primarily governed by Section 54(3) of the Central Goods and Services Tax (CGST) Act, 2017. It provides that a registered person may claim a refund of any unused input tax credit where the credit has accumulated due to the rate of tax on inputs being higher than the rate of tax on output supplies.
Further clarity is provided through Rule 89(5) of the CGST Rules, 2017. This Rule defines how the refund amount is to be computed under an inverted duty scenario and has been amended multiple times to accommodate practical difficulties and judicial interpretations.
Notification and Circular Trail
Several notifications and circulars have been issued by the Central Board of Indirect Taxes and Customs (CBIC) to explain and modify the provisions of refund under the inverted duty structure:
- Notification No. 21/2018-Central Tax dated 18.04.2018 clarified the refund calculation formula.
- Notification No. 26/2018-Central Tax dated 13.06.2018 amended Rule 89(5).
- Circular No. 135/05/2020-GST dated 31.03.2020 provided clarification on admissibility of refund of accumulated ITC on input services.
- Notification No. 14/2022-Central Tax dated 05.07.2022 amended the formula yet again, defining the “Net ITC” term to exclude input services and capital goods from refund calculation.
These notifications show a pattern of restricted refund benefits under inverted duty where input services and capital goods are specifically excluded, thereby narrowing the scope of refund.
Formula for Refund Under Rule 89(5)
As per the latest amendment, the formula to calculate refund in cases of inverted duty structure is:
Maximum Refund Amount = (Turnover of inverted rated supply of goods and services × Net ITC ÷ Adjusted Total Turnover) – Tax payable on such inverted rated supply
Where:
- Net ITC means input tax credit availed on inputs during the relevant period (excluding input services and capital goods).
- Turnover of inverted rated supply of goods and services refers to the value of supply of goods and services with inverted duty.
- Adjusted Total Turnover includes the turnover in a State or Union Territory as defined under Rule 89(4).
This formula is crucial as it is the backbone for processing refund claims and directly affects the quantum of refund allowable to taxpayers facing inverted duty accumulation.
Judicial Pronouncements on Inverted Duty Refunds
Several High Courts and the Supreme Court of India have examined the refund mechanism under inverted duty and interpreted the legal and constitutional validity of the exclusion of input services and capital goods.
VKC Footsteps India Pvt Ltd vs. Union of India
In this landmark Gujarat High Court judgment, the petitioner challenged Rule 89(5) on the grounds that it violates Section 54(3) by excluding input services from the computation of refund.
The High Court held that Rule 89(5), as amended, is ultra vires the CGST Act because the statute itself does not differentiate between inputs and input services. It allowed refund of the entire unutilised ITC including input services.
Transtonnelstroy Afcons Joint Venture vs. Union of India
The Madras High Court took a contrary view and upheld Rule 89(5), asserting that the rule-making authority has the power to define refund eligibility and quantum, and the exclusion of input services is a valid classification.
Supreme Court Ruling
The conflicting High Court judgments were finally settled by the Supreme Court in the case of Union of India vs. VKC Footsteps India Pvt Ltd. The Apex Court upheld the validity of Rule 89(5), stating that it does not contravene Section 54(3) and the exclusion of input services in refund computation is a conscious legislative choice.
This judgment has a significant impact on taxpayers, particularly manufacturers and service providers, who rely heavily on input services and may now find limited relief under the inverted duty refund mechanism.
Challenges Faced by Taxpayers
Despite the availability of refund under inverted duty structure, taxpayers encounter several challenges in practical implementation:
Restriction on Input Services and Capital Goods
The most common issue is the exclusion of input services and capital goods from the refund mechanism, which leads to stranded credits. In many industries, input services like consultancy, logistics, and utilities form a major portion of input costs, and their non-refundability results in increased costs and reduced competitiveness.
Documentation Burden
Claiming refund under inverted duty requires submission of numerous documents such as:
- GST RFD-01 application
- CA certificates for turnover and credit availed
- Invoices of input purchases
- Statement of inward supplies (Annexure B)
- Reconciliation of GSTR-3B and GSTR-1
The documentation process is tedious, and any discrepancy can lead to rejection or delay in refund.
Time-Consuming Process
Although the law mandates refunds to be issued within 60 days, in practice, refunds are often delayed due to manual verification, system limitations, and procedural lapses at the departmental level. Many taxpayers face working capital issues due to delayed receipt of legitimate refunds.
Frequent Changes in Law and Procedure
Constant amendments to Rule 89(5), formula changes, and new circulars have created uncertainty and compliance confusion. Small and medium businesses often lack the resources to track these changes, resulting in non-filing or incorrect filing of refund claims.
Refund Denials and Litigations
Many refund claims are denied on technical grounds such as mismatch in invoices, late filing, incorrect classification of supply, or procedural non-compliance. This leads to a rise in litigation and blockage of funds that could otherwise be used in the business.
Sector-Specific Impact of Inverted Duty
The inverted duty structure affects different sectors in different ways based on their input-output tax rates. Here are some notable sectors affected:
Textile Sector
One of the most impacted industries, the textile sector has multiple products under 5% GST while the inputs like yarn, packaging material, and dyes attract 12% or 18%. Although the government once blocked refund of inverted duty for this sector, it was later restored after industry pressure.
Fertiliser Industry
Fertiliser is taxed at 5% while most raw materials are taxed at 12% or 18%. Accumulation of unutilised ITC is rampant and continues to be a pain point for this essential industry, where working capital is already tight.
Footwear Industry
Footwear up to Rs. 1,000 is taxed at 5% while inputs like adhesives, chemicals, and rubber are taxed at higher rates. This disparity results in high ITC accumulation without adequate refund mechanisms.
Solar Power and Renewable Energy
While solar modules are taxed at 5%, inputs like structures and components attract higher rates, leading to ITC accumulation and affecting project cost viability.
Pharmaceutical Industry
Formulations are taxed at 5%, but the input goods, packaging material, and input services attract 12%-18%. The inability to claim full refunds increases the cost burden on pharma companies.
Recent Developments and Policy Updates
Over the years, the government has taken some steps to rationalise and ease the process of inverted duty refund:
- Online Refund Processing: Most refunds are now processed electronically through the GST portal with integration to ICEGATE for export-related claims.
- Auto Population of Data: Return filing systems are being upgraded to allow automatic population of data in RFD-01 to reduce manual errors.
- Sectoral Rationalisation: GST Council continues to review and rationalise rates across sectors to reduce inverted duty instances. Several rate corrections have been announced in Council meetings.
However, there is still a long way to go in ensuring seamless refunds and comprehensive credit utilisation under the inverted duty framework.
Impact of 2022 Amendments on Refund Claims
The amendments introduced through Notification No. 14/2022-Central Tax and aligned changes in Rule 89(5) have made the refund formula more restrictive by legally defining Net ITC to only include inputs. This change has codified the exclusion of input services, which was previously interpreted judicially.
These amendments have brought clarity in computation but have also intensified the credit blockage problem for businesses relying on service-based input costs. Industry stakeholders have urged the GST Council to relook at the formula to make it more inclusive.
GST Council Discussions and Future Outlook
The GST Council has been actively reviewing inverted duty structures in multiple sectors. Some of the measures being discussed include:
- Rationalisation of GST rates to correct inverted duty situations.
- Inclusion of input services in the refund formula through legislative changes.
- Creating separate categories for essential industries like textiles, pharma, and renewable energy.
- Developing faster and automated refund mechanisms to ease working capital strain.
However, political consensus and fiscal considerations often delay these reforms. The Council’s ability to address these concerns holistically will determine how effective the refund mechanism will be in reducing tax inefficiencies.
Common Challenges Faced by Taxpayers
Procedural Delays and Bottlenecks
A frequent grievance among taxpayers is the delay in processing refund applications. Though the law mandates a refund to be sanctioned within 60 days of filing a complete application, practical realities often differ due to incomplete scrutiny, pendency of queries from officers, or backlogs in jurisdictional offices.
Taxpayers are often required to repeatedly respond to notices for submission of additional documents, which elongates the refund cycle and affects working capital flow.
Classification Disputes
Inverted duty structure refunds rely heavily on the classification of input and output goods. Any mismatch or dispute regarding HSN codes or tax rates applied to inputs versus outputs may attract departmental scrutiny. Goods which fall under multiple tax slabs depending on their use or specification often complicate refund calculations.
Additionally, confusion over whether the supplies are actually output supplies or deemed exempted supplies can significantly alter refund eligibility.
Restriction Due to Notifications and Circulars
Several circulars and notifications have periodically changed the refund eligibility for certain sectors, such as textiles and fertilizers. These changes have caused uncertainty for businesses operating in these sectors, particularly regarding the retrospective or prospective application of restrictions.
A major challenge arises when a particular notification restricts refund on specific inputs (like services or capital goods), leaving taxpayers to reorganize cost structures or accounting practices.
Errors in GSTR Filings
Mismatch between GSTR-1 and GSTR-3B returns, or discrepancies between reported input credits and invoices, can lead to refund rejections or notices under scrutiny. Errors in invoice details such as GSTIN of the supplier, incorrect invoice value, or failure to report debit/credit notes also impact refund computation.
Additionally, taxpayers failing to claim ITC properly in GSTR-3B due to omission or oversight cannot later claim a refund based on GSTR-2A/2B reconciliation alone.
Blocking of Credit under Rule 86A
In certain cases, input tax credit gets blocked under Rule 86A due to suspicion of fake invoicing or non-compliance by suppliers. Such blocked credit is not considered for refund computation, even if the taxpayer has acted in good faith. This directly impacts the refund amount and creates a compliance burden.
Practical Tips and Best Practices
Maintain Strong Documentation
Taxpayers must maintain a comprehensive audit trail for all input purchases and output supplies, including tax invoices, transport documents, purchase orders, and proof of payment. Reconciliation of books with GST returns, particularly GSTR-2B and GSTR-3B, should be done monthly.
A folder system or software solution to track eligibility of ITC as per Section 17(5), bifurcation of inputs, capital goods, and services is essential for reducing refund disputes.
Timely Filing and Monitoring
Refund applications should be filed well within the statutory time limits (i.e., before the expiry of two years from the relevant date). Internal compliance calendars, workflow approvals, and checklist-driven submissions help in reducing filing errors and ensuring timely tracking of refund status.
The taxpayer dashboard on the GST portal should be regularly monitored for any deficiency memos or queries raised by the jurisdictional officer.
Segregation of Inputs and Capital Goods
Since refund under inverted duty structure excludes capital goods, businesses must ensure that capital goods are correctly classified in books of accounts and returns. Mixing them with inputs in accounting can lead to incorrect refund claims and future liabilities.
A clear tagging system in ERP or accounting software can help demarcate ITC that is claimable under inverted duty refund.
Replying to Deficiency Memos and Notices Promptly
When refund applications are flagged for deficiencies (via Form GST RFD-03), taxpayers should respond promptly and completely. Delay in addressing such memos can lead to application rejection and refiling, which further extends the refund timeline.
Replies to show cause notices must be drafted clearly with reference to factual details and legal provisions, preferably with assistance from a qualified consultant if needed.
Proactive Supplier Reconciliation
Regular reconciliation of purchase data with GSTR-2A/2B helps identify non-compliant suppliers who might not have filed their returns or paid taxes. Follow-up with vendors for compliance not only protects input tax credit but also prevents refund rejections.
Sector-wise Implications of Inverted Duty Refund
Textile Sector
The textile industry has been significantly impacted by inverted duty structure owing to GST on synthetic fibers, yarns, and fabrics. Initially allowed to claim refunds, the sector faced restrictions through specific notifications that excluded refund on input services and certain fabrics.
Policy changes over time have alternated between allowing and restricting refunds, causing planning issues and working capital strain for businesses operating in this sector.
Fertilizer and Chemical Industries
Fertilizer manufacturers often face a scenario where inputs such as ammonia or urea attract higher GST, while output fertilizers are taxed at a concessional rate of 5%. This persistent inversion has necessitated periodic refund claims. However, due to policy decisions to restrict refunds on certain subsidized items, businesses need to carefully interpret applicable rate notifications.
Solar and Renewable Energy Sector
The solar power sector, due to concessional output rates and a composite supply mechanism (under deemed valuation rules), faces substantial blockage of ITC. While inverted duty refund is allowed in some cases, the treatment of inputs like modules, inverters, and civil construction materials complicates the claim.
Footwear and Leather Industry
Manufacturers of low-value footwear and leather goods face output tax rates of 5% while raw materials like chemicals, adhesives, and packaging attract 18%. This leads to continuous input tax accumulation. However, sector-specific clarifications and threshold-based restrictions have made refund claims unpredictable.
Judicial Interpretations and Key Rulings
VKC Footsteps India Pvt Ltd v. Union of India (2021)
This was one of the most crucial Supreme Court judgments on inverted duty refund. The case questioned the constitutional validity of Rule 89(5) which excludes input services from refund computation under inverted duty structure.
The Gujarat High Court had earlier ruled that such exclusion was ultra vires the GST Act. However, the Supreme Court overruled it, holding that the legislature had consciously chosen to exclude input services and that Rule 89(5) was within legal limits.
This judgment laid down the principle that the courts would not interfere with economic legislation unless it is manifestly arbitrary, thereby upholding legislative intent behind restricting refund on input services.
Shabnam Petrofils Pvt Ltd v. UOI (2022)
This case involved refund denial due to minor errors in invoices and procedural shortcomings. The High Court emphasized the importance of granting substantial benefit over procedural lapses, directing authorities to process refunds if material compliance was met.
The judgment reinforced the view that refund claims should not be rejected merely for clerical errors, especially when tax has been actually paid and credit is available.
Tvl. Transtonnelstroy Afcons JV v. Assistant Commissioner (2022)
The Madras High Court held that the denial of refund merely due to system error or technical glitches on the GST portal was unjustified. The department was directed to allow the refund considering the petitioner’s inability to file due to genuine system constraints.
This ruling highlighted the duty of tax authorities to consider procedural fairness and not rely solely on portal-based limitations to deny refund rights.
Union of India v. Bharti Airtel Ltd (2021)
Although not directly on inverted duty refund, this case dealt with the rectification of GSTR-3B and retrospective claim of ITC. The Supreme Court ruled that GSTR-3B is not a mere summary but a statutory return, and rectification cannot be done for past periods.
The judgment indirectly impacted refund scenarios by underlining the importance of timely and correct return filing. Once missed, ITC could not be retrospectively claimed, affecting refund computation as well.
Upcoming Policy Changes and Recommendations
With the GST regime maturing, the government has been exploring ways to simplify inverted duty refund mechanisms. Some of the proposals under consideration include:
- Allowing refund on input services in a phased manner.
- Automating refund computation using AI-integrated return systems.
- Introducing sector-specific standard operating procedures (SOPs).
- Revising the formula under Rule 89(5) to enhance equity.
Stakeholder representations continue to urge the authorities to consider practical business realities, particularly in industries with seasonal or export-linked revenue cycles.
Conclusion
The concept of inverted duty structure and its corresponding refund mechanism under GST plays a pivotal role in ensuring the financial neutrality of businesses. When the input tax rate exceeds the output tax rate, the resultant accumulation of unutilized input tax credit can lead to significant working capital issues. The refund mechanism under Rule 89(5) of the CGST Rules, although beneficial, has undergone multiple amendments and judicial scrutiny, reflecting the evolving nature of GST law.
Through this guide, we explored the foundational aspects of inverted duty structure, delved into the procedural requirements for claiming refunds, and examined key judicial interpretations and departmental circulars that shape its implementation. It is evident that businesses need to carefully assess their eligibility, maintain meticulous documentation, and stay updated with legislative and policy developments to effectively navigate the refund process.
Challenges such as classification disputes, rate anomalies, and restrictions on certain inputs continue to exist. However, with proactive compliance strategies and awareness of legal resources, businesses can mitigate the impact of an inverted duty structure and ensure a seamless refund process under GST. As the GST framework continues to mature, further clarity and simplification in the refund mechanism are expected to support a more robust and business-friendly tax ecosystem.