The inverted duty structure arises when the rate of tax on inputs is higher than the rate of tax on outward supplies. This situation creates an imbalance for taxpayers who end up paying more GST on purchases than they collect on sales, leading to the accumulation of input tax credit (ITC). The GST law acknowledges this anomaly and provides a mechanism for refund of the unutilized ITC under specific conditions.
Legal Framework Governing Inverted Duty Refund
The legal basis for the refund of unutilized ITC due to an inverted duty structure is laid down in Section 54(3) of the Central Goods and Services Tax (CGST) Act, 2017. It permits a registered person to claim a refund of any unutilized ITC at the end of a tax period, subject to certain restrictions.
Key Provisions
- Section 54(3)(ii): Refund of unutilized ITC is allowed where the credit has accumulated on account of the rate of tax on inputs being higher than the rate of tax on output supplies.
- First Proviso: Refund is not allowed for the accumulation of ITC if the goods exported are subject to export duty.
- Second Proviso: No refund is allowed if the supplier avails of drawback in respect of central tax or claims refund of IGST paid on such supplies.
Rule 89(5) of CGST Rules
Rule 89(5) of the CGST Rules prescribes the formula for calculating the maximum refund amount in case of inverted duty structure:
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.
Key Definitions under Rule 89(5)
- Turnover of inverted rated supply: Value of outward supply of goods and services where the rate of tax on inputs is higher than the rate of tax on output supplies.
- Net ITC: Input tax credit availed on inputs and input services during the relevant period.
- Adjusted Total Turnover: Total turnover in a State or Union territory, excluding exempt supplies, during the relevant period.
Clarifications Issued via Circulars
The Central Board of Indirect Taxes and Customs (CBIC) has issued several circulars to remove ambiguities concerning inverted duty refunds.
Circular No. 135/05/2020-GST dated 31 March 2020
This circular clarified that refunds of accumulated ITC are not admissible in respect of input services and capital goods in cases of inverted duty structure. The restriction is only on the refund claim, not on availability of ITC on such services or capital goods.
Circular No. 173/05/2022-GST dated 6 July 2022
This clarified that refund under an inverted duty structure is not available for supplies that are fully exempt or nil-rated, such as solar power generation units which involve zero-rated supplies.
Common Scenarios of Inverted Duty Structure
The inverted duty structure is prevalent in several industries due to varying GST rates on raw materials and finished goods.
Example 1: Textile Sector
- Inputs: Man-made fibre attracts GST at 18 percent.
- Output: Finished garments attract GST at 5 percent. This disparity results in accumulation of ITC.
Example 2: Fertilizer Industry
- Inputs: Chemicals used for making fertilizers attract 12 percent.
- Output: Fertilizers attract GST at 5 percent. Refund of unutilized ITC becomes critical for working capital management.
Example 3: Renewable Energy Sector
- Inputs: Capital goods and services attract 18 percent.
- Output: Electricity is outside the GST net. While electricity is not taxed under GST, ITC accumulation still happens.
Filing Process for Inverted Duty Refund
Refund of accumulated ITC due to inverted duty structure is filed electronically in Form GST RFD-01 on the GST portal. The process involves the following steps:
Step 1: Log in to the GST Portal
Registered taxpayers must log in using their credentials.
Step 2: Navigate to Refund Application
From the dashboard, navigate to Services > Refunds > Application for Refund > Refund on account of ITC accumulated due to inverted tax structure.
Step 3: Fill in Form GST RFD-01
The form must include details such as:
- Tax period for which refund is being claimed
- Turnover details
- ITC accumulated
- Bank account details
Step 4: Upload Supporting Documents
Mandatory documents include:
- Statement 1A: Detailing inward and outward supplies
- CA certificate (in cases where refund exceeds the threshold limit)
- Undertaking of non-passing of burden of tax to the buyer
Step 5: Submit and Acknowledge
On submission, an acknowledgment in Form GST RFD-02 is generated.
Time Limit for Filing Refund
As per Section 54(1) of the CGST Act, the application for refund must be made within two years from the relevant date. In the case of refund of unutilized ITC, the relevant date is the end of the financial year in which such claim arises.
Restrictions and Conditions
Several restrictions have been imposed on the eligibility of inverted duty refunds:
Capital Goods and Input Services
Refund is not allowed on capital goods and input services used in making the inverted duty rated supplies. Only input goods are eligible for refund.
Non-Passing of Incidence
The applicant must furnish an undertaking and evidence that the incidence of tax has not been passed on to another person, to avoid unjust enrichment.
Non-availability in Certain Cases
No refund of unutilized ITC is permitted under the following scenarios:
- Goods exported are subject to export duty
- Supplier claims drawback of central tax
- Supplier claims refund of IGST paid on export
Practical Challenges Faced by Taxpayers
Despite legal provisions and online mechanisms, taxpayers face several operational hurdles while claiming refunds.
Delay in Processing
Refund applications often face delays beyond the statutory time limits, affecting the working capital of businesses.
Mismatch of GSTR-1 and GSTR-3B
Mismatch between details filed in GSTR-1 and GSTR-3B returns leads to rejection or delay of refund claims.
Difficulty in Computing Eligible Refund
Calculating refund as per Rule 89(5) is complex due to restrictions on input services and capital goods.
Portal Glitches
Technical issues on the GST portal often obstruct seamless submission of refund applications and uploading of supporting documents.
Jurisdictional Issues
Taxpayers are sometimes confused about whether the application should be submitted to the central or state jurisdictional officer.
Suggested Best Practices
Maintain Clear Documentation
Taxpayers must maintain proper invoices, purchase registers, and reconciliations to support refund claims.
Reconcile Returns Regularly
Ensure consistency between GSTR-1, GSTR-3B, and books of accounts to avoid mismatches.
Categorize Inputs Carefully
Classify goods as inputs, input services, or capital goods accurately, as only input goods qualify for refund.
Monitor Refund Timelines
Regularly follow up with the GST authorities in case of delayed refund processing beyond 60 days.
Take Professional Advice
Complexities in law and calculations often require assistance from professionals to ensure accurate filing and compliance.
Forms Relevant to Inverted Duty Refund
Form GST RFD-01
Used for claiming refund of accumulated ITC under the inverted duty structure.
Form GST RFD-02
Acknowledgment of refund application filed in RFD-01.
Form GST RFD-03
Issued by the proper officer if there are any deficiencies in the refund application.
Form GST RFD-04
Provisional refund order issued, allowing 90 percent of the claimed refund.
Form GST RFD-05
Payment order issued by the proper officer.
Form GST RFD-06
Final refund sanction/rejection order.
Form GST RFD-07
Order for withholding the refund or release of withheld refund.
Form GST RFD-08 and RFD-09
Show-cause notice and reply submission in case of rejection of refund claim.
Introduction to Legal Disputes Arising from Inverted Duty Structure
The inverted duty structure under GST has been a source of ongoing litigation due to the complications involved in refund mechanisms, rate structures, and the interpretation of statutory language. Taxpayers and authorities often find themselves at odds over the refund eligibility of input tax credit when output tax rates are lower than input tax rates. The ambiguities surrounding key phrases like “unutilised input tax credit” and “rate of tax” have sparked several high-stakes disputes.
Section 54(3) of CGST Act – Language and Scope
Section 54(3) of the CGST Act provides that a registered person may claim a refund of any unutilised input tax credit at the end of any tax period. However, the second proviso to the section restricts refund claims when the credit has accumulated on account of the rate of tax on inputs being higher than the rate of tax on output supplies. This clause has become central to most of the legal challenges in the context of inverted duty refunds.
Judicial Interpretations on Refund Eligibility
Case Law: VKC Footsteps India Pvt. Ltd. v. Union of India (2020)
The Gujarat High Court in this landmark case held that Rule 89(5) of the CGST Rules, which restricts refund of input services in the context of inverted duty structure, is ultra vires Section 54(3). The court ruled that the statute does not differentiate between inputs and input services, and therefore, both should be eligible for refund.
Case Law: Transtonnelstroy Afcons Joint Venture v. Union of India (2020)
In contrast, the Madras High Court upheld the validity of Rule 89(5), holding that the rule is consistent with the statutory provision in Section 54(3). According to the court, the legislature has the power to frame rules limiting refund to inputs only.
Supreme Court Judgment: Union of India v. VKC Footsteps India Pvt. Ltd. (2021)
The divergence in High Court rulings led to an appeal before the Supreme Court. The apex court upheld the validity of Rule 89(5), observing that refund of unutilised input tax credit is a statutory right, and the government is within its powers to frame rules prescribing conditions. The judgment settled the controversy by clarifying that only input goods, not input services, qualify for refund under the inverted duty structure.
Rule 89(5) and its Amendments
Rule 89(5) provides the formula for computing refund in the case of an inverted duty structure. It has seen several amendments to align with legal developments and policy considerations. The formula calculates refund as:
Refund = (Turnover of inverted rated supply of goods and services × Net ITC ÷ Adjusted Total Turnover) − Tax payable on such inverted rated supply
The term ‘Net ITC’ includes only input goods and excludes input services, in line with the Supreme Court ruling.
Practical Challenges in Adhering to Rule 89(5)
Despite the clarity provided by the apex court, taxpayers face considerable challenges:
- Accurately classifying inputs vs input services
- Understanding the scope of “inverted rated supply”
- Matching input tax credit with relevant outward supplies
Businesses operating in sectors with mixed supplies often struggle with partial refunds and accumulation of credits.
Refund on Capital Goods in Inverted Duty Structure
Refund of input tax credit on capital goods continues to be excluded under the inverted duty refund mechanism. This has led to a significant working capital burden for businesses involved in manufacturing and infrastructure sectors where capital goods form a major component of procurement.
Legal Position on Capital Goods
The law does not permit refund of input tax credit accumulated on account of capital goods. Though there have been representations and legal opinions advocating the inclusion of capital goods for refund purposes, there has been no favorable legislative or judicial development so far.
Disputes Regarding Classification of Supplies
Taxpayers have also contested the classification of supplies as inverted rated or otherwise. This dispute arises when different rates are prescribed for goods under the same HSN Code based on use or functionality.
For instance, while manufacturing paints or tiles, the classification of the finished product and its corresponding GST rate can significantly affect refund eligibility.
Advance Rulings and Their Influence
Advance Ruling Authorities (AARs) across states have passed divergent rulings on eligibility and classification issues concerning inverted duty refunds. While these rulings are binding on the applicant and jurisdictional officer, they contribute to legal uncertainty when contradictory rulings exist in different jurisdictions.
Notable AAR Rulings
- AAR Kerala in the case of Fairmacs Ship Stores Pvt. Ltd. denied refund of ITC on input services.
- AAR Maharashtra allowed refunds in cases where outward supplies included a mix of goods and services, provided they were classified under inverted duty rates.
Refunds for Mixed Supplies – Goods and Services
A persistent issue concerns the interpretation of refunds when the outward supply includes both goods and services. Post-Supreme Court ruling, input services are not eligible for refund, but their treatment in the computation formula continues to create confusion.
Authorities often question refund claims where the proportion of services is substantial, even when goods are the principal component of the supply.
Judicial Review on Refund Rejections
Taxpayers aggrieved by refund rejections often resort to writ petitions before High Courts, citing procedural lapses, arbitrary rejections, or violation of principles of natural justice.
Common Grounds for Legal Challenges
- Incorrect interpretation of turnover definitions
- Excessive scrutiny or rejection of legitimate claims
- Delay in processing refund applications beyond stipulated timelines
Impact of Circulars on Legal Interpretation
Circulars issued by the CBIC have added another layer of complexity. Though these are clarificatory in nature, courts have varied in their view on whether such circulars can override statutory provisions or rules.
For example, Circular No. 135/05/2020 clarified the non-admissibility of refunds on input services under inverted duty structure, reinforcing the view upheld later by the Supreme Court.
Industry-wise Legal Concerns
Textile Sector
The textile industry has been among the hardest hit due to frequent changes in GST rates, especially for man-made fibres. Businesses face working capital blockage due to accumulation of credits, leading to several legal appeals.
Pharmaceutical Sector
Pharma companies engaged in bulk drug production often accumulate credits due to high GST on chemical inputs. Denial of input service credit refund exacerbates the burden.
Renewable Energy Sector
Manufacturers of solar panels and wind energy equipment deal with substantial input tax credits that remain unutilised due to low or nil-rated outward supplies. The exclusion of input services and capital goods from refund eligibility has led to prolonged litigation.
Retrospective vs Prospective Application of Rule Changes
Another contentious issue is the retrospective application of amendments made to Rule 89(5). Taxpayers argue that such changes should apply prospectively to avoid unsettling vested rights. However, authorities often apply these retrospectively, leading to refund rejections and subsequent appeals.
Lack of Clarity on Refund Timelines and Redress Mechanism
Although the GST law prescribes a 60-day timeline for refund processing, delays are common. Lack of penal consequences for such delays and absence of an effective redressal mechanism compels taxpayers to pursue legal remedies, further burdening the judiciary.
Role of GST Appellate Authorities and Tribunals
The absence of functional GST Appellate Tribunals has left High Courts as the sole forum for resolving refund disputes. This results in an increasing number of writ petitions even for issues that would ideally be adjudicated at the appellate level.
Efforts are underway to operationalise the GST Appellate Tribunal, which is expected to provide faster and more specialised resolution of disputes including those related to inverted duty refunds.
Evolving Legal Landscape
The legal discourse around inverted duty refunds has matured significantly, especially post the Supreme Court’s verdict in VKC Footsteps. However, implementation issues, practical constraints, and pending clarifications continue to generate litigation. Judicial and quasi-judicial bodies remain pivotal in shaping the evolving refund framework.
Addressing Practical Hurdles in Claiming Refund
While the law prescribes a clear pathway for claiming refunds of accumulated Input Tax Credit (ITC) under an inverted duty structure, practical hurdles often complicate the refund journey. One such issue includes incorrect classification of goods or services, leading to rejections or delays in processing refund applications.
For instance, if a taxpayer erroneously classifies a product under a concessional rate when it should fall under a higher rate category, the system may not flag it immediately. However, during refund scrutiny, the tax department can reject the refund claim entirely, citing misclassification.
Another issue arises due to incorrect computation of the refund formula. Businesses often miscalculate turnover ratios or exclude essential data like exports or deemed exports from the adjusted turnover, thereby under-reporting or over-reporting refund amounts. Further complications occur in tracking inward and outward supplies through GSTR-2A/2B and GSTR-1 reconciliation. Refunds claimed on unmatched or ineligible credits often get denied.
Restrictions on Certain Goods and Services
Despite the eligibility framework, the law specifically blocks refund claims under inverted duty structure for certain notified goods and services. The government has used powers under Section 54(3)(ii) of the CGST Act to notify items for which refund of unutilised ITC shall not be allowed.
For instance, notification no. 5/2017-Central Tax (Rate) dated 28th June 2017 has listed several goods such as fabrics and textiles, where refund under inverted duty structure was initially restricted. Over time, the government has issued subsequent notifications to include or exclude products based on industry representations.
Notably, the restriction does not affect the carry forward of such credit, only the refund thereof. Businesses must ensure they identify these restricted items and do not include them while filing refund applications to avoid rejections.
Refund Restrictions on Input Services and Capital Goods
One of the most litigated areas in inverted duty refunds is the treatment of input services and capital goods. Rule 89(5) of the CGST Rules, 2017 prescribes a formula for refund under inverted duty structure that expressly excludes input services and capital goods from the refund computation.
This has raised serious concerns among taxpayers, particularly in sectors like pharmaceuticals and textiles, where a significant portion of inputs comprises services such as job work, testing, or packaging.
The constitutional validity of this exclusion was challenged in several high courts. While the Gujarat High Court ruled in favour of the assessee, the Madras High Court upheld the government’s stand. Eventually, the Supreme Court in the case of VKC Footsteps India Pvt Ltd. vs. Union of India (2021) upheld the exclusion of input services from the refund mechanism under Rule 89(5). This judgment has led to further policy-level clarifications. Businesses must now distinguish between goods and services while calculating refund under the inverted duty structure.
Role of Chartered Accountants and GST Practitioners
Due to the procedural complexity and the risk of rejection, businesses increasingly depend on professionals such as chartered accountants and GST practitioners for the accurate preparation and filing of refund claims.
Professionals ensure proper classification of goods and services, correct interpretation of notifications, reconciliation of returns, and compliance with documentary requirements. They also help in drafting replies to refund rejections or show-cause notices issued by the department.
In refund applications involving large amounts, the involvement of professionals is indispensable in preparing working papers, refund computation sheets, and CA certificates required under Rule 89(2)(m) for certain refund categories.
Standard Operating Procedures (SOPs) Issued by the Government
To streamline the refund process, the government has issued Standard Operating Procedures (SOPs) that provide detailed guidance to tax officers and taxpayers. These SOPs elaborate on timelines, documentation, scrutiny process, and issuance of deficiency memos.
For example, SOPs prescribe that refund applications should be processed within 15 days from the date of ARN (Acknowledgement Reference Number) and any deficiency memos must be issued within the same time frame. The SOPs also standardise the scrutiny process by requiring tax officers to record reasons for rejection and provide an opportunity for personal hearing before passing final orders.
Common Mistakes Made by Taxpayers
Despite guidelines, taxpayers frequently make mistakes in refund filings which can lead to delays or outright rejections. Some common errors include:
- Incorrect selection of refund type in Form RFD-01
- Non-upload of relevant supporting documents
- Misreporting of invoice details
- Non-reconciliation of ITC with GSTR-2A or 2B
- Claiming refund on restricted goods or services
Rectifying these errors requires either withdrawal and re-filing or pursuing appeals if the department issues an adverse order.
Automation and Digitisation of Refund Processing
The government has undertaken several initiatives to automate and digitise refund processing to reduce manual intervention and improve transparency.
The refund module on the GST portal now facilitates:
- Real-time tracking of refund application status
- Auto-populated data from GSTR-1 and GSTR-3B
- Upload of invoices and supporting documents in PDF
- Auto-debit of ITC ledger on sanctioning of refund
Moreover, the system sends real-time alerts via SMS and email at every stage, from ARN generation to refund disbursement.
Timelines and Interest on Delayed Refunds
The law mandates that refund claims should be processed within 60 days from the date of receipt of a complete application. Failure to adhere to this timeline results in interest payable to the taxpayer under Section 56 of the CGST Act.
The rate of interest is 6% p.a. if refund is delayed beyond 60 days and 9% p.a. for refund arising from appellate orders or court rulings. It is crucial for taxpayers to monitor these timelines and escalate matters to grievance redressal platforms if delays persist beyond statutory limits.
Refund in Special Economic Zones (SEZs) and Export-Oriented Units (EOUs)
Refund of accumulated ITC under inverted duty is also available to SEZs and EOUs, subject to additional documentation and procedural compliance. These units must submit endorsements from the designated officer and maintain separate records for domestic and export transactions.
In case of EOUs, specific conditions apply regarding duty foregone benefits, compliance under customs laws, and non-availment of drawback claims. Misinterpretation of these conditions often leads to partial or full rejection of refund claims, necessitating expert guidance.
Recent Amendments and Budget Announcements
The government continues to review and amend the inverted duty refund mechanism based on sectoral representations and legal developments.
Recent amendments have:
- Rationalised rates to remove inverted duty structure in some sectors like fertilizers and renewable energy
- Allowed refunds for previously restricted items
- Modified the refund computation formula to reflect actual supply patterns
Budget announcements often propose changes in rate structures or refund eligibility that become applicable from the next financial year. Taxpayers must remain vigilant and update their ERP systems and internal policies accordingly.
Conclusion
The inverted duty refund mechanism under GST was designed as a remedy to address the structural imbalance caused when the rate of tax on inputs exceeds that on outputs. While the intent behind this provision is to reduce the accumulation of unutilised input tax credit and to promote ease of doing business, its actual implementation has been riddled with complexities, judicial interventions, sectoral challenges, and procedural hurdles.
From a legal standpoint, the scheme has evolved significantly through circulars, rules, and landmark judicial pronouncements. Courts have repeatedly emphasized the need for a rational, non-discriminatory approach to refund claims, particularly concerning the denial of refund of input services and capital goods. The Apex Court in cases like VKC Footsteps and Transtonnelstroy Afcons has underlined the importance of aligning statutory interpretation with the scheme’s objectives while still adhering to legislative intent.
The process of filing refund applications, although structured through forms like GST RFD-01 and validations through GSTN, still poses practical challenges. Mismatches in GSTR-1 and GSTR-3B, the scrutiny of invoices, the restriction on refunding input services, and time limitations under Section 54 further complicate the refund process. The sectoral application of inverted duty refunds, especially in textiles, fertilizers, and footwear industries, presents another layer of complexity, often leading to cash flow issues and working capital inefficiencies.
The frequent amendments in rules, especially Rule 89(5), and evolving clarifications through CBIC circulars indicate a policy space still in flux. Businesses need to remain vigilant about changes and proactively reassess their procurement patterns, pricing policies, and supply chain structures to manage the impact of the inverted duty structure effectively.
Moreover, GST audits have brought increased scrutiny of refund claims. Authorities often challenge the admissibility of claims based on invoice mismatches, classification disputes, or incorrect declarations. This calls for robust internal controls, documentation, and reconciliation practices by taxpayers to withstand departmental examinations.
Going forward, a stable and predictable policy regime, reduction in classification anomalies, uniform tax rates, and perhaps even an automated refund ecosystem could significantly ease the burden on businesses. Policymakers must also consider the legitimate concerns raised by affected sectors and ensure that the refund mechanism truly serves its intended economic purpose.
In essence, the inverted duty refund mechanism remains a critical but intricate feature of India’s GST framework. Navigating it requires a thorough understanding of legal provisions, procedural discipline, sector-specific insights, and constant adaptation to the evolving compliance landscape.