The introduction of the Goods and Services Tax in India on 1 July 2017 represented one of the most significant tax reforms in the country’s history. Among its many features, the concept of input tax credit stood out as a central mechanism to eliminate cascading taxes and improve the efficiency of the indirect tax system. By allowing credit for tax paid on inputs to be set off against tax payable on outputs, GST sought to create a seamless value-added tax system across goods and services.
Under the GST framework, input tax credit can be availed by a registered person subject to certain statutory conditions. This credit system was designed to work on trust and self-assessment, with distinct compliance responsibilities assigned to suppliers and recipients. For the initial years of GST, one of the fundamental questions that arose was whether a recipient could be made to reverse input tax credit if the supplier had not deposited the collected GST with the government. This question became even more relevant with the introduction of Section 41(2) of the Central Goods and Services Tax Act, 2017 from 1 October 2022.
This article examines the legislative background, statutory provisions, and key implications of the reversal of input tax credit in such circumstances, focusing specifically on the period from 1 July 2017 to 30 September 2022. It sets the foundation for a detailed legal discussion in subsequent parts of the series.
Legislative Framework Prior to 01-10-2022
When GST was implemented, the entitlement to input tax credit was primarily governed by Section 16 of the CGST Act. Section 16(1) provided that every registered person shall be entitled to take credit of input tax charged on any supply of goods or services or both to them, which are used or intended to be used in the course or furtherance of their business. The provision was subject to such conditions and restrictions as might be prescribed, and the amount of such credit would be credited to the electronic credit ledger of the registered person.
Section 41 of the CGST Act, in its original form, dealt with the claim of input tax credit and provisional acceptance thereof. Section 41(1) stated that every registered person shall be entitled to take the credit of eligible input tax, as self-assessed, in their return, and such amount shall be credited on a provisional basis to the electronic credit ledger. There was no sub-section (2) at this stage, and thus no explicit legislative requirement for reversal of credit in the event of non-payment of tax by the supplier.
Under this structure, the recipient’s obligation was to pay the supplier the value of the supply along with applicable GST. The supplier, being registered under the GST regime, was required to collect this tax as an authorised agent of the government and remit it to the exchequer through their own GST return filings. The legal responsibility for tax payment to the government lay solely with the supplier in a forward charge transaction.
Position Under Section 16 and Section 41 Before the Amendment
The entitlement to input tax credit before 1 October 2022 was subject to certain specific conditions in Section 16(2), including possession of a valid tax invoice, receipt of goods or services, payment of tax to the supplier, and furnishing of returns. Clause (c) of Section 16(2) stated that the tax charged in respect of the supply must have been actually paid to the government, either in cash or through utilisation of input tax credit admissible in respect of the said supply.
While this clause might appear to make the recipient’s entitlement dependent on the supplier’s payment of tax, the absence of a procedural mechanism for enforcing reversal purely on the ground of supplier’s default meant that recipients were not automatically required to reverse credit if the supplier failed to remit tax. Unless there was evidence of collusion, fraud, or fictitious transactions, genuine business recipients who had complied with the other conditions under Section 16 retained their credit.
The GST law during this period emphasised self-assessment and post-facto verification. Matching of input and output supplies through return filings was envisaged but never fully operationalised in the original form. Instead, tools such as GSTR-2A and later GSTR-2B were introduced to assist taxpayers in reconciling their credits, without creating automatic statutory reversal obligations.
Insertion of Section 41(2) and Notification 18/2022
A significant legislative change occurred with the Finance Act, 2022, which inserted sub-section (2) into Section 41 of the CGST Act. This provision came into effect from 1 October 2022 through Notification No. 18/2022 dated 28 September 2022. Section 41(2) provides that the credit of input tax availed by a registered person under sub-section (1), in respect of such supplies where the tax payable has not been paid by the supplier, shall be reversed along with applicable interest, in such manner as may be prescribed.
This change marked a departure from the earlier position by expressly making the recipient responsible for reversing credit in certain cases of supplier default. The provision operates prospectively and is coupled with a mechanism for re-availment of credit once the supplier has discharged the tax.
Introduction of Rule 37A and Notification 26/2022-CT
To operationalise Section 41(2), Rule 37A was inserted into the CGST Rules, 2017 by Notification No. 26/2022-CT dated 26 December 2022. The rule stipulates that where the supplier has not paid tax on such supply by the due date for furnishing the return for the month of September following the end of the financial year, the recipient shall reverse the input tax credit availed in respect of such supply along with interest under Section 50.
Upon payment of tax by the supplier, the recipient is entitled to re-avail the reversed credit. Rule 37A thus provides the procedural clarity that was absent prior to 1 October 2022, laying down the timelines and conditions for reversal and re-availment in the event of supplier default.
Implication for the Period 01-07-2017 to 30-09-2022
Before the effective date of Section 41(2), there was no statutory provision in the CGST Act or the CGST Rules that compelled recipients to reverse input tax credit solely because the supplier had not paid tax to the government. The only relevant requirement was that contained in Section 16(2)(c), which was interpreted in light of the overall structure of GST compliance.
In the absence of Section 41(2) and Rule 37A, any attempt to enforce reversal for past periods would effectively amount to applying the law retrospectively, which is generally disfavoured in tax jurisprudence unless expressly provided for in the statute. The legislative history supports the view that Parliament intended the new reversal obligation to apply prospectively.
During the initial GST years, the understanding in industry and among professionals was that once the recipient had paid the supplier the value of the supply plus GST, their entitlement to credit was complete, subject to compliance with other conditions of Section 16. This interpretation was also consistent with the nature of GST as a destination-based consumption tax, where the liability in forward charge transactions was clearly demarcated between supplier and recipient.
The Supplier as an Agent of the Government
In the GST framework, the supplier’s role in collecting tax from the recipient and remitting it to the government is akin to that of an agent holding public funds in trust. The recipient’s legal obligation is fulfilled when they pay the agreed consideration and tax to the supplier. Any failure by the supplier to remit the tax to the government is a breach of the supplier’s statutory duty, not of the recipient’s.
This agency relationship reinforces the argument against imposing reversal obligations on recipients for periods before 1 October 2022. Shifting the burden to recipients for the supplier’s default without explicit statutory authority would undermine the principle of certainty in taxation and could disrupt business cash flows.
Judicial Interpretation of Section 16(2)(c) Before 01-10-2022
Several judicial decisions before the introduction of Section 41(2) examined the interplay between Section 16(2)(c) and the recipient’s right to credit. In cases where recipients could demonstrate that they had paid the supplier the tax amount charged in the invoice, courts often held that denial of credit was not justified in the absence of fraud, collusion, or fictitious transactions.
While the government has argued that Section 16(2)(c) imposes a substantive condition requiring tax to be actually paid to the government, the practical difficulty for recipients in verifying supplier compliance has been recognised. The GST system was not designed to make recipients investigative auditors of their suppliers’ tax compliance. The absence of a procedural reversal mechanism before Section 41(2) further supports the prospective nature of the obligation.
Changes in Compliance Landscape After 01-10-2022
The insertion of Section 41(2) and Rule 37A fundamentally changes the compliance landscape. From 1 October 2022 onwards, recipients must monitor their suppliers’ tax payment status more actively. This may involve regular reconciliation of purchase data with GSTR-2B, follow-up with suppliers for timely filing of returns, and ensuring that tax is paid within the statutory timelines to avoid reversal and interest liability.
However, for the period before 1 October 2022, the legal framework did not impose such monitoring obligations. Recipients were entitled to operate on the basis of trust and their own compliance with Section 16 conditions.
Conditions for Availing Input Tax Credit and Legal Position Before 01-10-2022
The right to input tax credit under the GST framework is not unconditional. The Central Goods and Services Tax Act, 2017 prescribes a specific set of statutory requirements that must be fulfilled for a recipient to avail and retain credit. Understanding these requirements is essential to assess the legal position before the insertion of Section 41(2) on 1 October 2022.
During the period from 1 July 2017 to 30 September 2022, the entitlement to credit, and the circumstances in which it could be reversed, were governed almost entirely by Section 16, Section 41(1), and related rules. We examine those provisions, the practical implications for recipients, and how judicial interpretation shaped the understanding of the law.
Section 16: Entitlement and Conditions
Section 16(1) establishes the general entitlement to input tax credit for every registered person, subject to such conditions and restrictions as may be prescribed. The entitlement is linked to the use of goods or services in the course or furtherance of business, ensuring that personal or non-business consumption is excluded from the credit chain.
Section 16(2) sets out the specific conditions that must be met:
- The recipient must be in possession of a valid tax invoice or other prescribed tax-paying document.
- The recipient must have received the goods or services or both.
- Subject to provisions of Section 41, the tax charged in respect of the supply must have been actually paid to the government by the supplier, either in cash or through utilisation of eligible credit.
- The recipient must have furnished the return under Section 39.
The first two conditions are factual in nature and relate to documentation and receipt of supply. The third condition, in clause (c), is more complex because it refers to an event — the supplier’s payment of tax to the government — which is not directly within the recipient’s control. The fourth condition is procedural and relates to the recipient’s own compliance.
Self-Assessment and Section 41(1)
Before the 2022 amendment, Section 41 consisted only of sub-section (1). This provision allowed the registered person to take credit of eligible input tax, as self-assessed, in their return, with the amount credited provisionally to the electronic credit ledger. There was no statutory requirement to verify whether the supplier had discharged the tax liability before availing the credit. The provisional nature of the credit meant that it could be adjusted in the future if conditions were found to be violated, but there was no automatic reversal mechanism for non-payment by the supplier.
This structure reflected a trust-based compliance model. Recipients could rely on their own records and the tax invoice issued by the supplier to claim credit. The supplier’s obligation to pay tax was separate and independent, enforceable by the tax authorities directly against the supplier.
Practical Challenges in Enforcing Clause (c) Before Section 41(2)
Enforcing Section 16(2)(c) in the absence of a specific mechanism created practical challenges. A recipient has no direct access to the supplier’s cash ledger or detailed return filing status beyond what is visible in GSTR-2A or GSTR-2B. These statements indicate whether the supplier has reported the invoice, but not necessarily whether the tax has been fully paid to the government.
Without Section 41(2) and Rule 37A, there was no prescribed timeline for reversing credit in the event of supplier non-payment. As a result, the department could only initiate action after establishing that the tax had not been paid and that the recipient was not entitled to credit under Section 16(2)(c). This often required investigation, and disputes arose where recipients argued that they had fulfilled their obligations by paying the supplier.
Judicial View on Supplier Default and Recipient Credit
Courts and appellate authorities have examined the question of whether input tax credit can be denied to a bona fide recipient solely due to supplier default. The general judicial trend before 1 October 2022 was that genuine recipients who had paid the supplier and possessed valid documentation should not be penalised for the supplier’s failure to remit tax, unless there was evidence of collusion or fraudulent intent.
These decisions often drew on principles of fairness and the statutory scheme of GST, emphasising that the recipient is not an agent of the government for the purpose of tax collection. The supplier is entrusted with the responsibility to collect and remit tax, and the recipient cannot be expected to police the supplier’s compliance beyond reasonable commercial checks.
The Supplier as an Independent Taxable Person
In the GST framework, the supplier and the recipient are both independent taxable persons. Each is responsible for their own compliance under the Act. In a forward charge transaction, the supplier is liable to collect and pay tax on the supply, while the recipient’s liability is limited to paying the agreed consideration plus tax to the supplier. This separation of responsibilities was a key factor in the pre-October 2022 position on input tax credit reversal.
The reverse charge mechanism under Section 9(3) and 9(4) of the CGST Act is an exception to this principle, where the recipient is directly liable to pay tax to the government. Outside these provisions, the recipient has no statutory liability to pay GST on a supply made by a registered supplier.
Role of GSTR-2A and GSTR-2B
GSTR-2A, introduced in the early stages of GST, was an auto-generated statement reflecting inward supplies as reported by suppliers in their GSTR-1 returns. GSTR-2B, later introduced, provided a static view of eligible credits for a particular month. These statements became important tools for reconciliation, but they were not statutory determinants of eligibility. Before Section 41(2), a mismatch between claimed credit and GSTR-2A or 2B did not automatically require reversal unless it could be shown that the conditions of Section 16 were not met.
This position meant that recipients could still avail credit for invoices not appearing in GSTR-2A if they had valid documentation and could prove receipt of goods or services. The onus was on the department to prove ineligibility, rather than on the recipient to prove supplier compliance in every case.
Finance Act 2022 and the Shift in Responsibility
The Finance Act 2022 introduced Section 41(2) and amended the scheme of credit availment and reversal. The provision, effective from 1 October 2022, requires reversal of credit along with interest where the supplier has not paid the tax. This represents a shift from a purely trust-based system to one where the recipient shares a measure of responsibility for ensuring supplier compliance.
The change was accompanied by Rule 37A, which provides the procedure for reversal and re-availment. This rule sets specific timelines and clarifies that reversal is required if the supplier has not paid tax by the due date for furnishing the return for September following the end of the financial year. Once the supplier pays, the recipient may re-avail the credit.
Prospective Application and Non-Retrospectivity
The absence of Section 41(2) and Rule 37A before 1 October 2022 supports the argument that the reversal obligation cannot be applied retrospectively. Applying it to past transactions would impose a new burden on recipients for periods when there was no such statutory requirement. Tax law generally avoids retrospective imposition of substantive obligations unless expressly stated in the legislation.
For the period from 1 July 2017 to 30 September 2022, recipients who complied with Section 16 conditions, paid the supplier, and held valid invoices could claim credit without fear of reversal solely due to supplier default. Any reversal in such cases would have to be justified under other provisions, such as ineligibility under Section 17 or evidence of fraudulent transactions.
Commercial Practices and Risk Mitigation
Before the introduction of Section 41(2), businesses managed the risk of supplier non-payment largely through commercial practices. This included dealing with reputed suppliers, maintaining proper documentation, and occasionally checking the filing status of key suppliers. While prudent, these steps were not mandated by law and non-compliance by the supplier did not automatically translate into reversal of the recipient’s credit.
This commercial approach allowed businesses to focus on their own compliance without being burdened with the role of monitoring supplier remittances in detail. The statutory separation of responsibilities meant that each party could be held accountable for their own defaults without shifting liability.
Early Disputes and Departmental Stand
Despite the absence of Section 41(2), some departmental officers sought to deny credit to recipients on the basis of supplier non-payment, invoking Section 16(2)(c). This led to disputes where the department argued that the condition required actual payment to the government as a prerequisite for credit. Recipients countered that they had no means to ensure supplier payment and that the absence of a procedural reversal mechanism made such enforcement impractical.
Tribunal and court rulings in several cases favoured the recipients, highlighting that the law as it stood did not impose an obligation to reverse credit in these circumstances. The department’s remedy lay in taking action against defaulting suppliers, not in penalising bona fide recipients.
The Need for Legislative Clarity
The introduction of Section 41(2) and Rule 37A can be seen as a response to this ambiguity. By creating a clear statutory requirement and procedure for reversal, the legislature removed the uncertainty that had characterised the pre-October 2022 period. However, this clarity also underscores that the earlier position did not mandate reversal solely for supplier non-payment.
For transactions in the earlier period, the law recognised the independence of supplier and recipient obligations. This framework balanced the objectives of revenue protection with the need for business certainty, avoiding the imposition of burdensome verification duties on recipients.
The Mechanics of Section 41(2)
Section 41(2) provides that the credit of input tax availed by a registered person under sub-section (1), in respect of such supplies where the tax payable has not been paid by the supplier, shall be reversed along with applicable interest, in the prescribed manner. This represents a direct statutory mandate, unlike the earlier period where such reversal was not explicitly required by law.
The provision operates in conjunction with Section 16(2)(c), which requires that the tax charged in respect of the supply be actually paid to the government. While Section 16(2)(c) had always existed, Section 41(2) and Rule 37A now provide the procedural enforcement tool to ensure that recipients cannot indefinitely retain credit for supplies on which the supplier has not discharged tax liability.
Rule 37A: Procedural Framework
Rule 37A, inserted with effect from 26 December 2022, sets out the process for reversal and re-availment of input tax credit in these circumstances. The rule specifies that where the supplier has not paid the tax on the supply by the due date for furnishing the return for the month of September following the end of the financial year in which the supply was made, the recipient shall reverse the credit along with interest payable under Section 50.
This timeline creates a clear cut-off for determining when reversal is required. If the supplier subsequently pays the tax, the recipient may re-avail the credit in the return for the period in which such payment is made. The re-availment does not require any fresh eligibility assessment, as the credit was originally admissible but temporarily reversed due to supplier default.
Compliance Responsibilities for Recipients
The introduction of Section 41(2) and Rule 37A has placed a new compliance burden on recipients. They must now monitor whether their suppliers have paid tax on supplies within the statutory timeframe. This involves:
- Regularly reconciling purchase records with GSTR-2B to identify invoices where suppliers have not reported the supply in their GSTR-1 or where payment of tax is uncertain.
- Following up with suppliers to ensure timely filing of returns and payment of tax.
- Maintaining records to substantiate that reversal has been made in cases of non-payment by the supplier, along with calculation and payment of applicable interest.
- Tracking subsequent payment by suppliers to re-avail reversed credit.
These responsibilities require enhanced accounting and tax compliance processes, often involving coordination between finance, procurement, and compliance teams.
Impact on Business Cash Flow
One of the significant consequences of this change is the potential impact on business cash flow. Reversing credit means paying the equivalent amount in cash towards output tax liability, along with interest from the date of original availment.
For businesses with high-value purchases, this can represent a substantial temporary cash outflow. While the credit can be re-availed once the supplier pays, the timing of such payment is not always within the recipient’s control, prolonging the cash flow impact. To mitigate this risk, businesses may adjust procurement practices, favouring suppliers with strong compliance records and prompt tax payment histories.
Transitional Challenges for Mixed-Period Transactions
A key area of complexity arises with transactions spanning the pre- and post-October 2022 periods. Supplies made before 1 October 2022 are not subject to the reversal requirement under Section 41(2) if the supplier fails to pay the tax, as the provision operates prospectively. However, supplies made after this date fall squarely within the scope of the provision.
This creates situations where businesses must segregate purchase records by supply date to determine which transactions are subject to the new rules. Invoices received after 1 October 2022 for supplies made earlier may require careful examination to determine the applicable regime.
Interaction with Section 16(2)(c)
The combination of Section 16(2)(c) and Section 41(2) creates a dual framework. Section 16(2)(c) remains a substantive condition for entitlement to credit, requiring that tax be paid to the government. Section 41(2) provides the procedural requirement to reverse and re-avail credit based on supplier payment status.
Before 1 October 2022, the absence of Section 41(2) meant that enforcement of Section 16(2)(c) in supplier default cases was less structured and often dependent on investigation. After 1 October 2022, the law provides a clear process, reducing scope for ambiguity but increasing the compliance load on recipients.
Interest Liability Under Section 50
Rule 37A specifies that interest is payable under Section 50 when reversing credit due to supplier non-payment. This interest applies from the date of original availment of credit until the date of reversal. The rate of interest is prescribed under the law, and the calculation must be precise to avoid further disputes.
This interest liability reinforces the importance of early detection of supplier defaults, as delays in reversal directly increase the cost to the recipient. Businesses may adopt monthly or quarterly monitoring cycles to limit interest exposure.
Supplier Relationship Management
The new regime heightens the importance of strong supplier relationship management. Recipients have a direct financial incentive to ensure that suppliers pay tax promptly, as failure to do so triggers reversal obligations. Strategies may include:
- Including compliance clauses in supplier contracts, with penalties or withholding provisions for non-compliance.
- Preferring suppliers with a track record of timely GST compliance.
- Regularly reviewing supplier GST return status through publicly available tools and portals.
Such measures help reduce the risk of credit reversal and associated interest costs.
Technology and Process Integration
Given the complexity of monitoring supplier compliance across potentially thousands of transactions, many businesses are turning to technology solutions. Integration of accounting systems with GST return data allows for automated reconciliation, flagging of risky transactions, and generation of reversal reports.
This reduces manual effort and improves accuracy in compliance. Automation can also assist in re-availment tracking, ensuring that once suppliers pay the tax, the credit is promptly reclaimed, restoring cash flow.
Departmental Enforcement Approach
From a departmental perspective, Section 41(2) provides a clear legal basis for recovery of ineligible credits due to supplier non-payment. Enforcement is likely to focus on ensuring that recipients reverse credit within the prescribed timelines, with interest. The availability of return data enables authorities to identify mismatches between credits availed and tax paid by suppliers.
However, for the pre-October 2022 period, departmental action must still be based on the original provisions, without reliance on the new reversal mechanism. This distinction is important in avoiding retrospective application of the law.
Risk of Litigation
The introduction of Section 41(2) reduces some areas of legal ambiguity but may create new grounds for dispute. For example, questions may arise about whether the supplier has “paid” tax for the purpose of the provision, particularly in cases involving set-off through credit utilisation, disputed liabilities, or adjustments in returns.
There may also be disputes over the classification of a transaction’s date for transitional cases, especially where there is a lag between supply, invoicing, and reporting in returns.
Comparative Perspective
The shift towards making recipients partly responsible for supplier compliance is not unique to India. In several VAT and GST regimes globally, mechanisms exist to deny or recover credit if the supplier fails to pay tax. These systems vary in their approach, with some placing heavy due diligence burdens on recipients, while others operate on a strict liability model.
India’s approach, through Section 41(2) and Rule 37A, represents a middle path — introducing a structured reversal and re-availment process while still allowing credit to be restored once the supplier pays.
Importance of Timely Supplier Compliance
The success of the post-October 2022 regime depends significantly on supplier compliance. Recipients have limited control over supplier payment behaviour beyond contractual and commercial measures. This reality underscores the importance of choosing reliable suppliers and building collaborative compliance relationships.
Some businesses are adopting more proactive approaches, such as linking payment release to confirmation of supplier GST filing for the relevant period. While this may not be feasible in all industries, it reflects the increasing alignment of tax compliance with commercial operations.
Education and Training
The new compliance environment requires that finance and procurement teams understand the operation of Section 41(2) and Rule 37A. Training sessions, internal guidelines, and clear workflows help ensure that staff can identify at-risk transactions, trigger reversal processes, and manage re-availment when eligible.
In larger organisations, dedicated GST compliance teams may be tasked with monitoring supplier behaviour, handling reversal and re-availment, and liaising with suppliers on compliance issues.
Conclusion
The evolution of GST input tax credit provisions from 1 July 2017 to the post-1 October 2022 era reflects a significant shift in compliance philosophy. In the initial years of GST, the statutory framework allowed recipients to claim credit based on valid tax invoices and payment to suppliers, without imposing a specific obligation to verify whether the supplier had actually remitted the tax to the government. This approach placed the primary responsibility for tax payment on suppliers, recognising their role as authorised tax collectors.
The introduction of Section 41(2) through the Finance Act, 2022, effective 1 October 2022, and the subsequent insertion of Rule 37A from 26 December 2022, fundamentally changed this position. Recipients are now procedurally required to reverse credit, along with applicable interest, if the supplier has not paid the tax within the prescribed timelines. The provision also enables re-availment of the reversed credit once payment is made, ensuring that the entitlement to credit is not permanently lost but is contingent on supplier compliance.
This change strengthens the government’s ability to secure tax revenue and closes gaps that previously allowed credit retention in supplier default cases. However, it also transfers part of the compliance and financial risk to recipients, necessitating closer monitoring of supplier behaviour, enhanced contractual safeguards, and integration of GST data reconciliation into regular business processes.
From a legal standpoint, the obligation under Section 41(2) operates prospectively and cannot be applied to supplies made before 1 October 2022. ITC availed for the period from 1 July 2017 to 30 September 2022 remains governed by the original self-assessment framework, subject only to the pre-existing conditions under Section 16. Any attempt to impose reversal for this earlier period solely on the basis of supplier non-payment would amount to a retrospective application of law, which is not supported by the statutory amendments.
For businesses, the path forward involves a combination of legal clarity, robust supplier due diligence, and the use of technology to manage compliance efficiently. While the revised framework may increase short-term administrative effort and cash flow exposure, it also provides a clear, codified process that, if managed well, can minimise disputes and secure legitimate credit entitlements in the long run.