The principle of value-added tax dictates that input tax credit is only available when tax is payable on the output. If a registered person is involved in both taxable and exempt supplies, they can claim only a proportionate input tax credit. This applies to input goods, input services, and capital goods. Section 17 of the CGST Act provides the framework for this mechanism.
According to section 17(1) of the CGST Act, when goods or services or both are used by the registered person partly for business and partly for other purposes, the input tax credit must be restricted to the portion attributable to business use. Similarly, section 17(2) of the CGST Act states that when the goods or services or both are used partly for taxable (including zero-rated) supplies and partly for exempt supplies, the credit shall be restricted to the portion attributable to taxable supplies. The manner for determining this proportionate credit may be prescribed by notification under section 17(6) of the CGST Act.
This concept is similar to the earlier Rule 6 of the CENVAT Credit Rules. Under the CGST Act, a taxable supply is any supply of goods or services that is subject to tax under the Act as per section 2(109). A non-taxable supply is defined under section 2(78) and refers to supplies that are not leviable to tax under either the CGST or IGST Act.
Inclusion of Alcoholic Liquor in Exempt Supplies
The supply of alcoholic liquor for human consumption is a non-taxable supply and hence is treated as an exempt supply. This principle was upheld in the case of Karnani FNB Specialities LLP, where it was held that proportionate reversal of input tax credit is required when a restaurant also supplies alcoholic liquor.
Zero-Rated Supplies and Input Tax Credit
Section 2(23) of the IGST Act defines zero-rated supply as a supply of goods or services under section 16 of the IGST Act. According to section 16(1), zero-rated supplies include exports and supplies to SEZ units or developers. Input tax credit is available for making such supplies, even if they are otherwise exempt. Section 16(2) allows credit for inputs used in making zero-rated supplies. The registered person can choose one of two methods to claim refunds:
Supplying goods under bond or LUT without payment of IGST and claiming a refund of unutilized input tax credit. Supplying goods on payment of IGST and claiming a refund of the tax paid. The refund process must comply with section 54 of the CGST Act as stated in section 16(3) of the IGST Act.
Definition and Valuation of Exempt Supply
Section 2(47) of the CGST Act defines exempt supply as any supply attracting nil rate of tax or wholly exempt from tax under section 11 of the CGST Act or section 6 of the IGST Act, and includes non-taxable supplies. Non-taxable supplies are defined under section 2(78). Exempt supply, however, does not include activities specified in Schedule III of the CGST Act, except for the value of land, buildings, and securities, as specified in section 17(3).
According to section 17(3), exempt supply includes supplies where GST is payable under reverse charge, transactions in securities, sale of land, and sale of buildings (except in cases where supply occurs before completion). The value of land and buildings for this purpose shall be the same as that adopted for stamp duty. The value of securities is considered to be 1% of their sale value. These explanations are elaborated in Rule 45 of the CGST Rules.
Apportionment of Input Tax Credit Based on Value or Area
Generally, section 17(3) mandates apportionment of input tax credit between exempt and taxable supplies based on value. However, for real estate services from 1 April 2019, apportionment is based on the area of construction as per Removal of Difficulties Order No. 04/2019-CT dated 29 March 2019.
Treatment of Schedule III Activities
Activities or transactions in Schedule III are not considered exempt supplies unless specifically mentioned. For section 17(3), exempt supply does not include the value of activities listed in Schedule III except those covered in paragraph 5 (sale of land or completed building) and certain activities under paragraph 8(a) (e.g., supply of warehoused goods before clearance). With effect from 1 October 2023, supplies from duty-free shops at arrival terminals fall under exempt supplies for input tax credit reversal under rule 43 of the CGST Rules.
Classification of Electricity and Interest
Electricity is classified as an exempt supply. Interest, although exempt, is excluded from the exempt supply for rules 42 and 43, except when provided by banks, financial institutions, or NBFCs. This clarification is found in Explanation 1(b) to rule 43(2) of the CGST Rules and applies retrospectively from 1 July 2017.
Supply to Nepal and Bhutan
Up to 1 February 2019, services supplied to Nepal and Bhutan were not considered exempt fromm input tax credit reversal if the payment was received in Indian rupees. This exclusion is found in Explanation (a) tRulele 43(2) of the CGST Rules. After 1 February 2019, supply to Nepal and Bhutan qualifies as export even if payment is received in Indian currency, making such supplies zero-rated and outside the scope of exempt supply.
Outward Freight and Duty Credit Scrips
From 1 October 2023, outward freight from India to foreign destinations is included in the value of exempt supply for purposes of ITC reversal. This follows the omission of Explanation 1(c) to Rule 43. Duty credit scrips, however, are not treated as exempt supply under Explanation 1(d) to Rule 43, confirmed in the ruling involving Kaveri Exports.
Special Provisions for Banks, Financial Institutions, and NBFCs
Section 17(4) of the CGST Act provides an alternative method for ITC for banking companies, financial institutions, and NBFCs. They may opt to avail of only 50% of the eligible input tax credit each month instead of calculating proportionate credit under section 17(2). Once this option is exercised, it must be followed throughout the financial year. Supplies made by one branch to another with the same PAN are excluded from this 50% restriction.
Eligibility of Co-operative Societies as Financial Institutions
Co-operative societies that accept deposits and provide loans qualify as financial institutions and can opt for the 50% ITC scheme under section 17(4). This was confirmed in the ruling concerning Knanaya Multi Purpose Co-operative Credit Society Ltd.
Claim Procedure for ITC by Financial Institutions
When opting for the 50% ITC method, a financial institution must not claim credit on inputs and input services used for non-business purposes or those blocked under section 17(5). Credit for inter-branch supplies under the same PAN may be fully claimed. Fifty percent of the remaining credit may be availed and reported in Form GSTR-2. The admissible amount will then be credited to the electronic credit ledger by rules 41 to 43 of the CGST Rules, which deal with provisional credit and reconciliation.
Allocation of Input Tax Credit (ITC) Between Business and Non-Business Use
According to Section 17(1) of the CGST Act, if goods or services or both are used partly for business purposes and partly for other than business purposes, the input tax credit must be restricted to the portion attributable to business purposes only. Rule 42 of the CGST Rules, 2017, specifies how such reversal shall be calculated.
The taxpayer must first identify input tax credit (ITC) related solely to business use and that used exclusively for other purposes. ITC related solely to business use is fully eligible, whereas ITC used for non-business purposes is ineligible and must be reversed. The remaining common credit must be apportioned using a prescribed formula. Rule 42 requires monthly calculation and reversal of ineligible ITC, with a final annual adjustment.
This apportionment process helps ensure that ITC is claimed only to the extent it relates to taxable supplies or business use. For example, if a registered person uses a car for both business and personal purposes, only the business portion of the fuel, repair, and insurance ITC can be claimed. The personal portion must be reversed as per the proportion determined using a reasonable method supported by records.
Apportionment of ITC Between Taxable and Exempt Supplies
Section 17(2) of the CGST Act requires that ITC be restricted to the portion used for making taxable supplies, including zero-rated supplies. If goods or services are used for both taxable and exempt supplies, ITC must be apportioned accordingly.
Exempt supplies include nil-rated, wholly exempt supplies, and non-taxable supplies. Rule 42 provides the method to calculate the eligible and ineligible portion of common credit. The taxpayer must identify the inputs and input services used exclusively for taxable supplies, those used exclusively for exempt supplies, and the remaining common credit.
The common credit must be apportioned using the formula: Ineligible Credit (D2) = Common Credit (C2) × (Exempt Turnover ÷ Total Turnover). This amount must be reversed in the electronic credit ledger. The total turnover includes taxable, exempt, and export supplies, but excludes inward supplies liable to reverse charge and taxes.
Monthly reversal must be done during the financial year, with a final adjustment after the end of the year based on actual turnover. Any excess or short reversal must be adjusted in September following the end of the financial year.
This ensures that ITC is not claimed on inputs or input services used in exempt supplies, thereby aligning with the destination-based nature of GST.
ITC in Case of Banking and Financial Institutions
Banking companies or financial institutions, including NBFCs, face difficulties in identifying the actual usage of input services for taxable or exempt supplies. To address this, Section 17(4) of the CGST Act allows them an option.
They may either:
- Follow the general method under Section 17(2) and Rule 42 for apportioning input tax credit, or
- Avail only 50% of the eligible input tax credit on inputs, capital goods, and input services each month.
If the 50% option is selected, it must be followed consistently for all credits in that financial year. Once opted for, this option cannot be withdrawn during the year. Additionally, ITC on supplies made between branches or units of the same entity having the same PAN is not subject to this 50% restriction.
The 50% restriction is not applicable to input services received from another registered branch under the same PAN. It allows ease of compliance and reduces the need for complex apportionment calculations.
For example, a bank having both exempt interest income and taxable processing fees may find it difficult to segregate ITC for each activity. The 50% flat rate option simplifies this process, even though it may lead to a loss of some credit.
Manner of Reversal of Input Tax Credit – Rule 42
Rule 42 of the CGST Rules provides the manner of determination of input tax credit attributable to non-business purposes or exempt supplies for inputs and input services. It involves the following steps:
- Identify the amount of input tax credit attributable to inputs and input services exclusively used for non-business purposes (T1) and exempt supplies (T2). These are fully ineligible.
- Identify the input tax credit attributable to inputs and input services exclusively used for taxable supplies (T3). These are fully eligible.
- Compute the common credit (C2) = Total input tax credit on inputs and input services – (T1 + T2 + T3).
- From the common credit (C2), calculate the ineligible portion attributable to exempt supplies (D1) using: D1 = (E ÷ F) × C2, where E is the aggregate value of exempt supplies during the tax period and F is the total turnover in the state of the registered person.
- Calculate D2, the ineligible portion attributable to non-business purposes, as 5% of common credit (C2).
- The total amount to be reversed (D) = D1 + D2. This must be added to the output tax liability.
- The remaining common credit (C3 = C2 – D) is the eligible credit.
A registered person must reverse this amount in GSTR-3B under Table 4(B)(1). An annual reconciliation and adjustment must be done before the due date for filing the September return of the following financial year.
If the actual exempt turnover at the year-end is higher than estimated, an additional reversal must be made with interest. If it is lower, excess reversal can be reclaimed.
This rule ensures that ITC is fairly attributed only to taxable business supplies and avoids misuse.
Manner of Reversal of ITC for Capital Goods – Rule 43
Rule 43 deals with the apportionment and reversal of input tax credit on capital goods used for both taxable and exempt supplies or for business and non-business purposes. The steps include:
- Identify capital goods used exclusively for taxable or exempt supplies and for non-business purposes. Credit on capital goods used exclusively for taxable supplies is fully eligible. Credit on those used exclusively for exempt supplies or non-business purposes is ineligible.
- For capital goods used commonly, the input tax credit must be spread over 60 months (5 years). The monthly ITC (Tm) = Total input tax on capital goods ÷ 60.
- The amount of ineligible ITC attributable to exempt supplies (Te) = (Exempt Turnover ÷ Total Turnover) × Aggregate of Tm for all such capital goods.
- This amount (Te) must be reversed in GSTR-3B. Interest is payable if the reversal is delayed beyond the due date.
- If capital goods are sold before 5 years, the balance of unutilized credit must be reversed.
Annual adjustments must also be made based on actual turnover. This ensures proportionate credit is claimed in line with usage and avoids over-claiming.
For example, if a machine costing Rs. 10,00,000 with Rs. 1,80,000 GST is used for both taxable and exempt supplies, the monthly credit = 1,80,000 ÷ 60 = Rs. 3,000. If 30% of turnover is exempt, then 30% of Rs. 3,000 = Rs. 900 is ineligible monthly credit and must be reversed.
Reversal of ITC on Failure to Make Payment to Supplier
Section 16(2) of the CGST Act provides that if a recipient fails to pay the supplier within 180 days from the date of invoice, the input tax credit availed must be reversed along with interest.
The reversal must be made in GSTR-3B in the month immediately following the expiry of 180 days. The interest is calculated from the date of availing the credit till the date of reversal. Once payment is made to the supplier, the ITC can be reclaimed.
This provision ensures that ITC is claimed only on genuine transactions where actual consideration has been paid. It discourages delays in vendor payments.
For example, if a taxpayer avails of ITC in January on an invoice dated 10th January but does not pay the vendor by 10th July, the ITC must be reversed in the July return, with interest. If payment is made in August, the credit can be reclaimed in the August return.
Reversal of ITC in Case of Credit Notes
When a credit note is issued by a supplier for return of goods, post-sale discounts, or corrections in value, the recipient must proportionately reverse the input tax credit. The reversal must be done in the same proportion in which ITC was originally claimed.
This is done by reducing the ITC in the month in which the credit note is reflected in GSTR-2B. If the ITC is already utilized, the reversal must be made by paying an equal amount in cash or by reducing future ITC claims.
Reversal of Input Tax Credit Under Rule 42 and Rule 43 of CGST Rules
In cases where inputs or input services are used partly for effecting taxable supplies (including zero-rated supplies) and partly for effecting exempt supplies, and also where such inputs are used partly for business and partly for non-business purposes, the common credit needs to be reversed proportionately under Rule 42 of the CGST Rules. The methodology for reversal is specifically laid out in Rule 42 (for input and input services) and Rule 43 (for capital goods). Rule 42 of the CGST Rules prescribes the manner of determination and reversal of input tax credit in respect of inputs and input services used partly for business and partly for non-business purposes, or partly for effecting taxable and exempt supplies.
The total input tax credit on inputs and input services, denoted as “T,” shall be segregated as follows: T1 – the amount of input tax credit attributable to inputs and input services intended to be used exclusively for purposes other than business. This amount shall not be credited to the electronic credit ledger. T2 – the amount of input tax credit attributable to inputs and input services intended to be used exclusively for effecting exempt supplies. This amount shall also not be credited to the electronic credit ledger. T3 – the amount of input tax credit attributable to inputs and input services intended to be used exclusively for effecting taxable supplies, including zero-rated supplies. This amount shall be credited to the electronic credit ledger. T4 – the amount of input tax credit in respect of inputs and input services which are common and attributable to both taxable and exempt supplies and business and non-business purposes. T = T1 + T2 + T3 + T4.
T1 and T2 are ineligible credits and are not included in the electronic credit ledger. T3 is an eligible credit that is fully allowed. T4 is the common credit that needs to be apportioned. T4 is calculated by subtracting T1, T2, and T3 from the total credit (T). Once T4 is calculated, the following computations are done: D1 – the amount of input tax credit attributable towards exempt supplies = (E/F) × T4, where E is the aggregate value of exempt supplies during the tax period, and F is the total turnover in the State of the registered person during the tax period. D2 – the amount of input tax credit attributable towards non-business purposes = 5% of T4. The total amount of credit to be reversed during the tax period = D1 + D2. This amount shall be added to the output tax liability. The amount of input tax credit credited to the electronic credit ledger = T – (T1 + T2) = T3 + T4. The amount of input tax credit eligible for the credit after reversal = T3 + (T4 – D1 – D2).
This calculation is to be done for each tax period, and at the end of the financial year, a final computation is required to ascertain the accurate amount of reversal. If there is any shortfall or excess in reversal compared to what was reversed monthly, the differential shall be adjusted in September following the end of the financial year.
Special Cases of Reversal of Input Tax Credit
There are certain specific instances where Input Tax Credit needs to be reversed. Some of these special cases include:
- Failure to pay supplier within 180 days: If a recipient fails to pay the supplier the value of the supply along with tax within 180 days from the date of invoice, the amount of ITC availed needs to be added to the output tax liability, along with interest. Once payment is made, ITC can be reclaimed.
- Depreciation on capital goods, including tax component: If depreciation is claimed on the tax component of capital goods under the Income Tax Act, ITC shall not be allowed on such tax component.
- Credit note issued by supplier: If a credit note is issued by the supplier for any supply and tax thereon is reduced, then proportionate ITC needs to be reversed by the recipient.
- Goods lost, stolen, destroyed, written off, or disposed of by way of gift or free samples: ITC is not available on such goods under Section 17(5) of the CGST Act.
- Change in the scheme: A taxpayer opting for the composition scheme from a regular scheme must reverse the ITC availed in respect of inputs held in stock, inputs contained in semi-finished or finished goods, and on capital goods (reduced by a prescribed percentage).
- Cancellation of GST registration: Upon cancellation of registration, the balance ITC on inputs in stock, inputs in semi-finished or finished goods, and on capital goods (after reducing depreciation) shall be reversed.
Input Tax Credit Reversal under Rule 43 for Capital Goods
Rule 43 provides the manner of determination and reversal of input tax credit in respect of capital goods used partly for effecting taxable supplies and partly for exempt supplies. The method under Rule 43 is more complex compared to Rule 42. In essence, it requires allocation of ITC over 60 months (5 years). The total ITC on capital goods is denoted as “A.” If the capital goods are used exclusively for non-business or exempt supplies, the credit shall not be allowed. If exclusively used for taxable supplies, the credit is fully allowed.
If the capital goods are used commonly, the credit is distributed equally over 60 months, i.e., A/60 for each month. This monthly ITC is considered for reversal in proportion to the exempt turnover. Every month, the common credit (A/60) needs to be apportioned as follows: Tm – amount of input tax credit attributable to exempt supplies = (E/F) × (A/60). This amount is to be added to the output tax liability. The remaining amount is retained as eligible ITC. If the capital goods are sold or disposed of before the expiry of 5 years, the unavailed credit needs to be reversed proportionately.
Input Tax Credit in Case of Banking Companies and NBFCs – Section 17(4)
Section 17(4) of the CGST Act provides a specific option to a banking company or a financial institution,, including a non-banking financial company (NBFC). They may opt for either: a) Avail ITC only on supplies used for business and taxable/exempt supplies (subject to reversal under Rule 42 and 43), or b) Avail 50% of the eligible input tax credit on inputs, capital goods, and input services every month. Once an option is chosen, it applies to all branches under the same PAN.
This provision offers simplified compliance to banks and financial institutions since it is difficult to maintain the segregation of inputs used for exempt and taxable services. However, this option of availing only 50% credit is not available on inward supplies from another registered person having the same PAN.
Manner of Reversal of Credit under Section 18
Under Section 18(4) of the CGST Act, where a person switches from a regular scheme to a composition scheme, or where goods or services become exempt, ITC shall be reversed. The reversal shall be in respect of inputs held in stock, inputs contained in semi-finished or finished goods, and capital goods (after reducing the credit by 5% per quarter of use). The reversal is required through the filing of Form GST ITC-03. Similarly, where a person becomes liable to pay tax and takes registration, or where exempt supplies become taxable, he may avail ITC on inputs and capital goods held in stock through Form GST ITC-01.
Reversal of Input Tax Credit in Case of Real Estate Projects – Rule 42 and Rule 43 with Modifications
For real estate projects, a specific mechanism for reversal of ITC is notified through Notification No. 11/2019 and 16/2019. For projects commencing on or after 1st April 2019, a real estate promoter has to reverse input tax credit proportionately if opting for a reduced rate of 1% (affordable housing) or 5% (other residential). The reversal is required even if the services/goods are used for taxable construction activity since under reduced rate schemes, ITC is not allowed. The mechanism under Rule 42 and Rule 43 is modified, and special formulae are prescribed to determine eligible and ineligible ITC based on project area, carpet area, and invoicing.
Reporting of ITC Reversal in GSTR-3B and GSTR-9
Reversal of input tax credit has to be reported properly in GST returns. In GSTR-3B, Table 4(B) is used for ITC reversals. The categories include: a) As per Rule 42 and 43; b) Others (such as reversal on account of non-payment to suppliers, or reversal under Section 17(5)). In GSTR-9, the Annual Return, details of ITC availed and reversed must be reported in Part IV and V. Any mismatch between GSTR-3B and GSTR-2A/2B due to ineligible credit or reversal also needs to be reconciled. Proper documentation is essential to support reversals and avoid demands from GST authorities.
Reversal of Input Tax Credit in Case of Non-Payment to Supplier
As per the GST provisions, the recipient of goods or services must pay the supplier the value of supply along with the tax within 180 days from the date of invoice. If the recipient fails to make the payment within 180 days, the ITC claimed on such supply will be added to the output tax liability along with interest thereon. This ensures that the tax credit is only retained when the corresponding payment is made. However, once the payment is made to the supplier, the ITC can be reclaimed. Therefore, businesses need to maintain proper records and regularly reconcile accounts payable to suppliers to ensure timely payment and avoid reversal of ITC.
Reversal of Input Tax Credit in Case of Credit Note Issued
When a supplier issues a credit note under Section 34 of the CGST Act and such credit note is linked to the invoice on which the recipient has claimed ITC, the recipient needs to reverse the ITC proportionate to the amount of the credit note issued. The reversal must be reported in the return in which the credit note is declared. It is important to track all credit notes and match them with the corresponding invoices to ensure accurate reversal of ITC.
Reversal of Input Tax Credit in Case of Capital Goods
If capital goods are used partly for business and partly for non-business purposes, or partly for taxable and partly for exempt supplies, the input tax credit is allowed only to the extent they are used for business and taxable supplies. When such capital goods are sold or disposed of, or their usage changes, the ITC claimed needs to be reversed accordingly. Moreover, if capital goods on which ITC was claimed are no longer used for business purposes, the remaining credit attributable to the unexpired life must be reversed. The useful life of capital goods is considered as five years from the date of invoice. Therefore, for reversal purposes, ITC is reduced by 5% per quarter or part thereof from the date of invoice.
Reversal of ITC on Switching from Regular Scheme to Composition Scheme
When a registered person opts for the composition scheme under Section 10, the person is required to reverse the ITC availed in respect of inputs held in stock, inputs contained in semi-finished or finished goods, and capital goods (calculated proportionately) on the day immediately preceding the date of opting into the composition scheme. The amount so reversed shall be paid by way of debit in the electronic credit ledger or cash ledger.
Reversal of ITC on Cancellation of GST Registration
When the registration of a person is cancelled, whether suo-moto or on application, the person is required to reverse the ITC in respect of inputs held in stock, inputs contained in semi-finished or finished goods, and capital goods (based on useful life) on the date of cancellation. The amount of reversal must be paid by debiting the electronic credit ledger or electronic cash ledger. Any balance ITC remaining after such reversal lapses and cannot be carried forward or refunded.
ITC Reversal in Case of Blocked Credits
Section 17(5) of the CGST Act provides for certain situations where input tax credit is not available (commonly referred to as blocked credits). If a taxpayer inadvertently avails such blocked credits, they must reverse the same in the return along with interest. Examples of blocked credits include motor vehicles (with certain exceptions), goods or services used for personal consumption, membership of clubs, health and life insurance (with exceptions), travel benefits to employees, construction of immovable property (except plant and machinery), and goods lost, stolen, destroyed, or disposed of by way of gift or free samples.
Reporting and Compliance for ITC Reversal
Proper and timely reporting of ITC reversal is mandatory. All reversals need to be disclosed in GSTR-3B under Table 4(B) “ITC Reversed.” If the ITC is reversed due to ineligibility, it must be reported under 4(B)(1), and if due to rule-based reversals, it must be reported under 4(B)(2). Further, all entries related to credit notes and reversals must also be matched with GSTR-2B and the purchase register. Any mismatch may lead to a notice from the GST department or disallowance of ITC. Businesses must maintain documentary evidence supporting ITC claims and reversals, including invoices, payment proofs, utilization details, and working papers for apportionment and reversal.
Interest and Penalty on Reversal
If the input tax credit is wrongly availed or not reversed within the stipulated time, interest at the rate of 18% per annum is payable from the date of availing the credit till the date of reversal. Further, if such reversal is not done voluntarily and is detected in assessment or audit proceedings, a penalty may also be levied under Section 73 or 74, depending upon the nature of the contravention (i.e., whether with or without intent to evade tax).
Conclusion
The allocation and reversal of Input Tax Credit under GST is a critical compliance area. Businesses must carefully track the usage of inputs and capital goods, payment status to suppliers, and changes in business structure or tax status that may require reversal of ITC. Proper maintenance of documentation, timely payment of tax, and accurate reporting in GST returns are essential to avoid interest and penalties. A robust accounting and reconciliation process can ensure that ITC benefits are availed optimally and within the framework of GST law.