The ITC Reversal Framework
The GST law permits credit only for inputs used in making taxable supplies. When inputs are used for both taxable and exempt supplies, or for business and non-business purposes, proportionate credit must be reversed under Rules 42 and 43 of the CGST Rules.
This sounds simple in principle but creates considerable complexity in practice. The boundaries between taxable and exempt use are not always clear. The calculation methodology requires careful application. The reconciliation between monthly provisioning and annual true-up demands attention to detail.
Rule 42: Inputs and Input Services
Rule 42 applies to inputs and input services. The computation involves three categories of credit. First, credit attributable exclusively to exempt supplies must be reversed in full. Second, credit exclusively for taxable supplies is retained in full. Third, common credit must be apportioned based on turnover.
Turnover-Based Apportionment
Common credit is reversed in the ratio of exempt turnover to total turnover. The rule requires monthly provisional computation with an annual true-up in the return for the month following the financial year end.
The monthly computation uses the turnover of the preceding month. This creates a lag that the annual true-up is designed to correct. Businesses must track both the monthly provisioning and the annual reconciliation as separate compliance obligations.
Rule 43: Capital Goods
Rule 43 provides a separate framework for capital goods, spreading the reversal over a five-year period. This recognises the longer useful life of capital goods and provides a mechanism for adjusting reversals if the use pattern changes.
The five-year spreading creates tracking complexity. Each capital asset must be monitored throughout its useful life for changes in taxable versus exempt use. Systems that were adequate for revenue compliance may need enhancement to handle capital goods tracking.
Common Compliance Issues
Several issues frequently arise in ITC reversal compliance. Incorrect identification of exempt versus non-GST turnover is surprisingly common. Securities trading, for instance, must be included in exempt turnover but is often overlooked by businesses that do not consider themselves in the securities business.
Failure to include securities trading in exempt turnover has caught many corporations by surprise. Interest income on inter-corporate deposits is another commonly missed item. The exempt turnover calculation requires comprehensive identification of all exempt activities, not just the obvious ones.
Errors in capital goods useful life calculations compound over the five-year period. Getting the base calculation wrong means getting every subsequent year wrong as well. The annual corrections become progressively more complex.
Missing the annual true-up deadline creates a different category of problem. The law specifies when the adjustment must be made. Failure to comply is a procedural violation regardless of whether the substantive calculation is correct.
Documentation Requirements
Taxpayers must maintain detailed records supporting ITC computations. Credit registers segregated by use category, turnover calculations supporting the apportionment ratios, and reversal workings for each period are essential. These records will be scrutinised in any audit.
The burden of proof in GST matters rests on the taxpayer. If you cannot demonstrate that your ITC claims are correct with contemporaneous documentation, the department will presume error and raise demands. Reconstruct evidence created years after the fact is always less convincing than records created at the time.
Practical Approach
We recommend implementing automated tracking systems for credit categorisation at the invoice level. Monthly reconciliation between credit ledgers and Rule 42/43 workings helps identify discrepancies early and ensures accurate annual true-up.
The investment in proper systems and processes pays for itself many times over. A single adverse assessment can cost more than years of compliance infrastructure. Build the systems now. Follow the processes rigorously. Sleep soundly when the audit notice arrives.
