ITC reversal under Rules 42 and 43: working the formula correctly

Two formulas that most taxpayers apply once a year and most auditors recompute. The difference is usually the definition of exempt supply.

Rule 42, in sequence

Start with total input tax on inputs and input services for the period. Remove credit attributable exclusively to non business purposes and credit attributable exclusively to exempt supplies. Remove blocked credit under Section 17(5). Remove credit attributable exclusively to taxable supplies including zero rated supplies, which remains fully available.

What is left is common credit. Five percent of common credit is attributed to non business purposes where inputs are used partly for business and partly otherwise. The balance is apportioned in the ratio of exempt turnover to total turnover.

The reversal is computed monthly on a provisional basis and finalised for the financial year before the due date for filing the return for September of the following year. The difference carries interest one way and a credit the other.

The turnover ratio uses the values of the preceding financial year where the current year's values are not available, which is a point departments frequently ignore in the first months of a year.

Rule 43, and the sixty month clock

Capital goods used exclusively for non business or exempt supplies get no credit. Those used exclusively for taxable supplies including zero rated get full credit. Common capital goods enter a pool.

The credit on common capital goods is spread over sixty months, and each month a proportion referable to exempt turnover is reversed. When a capital good leaves the pool, the residual life is adjusted.

The practical failure is the register. Rule 43 cannot be reconstructed at audit from a fixed asset schedule; it needs a month by month pool register maintained from the date of capitalisation.

Where the disputes actually arise

The definition of exempt supply. Section 17(3) includes supplies on which the recipient pays tax under reverse charge, transactions in securities, the sale of land, and the sale of a building subject to the construction entry. Interest income from deposits and loans is exempt and enters the ratio, which surprises manufacturers with treasury operations.

Zero rated supplies. These are not exempt, and credit attributable to them is fully available. An auditor who includes export turnover in exempt turnover is making a fundamental error.

Schedule III activities, which are outside supply altogether, and whether their value enters total turnover. This affects the ratio and should be computed and disclosed rather than assumed.

Interest income on inter corporate deposits and on delayed payments from customers, which are treated differently and must be separated.

What to do on Monday

1. Rebuild the exempt turnover definition from Section 17(3) each year, including interest income, securities and land, before running the formula.

2. Maintain the Rule 43 capital goods pool as a live monthly register from the date of capitalisation.

3. Complete the annual reconciliation before the September return deadline and record whether the difference is payable with interest or claimable.

4. Keep the working papers with the turnover source data; a formula without the source data is not defensible three years later.

Questions we are asked on this

Is export turnover included in exempt turnover for Rule 42?

No. Zero rated supplies are taxable supplies for this purpose and credit attributable to them is fully available.

Does interest income affect the reversal?

Interest on deposits, loans and advances is an exempt supply and enters the exempt turnover in the ratio. For entities with large treasury balances this is often the single largest driver of the reversal.

What happens if the annual reconciliation shows we over reversed?

The excess is available as credit, claimed in the return for a period not later than September of the following financial year.

Are the five percent non business attribution and the exempt ratio both applied?

Yes, in sequence, where inputs are used partly for non business purposes. Applying only one of them understates the reversal.

Do we need a separate register for Rule 43?

In practice, yes. The sixty month pool cannot be reliably reconstructed later, and its absence is treated as an absence of the reversal.

In this cluster

• Input tax credit under GST: the complete 2026 position
• Section 16(2)(c): can your ITC be denied because the supplier did not pay tax?
• Section 16(4) time limit for claiming ITC: what survives after the amnesty
• GSTR-2A and 2B mismatch notices: how to answer without conceding
• Blocked credits under Section 17(5): the clause by clause map
• Safari Retreats: what the Supreme Court decided on ITC for construction, and what Parliament then undid
• ITC on canteen, transport, insurance and other employee benefits
• Rule 37: ITC reversal when you do not pay your supplier within 180 days
• Rule 37A: reversal where your supplier did not file its GSTR-3B
• Rule 86A blocking of the electronic credit ledger: the remedies that actually work

GST Insights is published by AMLEGALS for general information. Law stated as on 3 September 2026. Not advice on any particular set of facts; not an advertisement or a solicitation under Rule 36 of the Bar Council of India Rules. Readers with a question on their own facts may write to the GST practice of their own accord.