Input Tax Credit (ITC) is one of the key features of the Goods and Services Tax (GST) regime, which allows taxpayers to claim the credit of GST paid on the purchases of goods and services used for business purposes. There are certain situations where the ITC claimed by the taxpayers needs to be reversed, either partially or fully, as per the provisions of the GST law and rules.
One such case is when taxpayers use inputs or services for both taxable/exempt supplies or business/non-business purposes. Rule 42 of CGST Rules, 2017, mandates reversing the proportionate ITC for exempt/non-business purposes.
In our blog, we'll break down ITC reversal under Rule 42, why it's required, and how to calculate it. Plus, we'll share examples and tips for compliance.
Also Read: A Closer Look at GST Section 17(5): The Blocked Input Tax Credit List
What is ITC Reversal under Rule 42?
Rule 42 of the CGST Rules governs the reversal of Input Tax Credit (ITC) for inputs and input services used for both taxable and exempt supplies or for both business and non-business purposes. This rule applies to all GST-registered taxpayers, except those under the composition scheme or paying tax under the reverse charge mechanism.
According to this rule, the ITC on inputs and input services can be classified into two categories:
Specific Credit:
Input Tax Credit (ITC) that is specifically connected to a given supply (taxable or exempt) or purpose (business or non-business) is known as a "specific credit." For example, the ITC on purchases of stationery made exclusively for personal use or raw materials used only for taxable supplies qualifies as a specific credit for the taxpayer.
Common Credit:
On the other hand, common credit includes ITC that is not directly related to any particular supply or purpose, but is instead used for both business and non-business purposes, as well as taxable and exempt supplies. The ITC on these purchases falls under common credit, for instance, if a taxpayer buys electricity for a factory that produces both taxable and exempt goods, or a laptop that is used for both personal and business purposes.
Rule 42 requires the taxpayers to reverse the common credit to the extent it is attributable to the exempt or non-business supplies or purposes. The specific credit, on the other hand, does not need to be reversed, as it is already identified and segregated.
Why is ITC Reversal under Rule 42 Required?
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Preventing Cascading Taxes:
- Avoiding tax on tax (cascading effect) is important.
- GST system aims to eliminate this by allowing GST credit on inputs for taxable supplies.
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Maintaining Tax Neutrality:
- Using inputs for both taxable and exempt supplies could lead to undue benefits from ITC.
- Distorts tax neutrality and fairness.
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Compliance with GST Laws:
- Rule 42 mandates the reversal of ITC related to exempt supplies to ensure accurate taxation.
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Ensuring Value Addition Taxation:
- ITC reversal ensures GST is only levied on value addition, not the entire supply value.
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Distinguishing Business vs. Non-Business Use:
- Inputs used for both business and non-business purposes need ITC reversal for non-business use.
- Aligns with GST principles, allowing ITC solely for business purposes.
How is ITC Reversal under Rule 42 Calculated?
1. Calculation Formula:
Rule 42 gives a way to figure out how much ITC needs to be reversed.
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Formula: D1 = (T1 × T2) / T3
- D1: The amount of ITC to be reversed
- T1: The common credit on inputs and input services for a tax period
- T2: The total value of exempt supplies made during the tax period
- T3: The total turnover in the state or union territory of the taxpayer during the tax period
2. Apportionment among Tax Heads:
The ITC reversal amount (D1) is divided among central tax, state tax, union territory tax, and integrated tax.
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Formula: D2 = (D1 × Tx) / T
- D2: The amount of ITC to be reversed for each tax head
- Tx: The tax rate applicable to the supply attracting the highest tax rate during the tax period
- T: The total of tax rates applicable to the supplies made during the tax period
3. Impact on Output Tax Liability:
The reversed ITC amount (D2) is added to the output tax liability for the month of reversal.
4. Interest Payment Requirement:
- Taxpayers must pay interest at 18% per year on the reversed ITC amount.
- Interest starts from the date of taking the ITC until the date of reversal.
5. Record Keeping Obligation:
- Taxpayers must keep a record of the ITC calculation and reversal under Rule 42 in Form GSTR-2 within the electronic credit ledger.
Examples of ITC Reversal under Rule 42
Let us understand the calculation and reversal of ITC under Rule 42 with the help of some examples.
Example 1: Manufacturer
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Business Overview:
- The taxpayer manufactures and supplies both taxable and exempt goods.
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Transaction Summary (January 2024):
- Purchases (including GST): Rs 1,00,000
- Taxable Goods Sales (excluding GST): Rs 2,00,000
- Exempt Goods Sales: Rs 1,00,000
- Tax Rate on Taxable Goods: 18%
- Tax Rate on Exempt Goods: Nil
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ITC Calculation:
- Total ITC Availed: Rs 18,000 (18% of Rs 1,00,000)
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Reversal Calculation:
- D1 = Rs 6,000 (ITC to be reversed)
- D2 = Rs 6,000 (ITC to be reversed for each tax head)
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Outcome:
- The taxpayer reverses Rs 6,000 of ITC and adds it to output tax liability for January 2024.
- Interest is payable at 18% per annum from the date of ITC availing.
Example 2: Service Provider
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Business Overview:
- The taxpayer offers both taxable and exempt services.
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Transaction Summary (January 2024):
- Purchases (including GST): Rs 50,000
- Taxable Services Sales (excluding GST): Rs 1,00,000
- Exempt Services Sales: Rs 50,000
- Tax Rate on Taxable Services: 12%
- Tax Rate on Exempt Services: Nil
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ITC Calculation:
- Total ITC Availed: Rs 6,000 (12% of Rs 50,000)
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Reversal Calculation:
- D1 = Rs 2,000 (ITC to be reversed)
- D2 = Rs 2,000 (ITC to be reversed for each tax head)
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Outcome:
- The taxpayer reverses Rs 2,000 of ITC and adds it to the output tax liability for January 2024.
- Interest is payable at 18% per annum from the date of ITC availing.
Tips and Tricks for ITC Reversal under Rule 42
Here are some tips and tricks that can help you comply with Rule 42 and avoid any penalties or interest:
1. Keep Clear Records
Maintain separate records for inputs and input services used exclusively for taxable or exempt supplies and for business or non-business purposes. This makes it easier to identify specific and common credits.
2. Use Electronic Ledger
Utilize Form GSTR-2 in the electronic credit ledger to track and record ITC calculation and reversal under Rule 42. Consider using online ITC reversal calculators for accuracy and ease.
3. Monthly Reversal
Reverse ITC under Rule 42 every month when filing the monthly return in Form GSTR-3B. This prevents any penalties or interest charges due to delayed reversal.
4. Year-End Review
Review and adjust ITC reversal under Rule 42 at the end of the financial year based on actual turnover and supplies data. Make necessary revisions in the annual return using Form GSTR-9.
Also Read: Cascading Taxes to GST: India's Journey to a Transparent Tax System
FAQs
Q: What is the Reversal of ITC under Rule 42 of CGST Rules?
A: Reversal of ITC under Rule 42 of CGST Rules is a process where the taxpayers who use the inputs and input services for both taxable and exempt supplies, or for both business and non-business purposes, have to reverse a portion of the ITC that they have claimed.
This is to ensure that the ITC is claimed only to the extent of the GST paid on the inputs and input services used for making taxable supplies and to avoid the cascading effect of taxes.
Q: When and how should the ITC reversal under Rule 42 be done?
A: The ITC reversal under Rule 42 should be done every month, along with the filing of the monthly return in Form GSTR-3B. The taxpayer should maintain a record of the calculation and reversal of ITC under Rule 42, in the electronic credit ledger, in Form GSTR-2.
The taxpayer should also review and revise the ITC reversal at the end of the financial year, based on the actual data of the turnover and the supplies. The adjustments should be made in the annual return in Form GSTR-9.
