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Published on:

September 27, 2024

Shaaransh Sharma

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Basics of GST

‍ITC Reversal Under Rule 42 of CGST & SGST Rules: A Comprehensive Guide

Goods and Services Tax (GST) have transformed the taxation process in India since it integrates multiple indirect taxes under one tax system. Input Tax Credit (ITC) is one of the key features of GST and allows businesses to claim credit for taxes paid on inputs used in the production of goods and services. However, some inputs are used for purposes other than making taxable supplies alone. Furthermore, some of the inputs may be utilised in exempt or non-taxable supplies which further complicates the ITC chain.

That is where Rule 42 of the CGST and SGST Rules comes in. This section provides the provisions of ITC Reversal and offers information as to how businesses can reverse credit in scenarios where inputs are applied for both taxable and exempt supplies.

GST Rule/Section

Situation

When Do You Need to Reverse ITC?

CGST Rule 37

You haven’t paid your supplier (fully or partly) for a supply

If you don’t pay within 180 days from the invoice date

CGST Rule 37A

Your supplier hasn’t paid their tax through GSTR-3B by 30th September of the next year

You need to reverse ITC by 30th November of the following financial year

CGST Rule 38

Banks or financial companies need to reverse 50% of their ITC

When filing your regular returns

CGST Rule 42

You’re using inputs for exempt supplies or for personal/non-business purposes

Periodically, either monthly or yearly, using a set formula for common credits

CGST Rule 43

Capital goods are used for exempt supplies or for personal/non-business purposes

Periodically (monthly/yearly), using a formula similar to Rule 42

CGST Rule 44

You’re canceling your GST registration or switching to the composition scheme

When filing form REG-16 or ITC-03, depending on the scenario

CGST Rule 44A

You had gold dores in stock on 1st July 2017

Reverse 5/6th of ITC when supplying gold dore bars, or gold/gold jewellery

Section 16(3)

You claimed depreciation on the GST portion of capital goods under Income Tax

When closing your financial books at the end of the year

CGST Section 17(5)

You claimed ITC on ‘blocked credits’

When filing your regular returns, up until the annual return filing date

CGST Section 17(5)(h)

Inputs were used in goods that were lost, destroyed, or stolen

Reverse ITC when filing returns for the month in which the loss happened

CGST Section 17(5)(h)

You gave out free samples of goods

Reverse ITC when filing returns for the month when you gave out the samples

This table summarises and hopefully clears all confusions you have regarding ITC reversal under rule 42 of CGST and SGST.

Understanding Rule 42 of CGST & SGST Rules

As per Rule 42 of the CGST & SGST Rules: ITC on inputs and input services is used partly to supply by way of both taxable and exempt supplies. This lays down a certain procedure for the determination of ITC to be claimed and the amount of ITC to be reversed on account of the use of such Inputs in Exempt Supplies.

You might also be interested in our other blog What are the Differences Between CGST and SGST?

When Is ITC Reversal Under Rule 42 Applicable?

Rule 42 applies when:

Both for supply of taxable and exempt Inputs and input services are permissible.
Inputs and input services are used for business as well as non-business purposes.

Here businesses cannot take the full amount of ITC as these are exempt supplies or non-business purposes and hence so the proportionate ITC will have to be invoked back.

The Mechanism of ITC Reversal as per Rule 42

Although the method of calculation for ITC reversal under Rule 42 is a little complex, it is required so that businesses do not utilise excessive ITC intentionally relating to occupied supplies or own consumption. The formula for computing the ITC reversal is stated below:

1. Total ITC Calculation

All the ITC on inputs and input services used for taxable as well as exempt supplies will be taken out, to find the maximum eligible वो sub-total of ITC.

2. ITC Details Reasonably Attributable Exempt Supplies

The next one is the ITC which is directly relatable to exempt supplies or non-GST supplies, so here we need to exclude those. This part of ITC is not credible and needs to be reversed completely.

3. Common ITC

If some inputs and input services are used for both taxable supplies under the GST regime and exempt supplies, common credit will be available. This general credit is split between taxable and exempt supplies by using the ratio of turnover of exempt supplies to the whole.

4. Reversal Proportion

The common credit for exempt supplies is calculated using the following formula:

5. Reversal for Personal Use

In addition to reversing ITC attributable to exempt supplies, taxpayers also need to reverse ITC for inputs used for non-business purposes, such as personal consumption.

6. Monthly & Annual Adjustments

ITC reversal under Rule 42 with monthly calculation and adjustment. The turnover of the entire year is then taken into consideration at the end of the financial year, wherein a final adjustment is available for actual ITC to be reversed on exempted supplies. Either of the shortfalls or excess in ITC reversal shall be corrected in September following the end of the financial year.

Rule 43: ITC Reversal for Capital Goods

Rule 43 – Regarding ITC Reversal of capital goods (complement to Rule 42) Although Rule 42 deals with inputs and input services, Rule 43 applies to capital goods that are utilized for both taxable and exempt supplies.

ITC Reversal for Capital Goods Under Rule 43

The calculation of ITC reversal for Capital Goods is a little bit different from others.

5 years or 60 monthly payments of ITC for capital goods. During this period the ratio of ITC to exempt supplies is determined and reversed every month.
At the end of the financial year, it is stated that as under Rule 42 a final reconciliation should be done to ascertain that the correct amount of Input Tax Credit has been reversed.

Calculation of ITC reversal under Rule 43 is likewise determined in the same manner as Rule 42, however for widespread credit of capital merchandise is stretched out to a more drawn-out period.

ITC Reversal Compliance and Reporting

Compliance is one of the most important points for ITC reversal under Rule 42 and Rule 43. ITC reversal is supposed to be reported by the Taxpayers in their GSTR-3B return every month. Leaving out to reverse the correct ITC on exempt supplies: Failure to not reverse the right amount of input tax credit on exempt supplies can lead to any/not all or none of — penalties, interest and scrutiny from tax authorities.

Every business needs to upkeep proper records and monitor its ITC utilization regularly especially where the supplies undertaken by it are of both taxable & exempted nature. Thus, any discrepancy between the ITC claimed and the usage can attract audits or investigations from the GST authorities.

Challenges and Practical Considerations

It is not always easy)To Reverse ITC under Rule 42 and Rule 43. Businesses, in particular those undertaking taxable and exempt activities such as healthcare providers are challenged to bifurcate inputs and capital goods used towards tax as well as non-tax supplies.

ITC Reversal Struggle Points

A Few Challenges include:

Keeping of Records: This can be time consuming to record which input and input services are used for taxable vis-a-vis exempt supplies.
The complex Reconciliation: Rule 42 can make the Reconciliation for large corporates tough, which have various types of sales and purchases.
Differences in Turnover: The ITC reversal formula is very sensitive to variations in turnover, which can lead to swings during the year between monthly ITC calculations and actual field collection efficiencies.

Yet, you need to understand and comply with ITC Reversal under Rule 42 as non-compliance can invite penal consequences and a GST audit which no business prefers.

Conclusion

ITC reversal under Rule 42 of CGST and SGST Rules helps in ensuring that businesses do not claim more tax credit which is ineligible for inputs used in exempt supplies and non-business activities. Rule 42, along with Rule 43 regarding the ITC reversal on capital goods, constitutes the bedrock of the ITC apportionment statute under GST.

For businesses, it should be an important part of record-keeping to continuously match data & proceed with their ITC claims on time for each month before filing monthly and annual returns. Although the actual process can be cumbersome, by adhering to the standards prescribed in Rule 42 and Rule 43, businesses stay compliant while availing of their lawful tax credits.

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FAQs

What is ITC reversal under Rule 42?

ITC reversal under Rule 42 is the process of reversing the Input Tax Credit claimed on inputs and input services used for both taxable and exempt supplies. Businesses must reverse the ITC attributable to exempt supplies or non-business purposes.

How is ITC reversal calculated under Rule 42?

ITC reversal is calculated by apportioning the common credit of inputs and input services based on the ratio of exempt turnover to total turnover. This calculation is done monthly with an annual adjustment.

What is the difference between Rule 42 and Rule 43?

Rule 42 applies to ITC reversal for inputs and input services, while Rule 43 governs the ITC reversal for capital goods used for both taxable and exempt supplies, spreading the reversal over 5 years.

When should ITC reversal be reported?

ITC reversal must be reported in the monthly GSTR-3B return. An annual adjustment is made at the end of the financial year, with any discrepancies corrected by September of the following year.

What happens if ITC reversal is not done?

Failure to reverse the correct ITC can lead to penalties, interest, and scrutiny from tax authorities. Maintaining compliance through accurate reporting is crucial.