The Goods and Services Tax (GST) system in India is a value-added tax where tax is levied at every stage of supply, but credit of the tax paid on purchases (inputs and input services) is allowed. This credit is called Input Tax Credit (ITC) and can be used to pay output GST.
However, in practice, inputs and input services are often used for multiple purposes:
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Partly for business and non-business (personal) purposes, or
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Partly for taxable supplies and exempt supplies.
To ensure that credit is claimed only on the portion used for business and taxable purposes, the law prescribes a manner of apportionment and reversal of ITC. This method is provided in Section 17(1) and 17(2) of the CGST Act, 2017 and detailed in Rule 42 of the CGST Rules, 2017.
Relevant Sections:
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Section 17(1): When goods or services are used partly for business and partly for other purposes, ITC is allowed only for business portion.
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Section 17(2): When goods or services are used for both taxable and exempt supplies, ITC is allowed only for taxable supplies.
Relevant Rule:
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Rule 42 of the CGST Rules, 2017: Provides the manner of determination and reversal of ITC on inputs and input services.
Step-wise Method of Apportionment under Rule 42:
Step 1: Segregation of Total ITC (T)
Start with the total ITC available for the month (T). Segregate it as follows:
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T1: ITC attributable to non-business purposes only – not eligible.
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T2: ITC attributable to exempt supplies only – not eligible.
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T3: ITC attributable to taxable supplies (including zero-rated) – fully eligible.
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T4: ITC attributable to blocked credits under Section 17(5) – not eligible.
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The balance is common credit (C1).
Formula:
C1 = T – (T1 + T2 + T3 + T4)
C1 represents credit used for both taxable and exempt/non-business purposes.
Step 2: Determine Credit for Non-Business Use (C2)
Out of common credit (C1), a fixed portion is treated as used for non-business purposes.
C2 = 5% of C1
This means 5% of common credit is automatically disallowed to account for incidental non-business use.
Step 3: Determine Credit for Exempt Supplies (C3)
The next step is to calculate the portion of common credit used for exempt supplies:
C3 = (E ÷ F) × (C1 – C2)
Where:
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E = turnover of exempt supplies during the tax period
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F = total turnover of all supplies during the tax period
This formula proportionally attributes the common credit to exempt supplies.
Step 4: Eligible Credit (C4)
The remaining balance of common credit after removing non-business and exempt components is allowed as ITC:
C4 = C1 – (C2 + C3)
C4 represents the portion of common credit attributable to taxable supplies.
Step 5: Final Eligible ITC
The total ITC available to be claimed for the tax period is:
Eligible ITC = T3 + C4
Step 6: Reversal of Ineligible ITC
The sum of C2 and C3 is added to the output tax liability (i.e., reversed) in the return (GSTR-3B) for the same tax period.
This ensures that ITC relating to non-business or exempt activities is neutralized.
Step 7: Annual Recalculation
At the end of the financial year, a final calculation is made based on the annual turnover (E and F).
If there is any difference between the total of monthly reversals and the final reversal, the adjustment must be made in the return for September of the next financial year.
Example:
Total ITC for April: ₹1,00,000
Segregation:
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T1 (non-business): ₹5,000
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T2 (exempt): ₹10,000
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T3 (taxable): ₹40,000
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T4 (blocked): ₹5,000
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Remaining (common credit): C1 = 1,00,000 – (5,000 + 10,000 + 40,000 + 5,000) = 40,000
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C2 = 5% × 40,000 = ₹2,000
Turnover:
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Exempt turnover (E) = ₹10,00,000
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Total turnover (F) = ₹50,00,000
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C3 = (10,00,000 ÷ 50,00,000) × (40,000 – 2,000) = 0.2 × 38,000 = ₹7,600
C4 = 40,000 – (2,000 + 7,600) = ₹30,400
Eligible ITC = 40,000 (C4) + 40,000 (T3) = ₹70,400
Reversal = C2 + C3 = ₹9,600
Special Cases and Provisions:
1. Common Credit on Capital Goods – Rule 43
While Rule 42 applies to inputs and input services, Rule 43 deals with capital goods.
Credit on capital goods is spread over 60 months, and a similar formula is applied to reverse ITC proportionately every month.
2. Option for Banks and NBFCs – Section 17(4)
Banks, financial institutions, and NBFCs can opt out of Rule 42 and Rule 43 and instead:
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Avail 50% of the eligible ITC on inputs, input services, and capital goods, and
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Forego the remaining 50%.
This option simplifies compliance.
Compliance Requirements
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Maintain Detailed Records: Taxpayers must maintain detailed records to identify T1, T2, T3, T4, and C1.
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Monthly Computation: Rule 42 calculations must be done monthly.
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Annual True-up: Final adjustments are required annually.
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Reversal Entries: Reversal must be made in GSTR-3B under “ITC Reversal”.
