Apportionment and Reversal of Credit

The two previous guides treated each purchase as either creditable or not. Many purchases are neither wholly one nor wholly the other. An office’s rent, its accountant’s fees and its electricity serve the whole business, including any part of it that makes exempt supplies. A company car may be used for business on weekdays and privately at weekends. Credit on such purchases cannot be taken in full. Neither is it lost in full. It has to be divided.

Section 17 sets out the principle in two sentences, and rules 42 and 43 of the CGST Rules turn it into a formula. The formula looks forbidding but follows a simple sequence, and this guide works through it.

The principle in section 17

Section 17(1) deals with use partly for business and partly for other purposes. The credit “shall be restricted to so much of the input tax as is attributable to the purposes of his business”.

Section 17(2) deals with use partly for taxable supplies, including zero-rated ones, and partly for exempt supplies. The credit “shall be restricted to so much of the input tax as is attributable to the said taxable supplies including zero-rated supplies”.

The reason for the second restriction is structural. Credit exists to remove tax from the price of a taxable supply. An exempt supply carries no output tax, so credit attributable to it would be a subsidy, not a set-off. Zero-rated supplies, mainly exports and supplies to SEZs, are treated as taxable for this purpose, so credit attributable to them is preserved.

What counts as an exempt supply

The division under section 17(2) turns on the ratio of exempt supplies to total turnover. Section 17(3) widens “exempt supply” beyond supplies exempted by notification. It includes:

• supplies on which the recipient pays tax under reverse charge
• transactions in securities
• sale of land
• sale of building, subject to paragraph 5(b) of Schedule II

The Explanation to section 17(3) then excludes most Schedule III activities from the value of exempt supply. The exclusion does not cover paragraph 5 (sale of land and building), or such value as is prescribed for warehoused-goods sales under paragraph 8(a). The rules prescribe the latter as sales from duty-free shops at arrival terminals to incoming passengers.

Explanation 1 to rule 43 removes two items from exempt supplies, for both rules 42 and 43. The first is interest or discount on deposits, loans or advances, except for banks, financial institutions and non-banking financial companies. The second is the supply of duty credit scrips. A trading company that earns some interest on surplus funds does not have to reverse credit on account of that interest.

Rule 42: inputs and input services, month by month

Rule 42 applies to inputs and input services. It sorts the month’s input tax into buckets, then divides only the bucket that serves both purposes.

The sequence, using the rule’s own labels:

1. T is the total input tax for the month.
2. Take out what is used exclusively for non-business purposes (T1), exclusively for exempt supplies (T2), and blocked under section 17(5) (T3). None of these is credited. What remains, C1, goes to the electronic credit ledger.
3. Of C1, identify what is used exclusively for taxable supplies, including zero-rated (T4). That is fully available.
4. The balance is common credit: C2 = C1 − T4.
5. The share of common credit attributable to exempt supplies is D1 = (E ÷ F) × C2. Here E is the value of exempt supplies and F the total turnover in the State, both for the month.
6. If common inputs are also used partly for non-business purposes, D2 is fixed at five per cent of C2.
7. The eligible common credit is C3 = C2 − (D1 + D2). D1 and D2 are reversed in GSTR-3B, or paid through FORM GST DRC-03.

A proviso allows a business that can split a mixed purchase at the invoice level to do so. It may put the non-business and exempt shares into T1 and T2 directly, and the rest into T4, rather than leave the purchase in common credit.

A worked example

A business in one State has, for a month:

Item	Rs
Total input tax (T)	1,00,000
Used exclusively for exempt supplies (T2)	10,000
Blocked under section 17(5) (T3)	5,000
Credited to the ledger (C1 = T − T2 − T3)	85,000
Used exclusively for taxable supplies (T4)	45,000
Common credit (C2 = C1 − T4)	40,000

Its exempt supplies for the month are Rs 20 lakh, against total turnover in the State of Rs 1 crore. E ÷ F is therefore 0.20. There is no non-business use, so there is no D2.

• D1 = 0.20 × 40,000 = Rs 8,000, reversed.
• C3 = 40,000 − 8,000 = Rs 32,000.
• Credit finally retained: T4 + C3 = 45,000 + 32,000 = Rs 77,000.

The arithmetic is the easy part. The judgement lies in the buckets. Every rupee correctly placed in T4 is spared the reversal, and every rupee wrongly placed there is credit taken without entitlement.

The annual true-up

Monthly ratios fluctuate. A month with a large exempt sale will reverse heavily, and the next month lightly. Rule 42(2) requires the whole calculation to be redone for the financial year, “before the due date for furnishing of the return for the month of September following the end of the financial year”.

If the annual D1 and D2 exceed the total reversed during the year, the excess is reversed by September. Interest runs “for the period starting from the first day of April of the succeeding financial year till the date of payment”. If the annual figures are lower, the business may claim the difference back as credit in a return no later than September.

Rule 43: capital goods over five years

Capital goods are not used up in a month, so rule 43 spreads their credit over a deemed useful life of five years from the date of invoice.

• Capital goods used exclusively for non-business or exempt purposes are not credited at all.
• Capital goods used exclusively for taxable supplies are credited in full.
• All others, the common capital goods, have their tax credited to the ledger directly as “A”. Each month, the aggregate of A for all common capital goods still within their five-year life (Tc) is divided by sixty to give the month’s share, Tm.
• The share attributable to exempt supplies, Te, is calculated by the same E ÷ F ratio. It is added to output tax liability each month, with interest, for the life of the asset.

The text of the rule has a loose end here. Clause (g) still computes Te as (E ÷ F) × “Tr”. Tr was defined in clause (f), which Notification No. 16/2020-Central Tax omitted from 1 April 2020, while leaving clause (g) unchanged. The only per-period common credit the rule now computes is Tm, under clause (e), so Tm is the figure the formula can sensibly operate on. The official text, however, still reads “Tr”.

Rule 43 has a proviso for capital goods that move from exclusively exempt use to common use. Credit becomes available, but reduced by five percentage points for every quarter, or part, during which the goods were in exempt use.

Banks and financial institutions

Section 17(4) gives banking companies and financial institutions, including non-banking financial companies, an alternative. Instead of the apportionment in section 17(2), they may “avail of, every month, an amount equal to fifty per cent. of the eligible input tax credit on inputs, capital goods and input services in that month and the rest shall lapse”. The option cannot be withdrawn during the rest of the financial year. The fifty per cent restriction does not apply to tax on supplies between registrations of the same PAN.

Real estate

Rules 42 and 43 carry long provisos for construction of residential and commercial projects. Two features distinguish them.

First, E and F are measured in carpet area, not value. The area of flats exempt or identified for sale after completion counts in E, and the area of all flats in the project is F.

Second, the final calculation is made once, for each project, at completion or first occupation, not annually. Credit on inputs is not treated as exclusively for taxable supplies during construction. The rules explain why: inputs during construction serve both flats booked before completion, which are taxable, and those unsold at completion, which are not.

These provisions are tied to the rate changes for real estate from 1 April 2019. The relevant detail is in rules 42(3) to (6) and 43(2) to (5).

Applying the rules

The order of analysis for each tax period is:

1. Sort each input and input service into non-business, exempt, blocked, exclusively taxable, or common. Split mixed invoices where possible, under the proviso to rule 42(1).
2. Compute the exempt ratio, E ÷ F. Include the items section 17(3) adds and leave out the items the Explanations exclude.
3. Reverse D1, and D2 where there is non-business use, on common credit.
4. For capital goods, credit common items to the ledger and reverse the monthly exempt share under rule 43 for five years.
5. At the year end, recompute under rule 42(2) by the September return, reversing any shortfall with interest or reclaiming any excess.

The next guide turns from credit to compliance: GSTR-1 and GSTR-3B, the two returns through which all of this is reported.