Inverted Reward: When Cheaper for Customer Becomes Costlier for Manufacturer

THE INVERTED REWARD: When Cheaper for the Customer Becomes Costlier for the Manufacturer

GST 2.0 fixed old anomalies and created new ones. For thousands of manufacturers in pharma, packaging, EV, food and handicrafts, the September 2025 rate cut put more money in the customer’s pocket — and locked the manufacturer’s working capital inside the credit ledger.

Mahesh runs a corrugated box unit on the outskirts of Raipur. Fifty-two years old, twenty-three years in business, three machines on the factory floor, and a clientele that runs from a local biscuit-maker in Bhilai to a mid-sized pharma packer in Nagpur. Turnover last year, around ₹8 crore. He files every return on time. He has never had a notice. He has never had a refund either.

On the morning of 22 September 2025, Mahesh logged into the GST portal and updated his sale rates. The new rate on his corrugated boxes, HSN 4819, was 5%. Down from 12%. His customers were thrilled. The biscuit-maker called by noon asking for a fresh quotation. Good news, Mahesh thought. Lower tax. More orders.

Then he checked the invoice for the kraft paper that had arrived the previous evening. HSN 4804. Still 18%. Unchanged.

By end-October, his electronic credit ledger had ₹14 lakh of unutilised ITC sitting in it. By December, it was ₹26 lakh. He had used every rupee he could to discharge output liability and the balance kept growing. He walked into my office in the first week of January with his ledger printouts and asked the question every manufacturer eventually asks his CA:

“Sahab, agar GST kam ho gaya hai toh phir mera paisa kyun phans raha hai?”

I poured him a cup of tea, opened his ledger, and gave him the only honest answer I had.

“Mahesh ji, GST aapke customer ke liye kam hua hai. Aapke liye ulta ho gaya hai. Welcome to the Inverted Reward.”

1. The Rationalization — What Changed and Why

To understand Mahesh’s situation, you have to understand what happened on 3 September 2025. The 56th GST Council Meeting collapsed the messy four-slab structure (5%, 12%, 18%, 28%) into a leaner two-rate system — 5% and 18% — with a 40% slab for luxury and sin goods. The changes were notified through Notification No. 09/2025-Central Tax (Rate) dated 17 September 2025 for goods and Notification No. 13/2025-Central Tax (Rate) dated the same day for handicrafts. Both took effect from 22 September 2025.

The Council declared three pillars of reform: correction of long-standing inverted duty structures, resolution of classification disputes, and greater rate certainty. For the consumer, the impact was immediate — soaps, shampoos, packaged foods, small cars, two-wheelers, medicines, cement, dairy, biscuits, snacks and dozens of daily-use items dropped to 5%. Two long-pending anomalies were finally fixed. Man-made fibres and yarns, long stuck at 12–18% while output fabric was at 5%, were brought down to 5% — ending the synthetic-textile inversion that had haunted the industry since 2017. Critical fertiliser inputs — ammonia, sulphuric acid, nitric acid — were similarly cut from 18% to 5%.

Where the policy delivered, it delivered well. The consumer paid less. The fertiliser maker exhaled. The man-made textile spinner exhaled.

But policy choices have arithmetic consequences. When the Council slashed output rates aggressively without correspondingly slashing the entire upstream chain, it inadvertently birthed a new generation of inverted duty cases. Corrugated boxes (12% → 5%) with kraft paper still at 18%. Standard medicines (12% → 5%) with active pharmaceutical ingredients still at 18%. Packaged biscuits, namkeens, chocolates (18% → 5%) with plastic and laminate packaging still at 18%. Handicrafts, candles, handbags (12% → 5% under Notification 13/2025-CTR) with chemical and metal inputs still at 18%.

Some sectors won outright. Some sectors lost a little to gain more. And some — Mahesh’s among them — found themselves caught in a paradox: their customer was happier, their order book healthier, and their bank balance bleeding.

2. When You Pay More Tax Than You Collect

The simplest way to understand the predicament is this. Imagine you are paying 18% tax on every kilo of raw material you buy, but when you sell the finished product, the Government only charges 5% from your customer. You have paid more tax going in than you are collecting going out. That gap — that trapped money — is what the law calls an “inverted duty structure” (IDS). And Section 54(3) of the CGST Act, 2017 says you can claim it back as a refund. In theory.

Section 54(3) permits refund of unutilised ITC in two situations only: (a) zero-rated supplies made without payment of tax, and (b) where credit has accumulated because the rate of tax on inputs is higher than the rate of tax on output supplies — excluding nil-rated or fully exempt outputs, and subject to notified exclusions. The second limb is the IDS limb. This is the door Mahesh has to walk through.

The mechanics are governed by Rule 89(5) of the CGST Rules, 2017, prescribing a formula (refined by Notification 14/2022-CT):

Maximum Refund = {(Turnover of inverted rated supply × Net ITC) ÷ Adjusted Total Turnover} − {Tax payable on such inverted rated supply × (Net ITC ÷ ITC availed on inputs and input services)}

Strip away the algebra and the formula tells the businessman one thing — the refund is not equal to the full amount of trapped credit. It is capped by inverted-rated turnover and adjusted total turnover. Two crucial exclusions are baked in. “Net ITC” means ITC availed on inputs only — not on input services (rent, freight, advertising, professional fees, job-work) and not on capital goods (machinery, factory tools).

For Mahesh, this is the second blow. He spends ₹40 lakh a year on freight, rent, electricity and machinery maintenance. All of that ITC sits in his ledger. None of it is refundable.

The third constraint is time. A refund claim must be filed within two years from the “relevant date” — for IDS refunds, the due date of the GSTR-3B for the period the claim arises. Miss the window and the right is extinguished.

III. Which Businesses Are Caught in the Middle

If your business involves any of the following products, this section is directly about your money. The table below — drawn from the post-22.09.2025 rate structure under Notifications 09/2025-CTR and 13/2025-CTR — sets out the sectors where IDS has either newly emerged or been aggravated:

*For nil-rated life-saving drugs (#21), refund under Section 54(3) is not available because the output is nil-rated — a critical statutory exclusion the manufacturer must factor into pricing.

The other side of the ledger deserves equal weight. The September 2025 reforms resolved several pre-existing inversions. Man-made fibres and yarns (HSN 5402, 5503, 5509) were brought down from 12–18% to 5%, eliminating the synthetic-textile chain inversion. Fertiliser raw materials — ammonia, sulphuric acid and nitric acid — were cut from 18% to 5%, ending one of GST’s oldest IDS battles. For these sectors, the rationalization is unambiguously a victory.

Four sectors deserve close narrative attention. Pharma: APIs and packaging at 18%, formulations at 5%, life-saving drugs at nil — manufacturers will run permanent refund cycles to stay solvent. Packaging: kraft paper at 18%, corrugated boxes at 5% — a 13-point gap on a high-volume, low-margin product. EV manufacturing: the inversion is by policy design — finished EVs at 5% to drive adoption, but lithium-ion cells (HSN 8507 60), motors, controllers and parts at 18%. Food processing: the entire packaged-foods chain, from snacks to chocolates to dairy, now has 5% output sitting on top of 18% packaging.

3. The Money That Cannot Move

Blocked ITC is money you have already paid out of your bank account to the Government — through your supplier — that the Government is technically holding for you but will not release until you complete a refund cycle that takes months. It is, in plain terms, a loan you have made to the State. Involuntarily. Without interest. Without a return date.

Put numbers on Mahesh’s case. He buys ₹2 crore of kraft paper a year at 18%, generating ₹36 lakh of input GST credit. He sells ₹8 crore of corrugated boxes at 5%, collecting ₹40 lakh of output GST. On paper, the credit gets utilised. But he also has ₹1.5 crore of other costs — labour, freight, rent, electricity, glue, ink, machinery upkeep — generating another ₹18 lakh of ITC, of which the input-services portion is not refundable under Rule 89(5). Net effect: every quarter, his ledger accumulates ₹5–8 lakh of structurally trapped credit. Over a full year, before any refund cycle completes, his blocked working capital is approximately ₹25–30 lakh.

That is roughly 3.5% of his turnover locked up. If financed through a cash credit facility at the prevailing 10.5% rate, the borrowing cost alone is ₹2.6–3.1 lakh per annum — between 6% and 10% of his entire annual profit, quietly bleeding out as the cost of structural inversion. Industry estimates suggest that in high-input, low-margin IDS sectors, blocked ITC can equate to roughly 10–15% of annual turnover, or ₹10–11 lakh per ₹10 crore of turnover. For an MSME packer, a small pharma formulation unit, or a corrugated box manufacturer, this is not a rounding error.

The counterpoint deserves equal honesty. For the cement manufacturer who saw rates drop from 28% to 18%, for the small-car maker whose product moved from 28% to 18%, for the consumer who pays 5% on shampoo instead of 18% — the rationalization was a net positive carrying no inversion. The pain of IDS is concentrated in chains where output rates were cut aggressively while inputs were left at standard. It is not a universal problem. But where it exists, it is severe.

4. Getting Your Money Back — The Promise and the Reality

The refund mechanism starts with FORM GST RFD-01, an online application filed on the GST portal. The form requires a CA’s certificate (where the claim exceeds ₹2 lakh), Statement-1A of inward and outward supplies with HSN/SAC detail, copies of invoices, GSTR-2B reconciliation, and the standard self-declaration on unjust enrichment. Relevant date is the due date of the GSTR-3B for the period claimed. Two-year window applies.

The formula caps the refund. It does not give back every rupee overpaid. For a manufacturer with significant service-input costs (rent, freight, advertising), the actual refund recovered ranges between 65% and 80% of the trapped ITC, not 100%.

The 90% provisional refund — the biggest reform you may not have heard about. Until October 2025, IDS refunds had to wait for full scrutiny — which in many states stretched to 6–9 months before the first rupee moved. The 56th Council recommended that Section 54(6) be amended to extend the 90% provisional refund mechanism (earlier reserved for zero-rated exports) to IDS claims. Pending statutory amendment, CBIC Instruction No. 06/2025-GST dated 3 October 2025 operationalised this administratively. IDS claims filed on or after 1 October 2025 are processed through a risk-based system that sanctions 90% provisionally within a short window; the remaining 10% goes to detailed scrutiny.

Statutory timeline and ground reality. Section 54(7) read with Rule 91 requires the proper officer to grant the refund within 60 days of a complete application. Where breached, interest at 6% under Section 56 runs from the 61st day. In practice, deficiency memos (Form RFD-03) — which restart the 60-day clock — are issued frequently, often for trivial reconciliation issues. Treat each deficiency memo as a litigation event in waiting; document the response in writing and preserve the trail.

Common grounds of scrutiny. Officers raise objections under four heads: classification disputes (is the input really an “input” or a capital good); GSTR-2B mismatches (credit in books but not in auto-populated 2B); Circular 135/05/2020-GST (bars IDS refund where accumulation is from rate changes on the same goods — i.e., transitional stock held on 22 September 2025 when the rate dropped); and Circular 173/05/2022-GST (the relief — allows IDS refund where input and output are same goods provided accumulation arises from a structural rate differential rather than a transitional one). Knowing which Circular applies to which fact pattern is now essential drafting.

Post-refund audit exposure. Grant of refund is not closure. Departments retain the right to audit refund grants for up to five years. Documentation built today is documentation that protects you in 2030.

5. What the Courts Have Said

Union of India v. VKC Footsteps India Pvt. Ltd. is the foundational Supreme Court ruling on IDS refunds — the case that decided whether refund is available on input services. VKC Footsteps argued that Section 54(3) refers to “any unutilised ITC”, which textually includes input-service ITC, and that Rule 89(5) — restricting refunds to ITC on input goods — was ultra vires. The Gujarat HC agreed. The Madras HC took the opposite view. The matter went to the Supreme Court.

On 13 September 2021, the Supreme Court upheld Rule 89(5) and held that refund under Section 54(3) is confined to ITC on input goods, excluding input services. The Court reasoned that the proviso to Section 54(3) specifically uses the phrase “rate of tax on inputs”, and “inputs” is a defined term referring to goods. While acknowledging that the formula produced inequities, the Court declined to legislate from the bench and urged the GST Council to revisit the formula.

Implication: Service-intensive businesses — retailers, restaurants, asset-light manufacturers — cannot today claim refund of their input-service ITC even when the structural inversion is real. The decision to widen the refund base lies with the Council, not the courts.

Favours the Department.

The Rule 89(5) formula refinement — Notification 14/2022-CT softened VKC’s edges. It revised the formula to proportionately adjust the output-tax deduction by the ratio of ITC on inputs to total ITC. The Gujarat High Court in 2024–2025 has considered whether the amended formula applies retrospectively from 01.07.2017, entitling taxpayers to recompute and claim differential refunds for past periods.

Implication: If you have past IDS refund claims processed under the old formula, you may have a re-computation entitlement. The department resists on limitation and finality grounds. For high-value past claims, a fresh computation is worth a CA’s afternoon — the upside can be 15–25% more refund.

Mixed — context-dependent.

Circular 173/05/2022-GST is the most important departmental document for post-22.09.2025 claims. Circular 135 had said IDS refund is not available where input and output are the same goods taxed at different rates over time. Circular 173 clarified that IDS refund is available even where input and output are the same goods, provided accumulation arises from a structural rate differential, not a transitional one.

Implication: For manufacturers like Mahesh whose input (kraft paper) and output (corrugated boxes) fall in the same paper-products chapter but are different HSNs at different rates, GST Circular 173 is your shield. Quote it in every RFD-01 narrative. For traders sitting on transitional stock who saw rate drops on the same goods, Circular 135 is your enemy.

Strongly favours the taxpayer where input and output are structurally different goods.

Sikkim High Court on refund of unutilised ITC at closure of business is the most recent expansion. The Court held that where a business is closed with unutilised ITC, the State cannot retain the amount without statutory backing; refund may be permissible under Section 49(6) read with Section 54, even though closure is not expressly listed in Section 54(3).

Implication: For businesses contemplating winding up with substantial IDS-related ITC balances, the Sikkim route is now a credible litigation strategy, rooted in Article 265 and hard to dislodge.

Strongly favours the taxpayer.

VII. Our View — What You Should Do Now

I am often asked by clients: ‘CA Sahab, jab GST mera customer pe kam hua hai, toh main kaise nuksaan mein hoon? Kuch karna hai, ya bas sehna hai?’ The answer is never simple, but here is the framework I use.

When to claim the refund and fight for it. If your input–output rate gap is 8 percentage points or more, your annualised blocked credit exceeds ₹5 lakh, and your input chain is dominated by goods rather than services, file IDS refund claims every quarter without exception. The 90% provisional refund regime under Instruction 06/2025-GST has materially reduced the working capital pain, but you have to be in the queue to benefit.

What documentation to build now. Three things, immediately. First, a clean HSN-wise reconciliation of every input purchase against the output it feeds into. Second, a separate workbook computing Net ITC and Adjusted Total Turnover under Rule 89(5) for each tax period, signed off monthly. Third, a contemporaneous record of every deficiency memo, departmental query, or oral indication received — dated, time-stamped, with the officer’s name. In the inevitable audit five years from now, this trail is the difference between defence and surrender.

A cautionary note on the same-goods trap. If you are a trader — buying corrugated boxes at 12% in August 2025 and selling at 5% in October 2025 from transitional stock — your situation is not an IDS case under Circular 135/05/2020-GST. You will get a deficiency memo, then a rejection, then an appeal that is hard to win. The IDS refund is for structural inversion, not transitional inversion. Traders should plan stock liquidation around rate-change dates, not assume refund will recover the cost.

VIII. Conclusion

For Mahesh, the story has now taken a forward turn. Armed with his Rule 89(5) computation, a clean HSN-wise reconciliation back to 22 September 2025, and a properly drafted RFD-01 invoking Circular 173/05/2022-GST, his first quarterly IDS refund application was filed in the third week of January 2026. The 90% provisional sanction came through under Instruction 06/2025-GST in late February. ₹11.2 lakh hit his bank account. He has built the refund cycle into his quarterly compliance calendar — a permanent fixture, like the GSTR-3B or the advance tax instalment. The fight continues, but the cash flow is moving again.

The September 2025 rate rationalization was, on balance, a genuine reform. It corrected old anomalies in textiles and fertilisers, simplified the rate structure for the consumer, and delivered real price relief on essentials. But for the manufacturer caught in a chain where his customer’s tax was cut while his supplier’s tax was left untouched, the same reform has quietly created a recurring drain on working capital — and the legal architecture to recover that drain is partial, formula-capped, and dependent on documentation few small businesses are equipped to maintain.

The Inverted Reward is real. But it is not inescapable — provided you understand which side of the table you are sitting on, and act before the two-year window closes.