Rule 38 governs Input Tax Credit (ITC) reversal for banking companies, financial institutions, and NBFCs. As per Section 17(2), when an entity provides both taxable and exempt supplies (e.g., interest income), ITC must be reversed proportionally under Rule 42 & 43. However, per Section 17(4), these entities can opt for Rule 38 instead. Under Rule 38, 50% of eligible ITC can be claimed, while the remaining 50% is lapsed. ITC on blocked credits (Section 17(5)), ineligible ITC due to place of supply rules, and ITC for personal use is non-claimable. Transactions between deemed distinct persons (DDPs) allow 100% ITC claims. The reversal must be reported in GSTR-3B under table 4B(1). The option to adopt Rule 38 can be exercised during any period of the financial year and remains in effect until the year-end. A practical comparison of Rule 38 and Rule 42 indicates that Rule 38 is generally more beneficial for banks and NBFCs since a significant portion (80-90%) of their income comes from exempt interest income. This reduces the proportion of ITC they can claim under Rule 42, making Rule 38 the preferable choice.
1. Section 17(2):-
If a registered person engaged in supplying of exempt goods or services along with the taxable supply then proportionate ITC needs to be reversed as per Rule-42 & 43.
2. Section 17(4):-
Any banking company or financial institution including NBFCs have to option to comply with the Rule-42 & 43 or Rule-38 for reversal of ITC.
3. Nature of transactions:-
Above mentioned entities engaged in providing services related to the loan or deposits etc.
Types of income earned by these entities:
a. Processing fees
b. Bouncing charges
c. Prepayment penalty
d. Interest income
e. Conversion charges
f. Foreclosure charges
g. Overdue charges etc.
Interest is an exempt supply as well as some other incomes. As per Sec 17(2), proportionate ITC needs to be reversed in the ratio of exempt supplies divided by total turnover
Or
Reverse the ITC as per Rule-38.
4. Sec 17(4) read with rule-38:-
As per this rule, these entities can claim 50% credit of eligible ITC. Remaining 50% credit will be lapsed.
ITC of below mentioned transactions can-not be claimed:-
a. ITC can-not be claimed which is blocked under Sec 17(5).
b. ITC can-not be claimed which is ineligible due to Place of supply rules.
c. ITC can-not be claimed if any goods or services used in personal purpose.
For remaining transactions, balance ITC is eligible ITC. Entity can claim 50% ITC of remaining transactions and balance ITC will be lapsed.
5. Transaction between deemed distinct persons(DDP):-
100% ITC can be claimed for those transactions which is entered between deemed distinct persons.
6. Reporting in GSTR-3B:-
Reversal of ITC shall be report in table- 4B(1) because it is permanent reversal of ITC. Entities can-not claim this ITC in future period.
7. When to exercise this option:-
This option can be exercise in during any period of the financial year.
Example: If this option exercised during the year say in the month of July, for remaining part of the financial year this rule should be followed. This option cannot be withdrawn till the end of the year.
8. Rule: 38 vs Rule:42:-
When an entity opts rule-38 for reversal of ITC then rule-42 & 43 will not be applicable.
9. Practical scenario:-
| Sr No | Particulars | Amount in Rs. |
| 1 | Total ITC | 10,00,000 |
| 2 | Blocked credit | 1,00,000 |
| 3 | Ineligible ITC due to POS rules | 50,000 |
| 4 | Ineligible ITC due to goods used for personal purpose | 50,000 |
| 5 | Eligible ITC of DDP transactions | 1,00,000 |
| 6 | Total turnover | 1,00,00,000 |
| 7 | Exempt turnover | 90,00,000 |
a. ITC needs to be reversed as per Rule-42:-
| Sr No | Particulars | Amount in Rs. |
| 1 | Total ITC | 10,00,000 |
| 2 | Blocked credit | -1,00,000 |
| 3 | Ineligible ITC due to POS rules | -50,000 |
| 4 | Ineligible ITC due to goods used for personal purpose | -50,000 |
| 5 | Common ITC | 8,00,000 |
| 6 | Total turnover | 1,00,00,000 |
| 7 | Exempt turnover | 90,00,000 |
| 8 | ITC needs to be reversed | 7,20,000 |
Total amount of reversal of ITC is 7,20,000. Hence, entity can claim only Rs 80,000 in GSTR-3B.
Reversed credit as per rule-42 shall be report in table-4B(1) of GSTR-3B.
b. ITC needs to be reversed as per Rule-38:-
| Sr No | Particulars | Amount in Rs. |
| 1 | Total ITC | 10,00,000 |
| 2 | Blocked credit | -1,00,000 |
| 3 | Ineligible ITC due to POS rules | -50,000 |
| 4 | Ineligible ITC due to goods used for personal purpose | -50,000 |
| 5 | Eligible ITC | 8,00,000 |
| 6 | Eligible ITC related to DDP transactions | 1,00,000 |
| 7 | Balance ITC | 7,00,000 |
| 8 | ITC needs to be reversed i.e 50% | 3,50,000 |
| 9 | Amt of eligible ITC | 4,50,000 |
Entity can claim the ITC of Rs 4,50,000 as per this rule.
Reversed credit as per rule-38 shall be report in table-4B(1) of GSTR-3B.
Practically, It is beneficial for these entities to opt the rule-38 because approx. 80 to 90% income is related to the interest which is exempt income. Interest is the main source of income of banking company or financial institutions.
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