Rule-42 of GST: Reversal of ITC of Input & Input Services in case of exempt supplies

Summary:  Rule 42 of the GST Act governs the reversal of Input Tax Credit (ITC) on inputs and input services when a registered person makes exempt supplies. It applies to various transactions, including imports of goods and services, RCM supplies, ISD credits, and supplies under the forward charge mechanism, but excludes zero-rated supplies such as exports and SEZ sales. Exempt supplies encompass nil-rated, non-taxable, RCM-liable, securities transactions, and sale of land and buildings. The reversal is computed proportionately using the formula: Common ITC × (Exempt Supplies ÷ Turnover in the State), calculated GSTIN-wise and monthly, with separate calculations for CGST, SGST, and IGST. Inputs exclusively used for taxable supplies retain full ITC, while those for exempt supplies are fully reversed; blocked credits are entirely non-eligible. Yearly adjustments reconcile monthly reversals, ensuring accurate credit reporting. Practical examples illustrate computation, emphasizing proper matching with GSTR-2B and differentiation between taxable, exempt, and zero-rated supplies.

1. Introduction:

In this article, I am covering Rule-42 of GST Act which explains the reversal of Input Tax Credit (ITC) of inputs and input services if a registered person is engaged in making exempt supplies.

2. Rule-43:

It explains the reversal of ITC of capital goods if a registered person is engaged in making exempt supplies. I will cover this topic separately.

3. Nature of transactions:

a. Import of goods:

Goods can be in the form of inputs or capital goods. Both rule will apply for reversal of ITC if a registered person is engaged in making exempt supplies.

b. Import of services:

Only Rule-42 will be apply for reversal of ITC if a registered person is engaged in making exempt supplies.

c. RCM other than (b):

Both rule will apply for reversal of ITC if a registered person is engaged in making exempt supplies on RCM transactions.

d. ISD ITC:

Only Rule-42 will be apply for reversal of ITC if a registered person is engaged in making exempt supplies.

e. FCM:

FCM is applicable on inputs, input services and capital goods. Hence, both rule will be apply for reversal of ITC if a registered person is engaged in making exempt supplies.

4. Reversal of ITC:

ITC will be reversed for all types of transactions whether it relates to the import of goods or services, RCM transactions, ISD ITC, or GST levied under forward charge mechanism as explained in 3^rd point.

5. Meaning of exempt supplies (Sec 2(47)):

Exempt supplies includes

a. Nil rated supplies which attracts nil rate of tax

b. Non-taxable supplies

c. Supplies which is specifically exempted by a notification like Interest on loan.

6. Meaning of exempt supplies for reversal of ITC:

Exempt supplies includes

a. Nil rated supplies which attracts nil rate of tax

b. Non-taxable supplies

c. Supplies which is specifically exempted by a notification like Interest on loan

d. Supplies on which recipient is liable to pay tax under RCM

e. Transaction in securities

f. Sale of land and building

7. Zero rated supplies:

If a registered person is engaged in making supplies outside India (export sales) or sale to the SEZ, it will be treated as a ZRS.

a. Supplies outside India with LUT:

b. Supplies outside India without LUT:

c. Supplies to SEZ with LUT:

d. Supplies to SEZ without LUT:

• In all of the above cases, there will be no reversal of ITC as per Rule- 42 & 43.
• ZRS are treated as taxable supplies. Even if exempt goods or services supplied outside India or sold to an SEZ, there will no reversal of ITC.

 8. Computation of reversal as per Rule-42:

a. ITC will be reversed in the proportionate of exempt supplies.

b. Rule-42 will apply GSTIN wise. Each branch will compute the reversal separately.

c. The turnover of each month will be considered for reversal. For example, if you are calculating the reversal for the month of August 2025 the turnover for August 2025 will be taken.

d. Formula:

->->->  Common ITC * Exempt supplies

Turnover in a state

e. Exempt supplies do not include the Zero rated supplies.

g. Turnover in a state includes both exempt and Zero rated supplies.

9. Sale of securities:

a. 1% of selling price of securities will be treated as an exempt supplies for the purpose of reversal of ITC.

b. Securities means equity shares, preference shares, debentures, bonds or mutual funds etc.

10. Sale of Land & building:

The value of land and building shall be taken as the same as adopted for the purpose of paying stamp duty.

11.Turnover in a state:

This means the total turnover of a registered person (GSTIN wise) during the month includes

a. Taxable supplies

b. Exempt supplies (Refer 6^th point)

c. Zero rated supplies

d. Supplies between deemed distinct persons

e. Sale of assets

f. Supplies on which the recipient is liable to pay tax under RCM

excluding the amount of GST.

12. Comparison chart: 

I have explained the different types of supplies that will be considered or not in the definition.

13. ITC used in taxable supplies:

If GST is paid on input and input services used exclusively for taxable supplies, there will be no reversal.

14. ITC used in exempt supplies:

If GST is paid on input and input services used exclusively for exempt supplies, there will be full reversal of ITC.

15. Blocked credit:

Full ITC needs to be reversed whether it is used in taxable or exempt supplies or both.

16. Common used of ITC:

Rule-42 will applies for reversal of ITC if input and input services used in both types of supplies.

17. Practical scenario:

a. Input details with the number of cases for better understanding of the readers:

We will take only those invoices that matched with the GSTR-2B. This means considering only the invoices that are reflecting both in our GSTR-2B & in our books.

** Do not consider ITC figures of all invoices merely because they are reflecting in our GSTR-2B or recorded in our books.

*** Reversal under this rule will be calculated separately for CGST, SGST & IGST. In my case, I am considering only IGST.

b. Turnover details with the number of cases for better understanding of the readers:

c. Exempt supplies for reversal purpose is 5,80,000

d. Total turnover is 25,80,000

e. Common ITC is 2,50,000

f. ITC figure which is used in exempt supplies:

->->-> Common ITC * Exempt supplies

Turnover in a state

>>> 2,50,000 * 5,80,000              = 56,202

25,80,000

g. ITC used in exempt supplies is 56,202

h. ITC used in taxable supplies is 1,93,798

i. Total amount of reversal as per Rule 42 is 1,06,202

j. Amount of blocked credit is 80,000

k. ITC will be credited in credit ledger of Rs. 3,93,798

18. Yearly reversal at the end of year:

At the end of the year, compute the yearly reversal by considering the total ITC for the entire year as explained above, and using the exempt and total turnover for whole of the year.

a. If the yearly reversal is greater than the monthly reversal, the balance ITC must be reversed in GSTR-3B or via DRC-03.

b. If the yearly reversal is less than the monthly reversal, claim the difference amount as input in GSTR-3B.

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Disclaimer: The views and opinions expressed in this article are those of the author. This article is intended for general information purposes only and does not constitute professional advice. Readers are strongly advised to consult a qualified professional for guidance specific to their individual situation before making any financial, legal, or tax-related decisions. The author shall not be held liable for any loss or damage of any kind incurred as a result of the use of this information or for any actions taken based on the content of this article.