Section 54(3) Rewritten: Finance Bill 2026 Overturns VKC Footsteps Extending Inverted Duty

Section 54(3) Rewritten – Finance Bill 2026 Overturns VKC Footsteps Extending Inverted Duty Structure Refunds to Input Services and Capital Goods – The Rule 89(5) Formula Rewrite, Rate-Rationalization Aftermath and Five Unresolved Sub-Issues for Post-Amendment Compliance

1. The Problem: A Supreme Court Ruling About to Be Legislatively Undone

On 13 September 2021, the Supreme Court in Union of India vs. VKC Footsteps India (P.) Ltd. [2021] 130 taxmann.com 193 (SC) delivered one of the most consequential GST rulings of the post-2017 era. Overturning the Gujarat High Court in VKC Footsteps India (P.) Ltd. vs. Union of India [2020] 118 taxmann.com 81 (Guj.) and affirming the Madras High Court in Tvl. Transtonnelstroy Afcons Joint Venture vs. Union of India [2020] 119 taxmann.com 324 (Madras), a Division Bench held that Rule 89(5) of the CGST Rules – which restricted refund of accumulated ITC under Inverted Duty Structure (IDS) to ITC on inputs alone, excluding input services and capital goods – was intra vires Section 54(3). The ratio turned on clause (ii) of the first proviso to Section 54(3), which speaks of “rate of tax on inputs being higher than the rate of tax on output supplies” – “inputs”, the Court held, was a term of art that excluded input services.

For four and a half years, [2021] 130 taxmann.com 193 (SC) has been the settled law. Manufacturers in structurally inverted sectors – textiles, footwear, fertilizer, pharmaceutical formulations, renewable energy, EV, processed food – have watched ITC accumulate on input services (R&D, technical consultancy, job work, logistics, software) and capital goods with no refund route. The result has been a silent but massive blockage of working capital, widely recognised as the most damaging structural flaw of the GST regime.

The 56th GST Council on 3 September 2025 took the decisive step, recommending an amendment to Section 54 of the CGST Act to extend the IDS refund route to cover both input services and capital goods. Finance Bill 2026 has translated the recommendation into law. While other GST amendments – post-supply discount (Section 15(3)(b)), provisional refund for IDS (Section 54(6)), intermediary services (Section 13(8)(b) IGST) – have received detailed coverage in professional commentary, this fifth amendment has been flagged only in passing. Yet it is, arguably, the most analytically rich of the package: it requires the re-engineering of Rule 89(5), the reconciliation with Section 17(5) blocked credits, and a careful answer to whether accumulated pre-amendment ITC qualifies for refund. This article addresses each of these issues.

2. Statutory Architecture Before the Amendment

Section 54(3) permits refund of any unutilised ITC at the end of a tax period, but the first proviso carves out only two categories: (a) zero-rated supplies made without payment of tax (clause (i)), and (b) accumulation due to rate of tax on inputs being higher than on output supplies – the IDS scenario (clause (ii)). All other accumulation must be carried forward indefinitely.

The operational mechanism is Rule 89(5). Notification No. 26/2018-Central Tax dated 13 June 2018 (the Fifth Amendment Rules) substituted the formula and provided in Explanation (a) that “Net ITC” “means input tax credit availed on inputs during the relevant period.” By confining Net ITC to inputs alone, the formula excluded both input services and capital goods from the numerator – effectively denying refund on these items even though the underlying ITC sat accumulated in the electronic credit ledger.

The Gujarat High Court in [2020] 118 taxmann.com 81 (Guj.) held that Rule 89(5) was ultra vires; the Madras High Court in [2020] 119 taxmann.com 324 (Madras) took the opposite view. The Supreme Court in [2021] 130 taxmann.com 193 (SC) resolved the conflict in favour of the Revenue, holding that “inputs” was deliberately chosen in contradistinction to “input tax credit” used elsewhere, and that Parliament was free to confine the refund to any subset of accumulated ITC. The Court did, however, expressly urge the GST Council to reconsider the formula – a strong signal that it recognised the structural inequity inherent in the restriction. Subsequent CBIC guidance, including Circular No. 135/05/2020-GST and Circular No. 173/05/2022-GST, sought to further constrain the operation of Section 54(3) by limiting refund eligibility to specified circumstances of inversion. Several High Courts, however, read these circulars down – reinforcing the broader judicial discomfort with restrictive interpretations of the IDS refund.

3. The Commercial Damage – Why the Exclusion Matters

Consider a textile manufacturer purchasing fabric at 12 per cent GST and selling finished garments at 5 per cent. Each Rs. 100 of turnover yields Rs. 5 of output tax but commands Rs. 8–10 of ITC on inputs alone – a Rs. 3–5 differential accumulates. Add Rs. 20 of input services at 18 per cent (job work, design consultancy, logistics, software, audit) – Rs. 3.60 of additional ITC – and the per-Rs. 100 accumulation rises to Rs. 6.60–8.60. Under [2021] 130 taxmann.com 193 (SC), the refundable portion is confined to the Rs. 3–5 on inputs; the Rs. 3.60 on input services remains trapped in the ledger indefinitely.

Across the textile industry, this aggregates to tens of thousands of crores of locked working capital, impairing competitiveness against imports and depressing export pricing. The renewable energy industry faces a similar story: solar modules and EVs attract 5 per cent output GST, while their components – lithium-ion cells at 18 per cent, BOS equipment at 18 per cent, project management consultancy at 18 per cent, capital goods at 18–28 per cent – create a structural inversion that the VKC Footsteps exclusion leaves unaddressed. Pharmaceutical formulations, processed food, and fertilizer manufacturers face equivalent arithmetic. The 56th Council’s rate rationalization, which moved several consumer-facing categories to 5 per cent, has sharpened the problem by enlarging the IDS-affected taxpayer universe – making the exclusion no longer an edge-case footnote but the single largest structural working-capital drag on Indian manufacturing GST compliance.

4. The Finance Bill 2026 Amendment – What the Law Does

Finance Bill 2026 amends Section 54 of the CGST Act and consequentially Rule 89(5) to extend the IDS refund route to include ITC on input services and capital goods. The amendment is legislatively minimal but operationally substantial: it widens the language of clause (ii) of the first proviso to Section 54(3) and rewrites Explanation (a) to Rule 89(5) to redefine “Net ITC” in parallel terms.

Critically, the amendment does not purport to disturb the Supreme Court’s ratio in [2021] 130 taxmann.com 193 (SC). Instead, it achieves the override indirectly by widening the statutory base on which that ratio operates. The Court’s reasoning that “inputs” was a deliberate textual choice is not legally undone; Parliament is simply exercising its power to expand the relief category. The constitutional validity of the amendment is therefore beyond doubt.

5. The Five Unresolved Sub-Issues That Require CBIC Guidance

5.1 The Retrospective/Prospective Divide

The single most important operational question is whether the amendment applies only prospectively or also covers accumulated ITC sitting in the ledger from prior periods. The Finance Bill text contains no saving clause; under the principle exhaustively reaffirmed by the Constitution Bench in CIT vs. Vatika Township (P.) Ltd. [2014] 49 taxmann.com 249 (SC), taxation statutes are prospective unless explicitly made retrospective. The amendment will likely apply only to accumulation arising from the notified date onward.

This creates a harsh line. A manufacturer with Rs. 50 crore of accumulated ITC on input services from July 2017 to March 2026 will find this amount stranded – refundable under a pre-VKC reading, denied under [2021] 130 taxmann.com 193 (SC), and unaddressed by Finance Bill 2026 because the accumulation predates the notified date. The CBIC should clarify whether such accumulated credit can be treated as Net ITC for the first post-amendment claim, or alternatively open a transitional refund window. A workable middle path would be to permit pre-amendment accumulation of ITC on input services and capital goods to be refunded over a defined transitional window – say, twelve tax periods from the notified date, with proportionate apportionment based on turnover. The Vatika Township fairness doctrine – that taxpayers should not bear retrospective disability absent express direction – supports such an accommodation, balancing revenue interests against the recognition that the pre-amendment accumulation was a product of a settled Supreme Court ruling that Parliament has now chosen to displace.

5.2 The Section 17(5) Interaction

Section 17(5) blocks ITC on specified categories: motor vehicles (with exceptions), works contract services for immovable property, and goods/services for construction of immovable property on own account. The Finance Act 2025 substitution of “plant or machinery” with “plant and machinery” in Section 17(5)(d) – retrospective from 1 July 2017, designed to overturn Chief Commr. of CGST vs. Safari Retreats (P.) Ltd. [2024] 167 taxmann.com 73 (SC) – has further narrowed the universe of eligible capital goods.

The Finance Bill 2026 amendment does not override the Section 17(5) block. Capital goods on which ITC is blocked remain outside the refund route. The complexity arises with mixed-use capital assets – partly for taxable manufacturing, partly for blocked use such as construction. Rule 43 provides for proportionate availmeny. The CBIC should clarify whether the eligible portion qualifies as Net ITC under the revised Rule 89(5), and what documentation substantiates the apportionment.

5.3 The Rule 89(5) Formula Rewrite

The existing formula, as amended by Notification No. 14/2022-Central Tax dated 5 July 2022, computes refund as: (Turnover of inverted-rated supply × Net ITC) / Adjusted Total Turnover, less tax payable on inverted-rated supply. When Net ITC expands to include input services and capital goods, two issues arise. First, capital goods ITC is front-loaded in the period of acquisition though the asset serves multiple years – a refund in the acquisition period may unduly deplete the ledger. Second, input services ITC often relates to overheads supporting both inverted and non-inverted outputs; the turnover-ratio apportionment may not reflect commercial reality.

The CBIC should consider two refinements: (a) for capital goods, distributing ITC over the Rule 43 useful life (5 years), with each year’s proportionate share qualifying as Net ITC; and (b) for input services, permitting direct attribution where supportable by contemporaneous documentation. The principles in BMG Informatics (P.) Ltd. vs. Union of India [2021] 130 taxmann.com 182 (Gauhati), Baker Hughes Asia Pacific Ltd. vs. Union of India [2022] 140 taxmann.com 326 (Rajasthan) and Shivaco Associates vs. Joint Commr. of State Tax [2022] 137 taxmann.com 213 (Cal.) – each reading down restrictive CBIC interpretations – reinforce the case for a commercially realistic formula design.

5.4 Interaction with the Parallel Section 54(6) Provisional Refund

Finance Bill 2026 also amends Section 54(6) to extend the 90 per cent provisional refund (previously available only for zero-rated supplies) to IDS. CBIC Instruction No. 06/2025-GST dated 3 October 2025 has operationalised this on an interim basis through system-based risk evaluation. The interaction question: does the 90 per cent apply to the full revised Net ITC base (including input services and capital goods), or only the inputs portion?

The plain answer is the former – the provisional refund is a percentage of the claim, and the claim is now computed on the revised base. But the risk evaluation under amended Rule 91(2), pursuant to Notification No. 14/2025-Central Tax dated 17 September 2025, operates at system level and may not yet be calibrated for the expanded Net ITC universe. A confirmatory CBIC Circular is needed.

5.5 The Rate Rationalization Aftermath

The 56th Council’s rate rationalization, effective 22 September 2025, expanded the IDS-affected population. Life and individual health insurance – nil-rated by Notification No. 16/2025-Central Tax (Rate) dated 17 September 2025 – creates a cliff-edge ITC problem: insurers face accumulated ITC on commission, brokerage, IT services, and operational inputs, but the output is exempt and therefore outside Section 54(3) altogether. Other sectors face partial inversion. For many of these, the VKC Footsteps exclusion was previously manageable because input services were a small part of the cost base. Post-rationalization, however, input services (IT, compliance, marketing, logistics) are material and the denial becomes punitive.

The CBIC should issue sector-specific guidance for: (a) classification of inverted-rated supplies post-rationalization, particularly for multi-product suppliers with mixed rate portfolios; (b) treatment of mixed portfolios in Rule 89(5); and (c) coordination with the insurance sector’s exempt-output regime, which falls outside Section 54(3) and triggers reversal under Section 17 rather than refund. Without such guidance, the very rate rationalization designed to ease the consumer burden will translate into fresh working-capital strain for the suppliers.

6. The Cross-Jurisdictional Check

A useful comparative frame is the EU VAT regime. Article 183 of the EU VAT Directive permits Member States to allow refund of excess deductible VAT or carry it forward. France, Germany, the Netherlands, and Italy provide a general refund route for excess deductible VAT without distinguishing between inputs, services, and capital goods. Australia, New Zealand, and Singapore similarly allow full refund of excess input tax credit without such distinction. The Indian position under [2021] 130 taxmann.com 193 (SC) was thus a distinctive departure from international VAT practice, the product of a specific Rule 89(5) drafting choice in 2018 and an interpretive approach in 2021. Its removal restores the structural coherence of the credit-and-refund architecture and aligns India with the global norm.

7. Practitioner’s Checklist for the Amended Regime

For taxpayers affected by the VKC Footsteps exclusion, the period from enactment to commencement is a critical preparation window:

(i) Reconcile Historical Accumulation: Quantify accumulated ITC on input services and capital goods for each FY from 1 July 2017 onwards in the Rule 89(2) format. Foundational regardless of CBIC transitional approach.

(ii) Verify Classification Post-Rationalization: For each output category, confirm “inverted-rated” status under clause (ii) of the first proviso to Section 54(3). Sectors newly inverted on 22 September 2025 should pursue advance rulings where classification is unclear.

(iii) Maintain a Capital Goods Register: Record date of acquisition, ITC availed, useful life, Rule 43 apportionment, and Section 17(5) status. This is the basis for capital goods claims.

(iv) Tighten Input Services Invoice Discipline: Ensure invoices are raised on the correct GSTIN (especially under the ISD regime mandatory from 1 April 2025 per Notification No. 16/2024-Central Tax dated 6 August 2024). Service descriptions should align with inverted-rated supply for direct-attribution claims.

(v) Ready Refund-Filing Infrastructure: Update ERP to capture Net ITC under the expanded definition. Prepare Form RFD-01 templates with separate line items. For 90 per cent provisional refund under CBIC Instruction No. 06/2025-GST, optimise risk profile through clean compliance and vendor tracking.

8. A Four-Point CBIC Action Plan

To maximise the facilitation benefit and minimise commencement disputes, the Board should:

(i)  Issue a Comprehensive Transitional Circular Before the Notified Date: Addressing (a) treatment of accumulated pre-amendment ITC, ideally with a transitional window consistent with the [2014] 49 taxmann.com 249 (SC) fairness doctrine; (b) Section 17(5) interaction; (c) revised Rule 89(5) with illustrations; and (d) sector-specific post-rationalization guidance.

(ii)  Update GSTN Portal Infrastructure: Form RFD-01 and Statement 1A should permit line-item declaration across inputs, input services, and capital goods. Vintage-based apportionment under Rule 43 should be automated.

(iii)  Calibrate the Rule 91(2) Risk System: For 90 per cent provisional refund, the risk parameters should reflect the expanded base. Capital goods claims are structurally lumpy and may trigger false-positive alerts under a smoothed turnover-based model.

(iv)  Coordinate with DGFT and CBDT on Sector Impact: The reform’s benefit will concentrate in textiles, footwear, renewable energy, EV, processed food, and pharmaceuticals. Joint sector studies will enable a calibrated rollout and pre-empt transitional disputes.

9. Conclusion

The exclusion mandated by [2021] 130 taxmann.com 193 (SC) has been, for four and a half years, the single largest structural flaw in India’s GST credit-and-refund architecture. Its removal through Finance Bill 2026 is a reform whose importance has not been adequately reflected in professional commentary. In commercial terms, this amendment unlocks a larger quantum of blocked working capital than the post-supply discount and intermediary services amendments combined.

The amendment does not disturb the Supreme Court’s ratio – it widens the statutory base on which the ratio operates. It restores India’s GST to alignment with international VAT practice, eliminates a working-capital drag on manufacturing competitiveness, and responds to the post-rationalization expansion of the IDS-affected taxpayer base. The reform is well-designed and constitutionally unassailable. Notably, the Supreme Court itself in [2021] 130 taxmann.com 193 (SC) had urged the GST Council to reconsider the formula – the present amendment is, in many ways, a delayed but principled response to that judicial nudge.

What remains is execution. The five sub-issues identified – transitional treatment of accumulated ITC, Section 17(5) interaction, Rule 89(5) refinements, coordination with provisional refund, and sector-specific rationalization aftermath – are the operational terrain on which success will be determined. The Board’s action plan must be in place by the notified date; otherwise, what should be a clean liquidity unlock will become a second round of disputes, arbitrage and litigation. Taxpayers, for their part, should not wait – the reconciliation, classification verification, and capital goods register work are necessary regardless of the CBIC’s transitional approach. The window is narrow; the opportunity is substantial.