Any Indian business making both taxable and exempt supplies must reverse a portion of ITC monthly under Rules 42 and 43 of the CGST Rules, 2017. Rule 42 covers inputs and input services; Rule 43 covers capital goods across a 60-month life. Under-reversal in GSTR-3B Table 4(B)(2) is a primary Show Cause Notice trigger under Section 73 of the CGST Act.
Why reversal is required — the Section 17(1) mandate
Section 17(1) of the CGST Act, 2017 establishes the core principle: ITC is available only to the extent that inward supplies are used for making taxable outward supplies. Where goods or services serve a dual purpose — partly taxable, partly exempt or non-business — the credit must be apportioned. Rules 42 and 43 operationalise this apportionment as a formula-driven monthly computation with an annual true-up under Rule 42(2).
Exempt supplies for this purpose include not just GST-exempt goods and services but also: sale of land, sale of completed residential units (where the entire consideration is received after the completion certificate is issued), and interest income from loans and deposits. This broad definition is what makes Rule 42 particularly significant for banks and real estate developers.
Rule 42 — ITC reversal for inputs and input services
Rule 42 applies to all ITC on inputs and input services in a tax period that is not exclusively attributable to either taxable or exempt supply. The starting point is isolating the common credit pool (C2):
C2 = Total ITC (C1) − T1 − T2 − T3
- T1: ITC directly and exclusively attributable to taxable (including zero-rated) supplies
- T2: ITC blocked under Section 17(5) (e.g., canteen services, motor vehicles for non-business use, construction of immovable property)
- T3: ITC directly and exclusively attributable to exempt supplies
From C2, two reversals are computed each month:
- D2 (non-business use reversal): 5% of C2, mandated by Rule 42(1)(f) as a proxy for personal or non-business use embedded in common expenditure
- D3 (exempt supply reversal): (Exempt turnover / Total turnover) × C2
Total monthly reversal = D1 = D2 + D3
Worked example — manufacturer with 20% exempt supplies (April 2025)
ABC Manufacturers Pvt Ltd has taxable turnover of ₹80 lakh and exempt turnover of ₹20 lakh in April 2025 (total: ₹100 lakh). Its ITC position after categorisation:
| ITC head | Amount | Category |
|---|---|---|
| Raw materials for taxable products | ₹9,00,000 | T1 (direct) |
| Canteen services | ₹5,000 | T2 (blocked §17(5)) |
| Electricity (whole plant) | ₹81,000 | C2 (common) |
| Office rent | ₹36,000 | C2 (common) |
| Legal fees | ₹18,000 | C2 (common) |
- C2 = ₹10,40,000 − ₹9,00,000 − ₹5,000 − ₹0 = ₹1,35,000
- D2 = 5% × ₹1,35,000 = ₹6,750
- D3 = (₹20 lakh / ₹100 lakh) × ₹1,35,000 = ₹27,000
- D1 (total reversal) = ₹6,750 + ₹27,000 = ₹33,750
- Net ITC retained (T4) = ₹1,35,000 − ₹33,750 = ₹1,01,250
The ₹33,750 reversal is entered in GSTR-3B Table 4(B)(2) for April 2025. The ₹9,00,000 T1 credit is used in full; the ₹5,000 T2 amount is permanently reversed.
Rule 43 — ITC reversal for capital goods (60-month rule)
Rule 43 applies where a capital good — machinery, servers, vehicles, plant and equipment — is used for both taxable and exempt supplies. The rule distributes the total ITC on the asset (called Tc) across a deemed useful life of 60 months.
Monthly reversal formula:
Te = (Exempt turnover of the period / Total turnover of the period) × Tc ÷ 60
Worked example — IT company purchases servers (January 2025)
XYZ Technologies buys servers for ₹20 lakh + ₹3.6 lakh GST (18%). The servers serve both taxable software services and an exempt interest-earning NBFC arm.
- Tc = ₹3,60,000
- Monthly base = ₹3,60,000 ÷ 60 = ₹6,000
In January 2025 (exempt turnover ₹10 lakh / total ₹50 lakh): Te = 20% × ₹6,000 = ₹1,200
In February 2025 (exempt turnover ₹8 lakh / total ₹55 lakh): Te = 14.5% × ₹6,000 = ₹873
The reversal ratio re-computes each month. There is no year-end true-up for Rule 43 — the monthly Te is the final reversal for that period. Businesses must maintain a capital goods register recording Tc, date of credit availment, monthly Te computations, and cumulative reversal for each asset in the common pool.
Annual reconciliation under Rule 42(2)
The monthly D3 computation uses the prevailing month's turnover ratio as a provisional estimate. Rule 42(2) mandates an annual true-up in the March GSTR-3B:
- Add up all 12 months' D1 reversals (ΣD1_monthly).
- Recompute D1_annual using the full-year exempt turnover / full-year total turnover × annual aggregate C2, plus 5% of annual C2.
- If ΣD1_monthly < D1_annual — add the shortfall to output tax liability in the March GSTR-3B. Interest under Section 50 at 18% per annum accrues from the date each month's ITC was originally availed, not from March.
- If ΣD1_monthly > D1_annual — claim the excess back as ITC in the March GSTR-3B (Table 4(A)(5)).
Annual reconciliation figures must also be disclosed in GSTR-9 Annual Return Table 7B (Rule 42 reversal) and Table 7C (Rule 43 reversal). Discrepancies between GSTR-3B cumulative reversals and GSTR-9 Table 7 are flagged automatically by the GSTN system and trigger scrutiny notices under Section 61 of the CGST Act.
Common SCN triggers
Interest income classified outside "exempt supply": Banks and NBFCs most frequently face SCNs on this ground. Entry 27 of Notification 12/2017-Central Tax (Rate) exempts interest income from loans and deposits. The CBIC's position is that this qualifies as an "exempt supply" for Rule 42 purposes, increasing the D3 ratio — sometimes to 70–80% of C2 for large banks. Advance Ruling authorities consistently upheld this position.
Real estate developers omitting land sale and post-CC proceeds: Rule 42 explicitly includes sale of land and sale of completed buildings in the definition of "exempt supply" for D3 computation. Developers who separate these transactions into a non-GST ledger and exclude them from the exempt turnover numerator typically face SCNs during the audit cycle.
Misclassification of common invoices as T1: Where an assessee includes a shared electricity or IT cost in T1 (wholly taxable) without sub-meter records or documented allocation methodology, field officers reclassify those invoices as C2, resulting in a higher D1 reversal and a corresponding demand with interest.
Rule 43 register not maintained: Absence of the capital goods common-credit register is treated as a record-keeping failure under Rule 56, and in some adjudications has been used to deny the credit in entirety on the ground that the eligibility cannot be verified.
Beyond this brief Preview Full Rule 42 and 43 formulae with all variables annotated, complete worked examples across manufacturing, BFSI, and real-estate scenarios, annual reconciliation step-by-step with interest calculation, leading HC and SC rulings on exempt turnover disputes (including Safari Retreats on construction ITC and AAAR rulings on interest income), verbatim Rule 42 and Rule 43 text, and a practitioner checklist for monthly ITC reversal compliance — in Veritect Legal AI. Access Veritect →
FAQ
Does interest income count as exempt turnover for banks applying Rule 42?
Yes, under the CBIC's operative position. Entry 27 of Notification 12/2017-Central Tax (Rate) dated 28 June 2017 exempts services by way of extending loans or deposits where the consideration is interest or discount. CBIC's field instructions and Advance Ruling decisions consistently treat this as "exempt supply" for the Rule 42 D3 ratio. For a bank where 75% of revenue is interest income, this means 75% of the common credit pool must be reversed under D3 alone.
What is the difference between Rule 42 and Rule 43 — which applies to my business?
Rule 42 applies to inputs and input services — i.e., goods and services consumed in the normal course of operations (electricity, professional services, office rent, raw materials used across product lines). Rule 43 applies to capital goods — assets that are capitalised in the books and used across multiple accounting periods (machinery, servers, vehicles). Most businesses with mixed supplies will need to apply both rules simultaneously — Rule 42 for ongoing operational expenditure and Rule 43 for assets with an ITC-available purchase in the last 60 months.
If I have 100% taxable supplies in a month, do I still need to apply Rule 42?
Not for that month's D3 computation — if exempt turnover is zero, D3 = 0. However, D2 (5% of C2 for non-business use) still applies unless you can establish that every rupee of common expenditure is 100% for business purposes. In practice, most businesses retain the 5% D2 reversal as a conservative compliance position. If you have 100% taxable supplies for the entire financial year, the annual Rule 42(2) reconciliation will confirm zero annual D3, and any provisional D2 reversals made during the year can be reclaimed.
How is D2 (non-business use) calculated in practice?
D2 is a flat 5% of C2 — the common credit pool after removing T1, T2, and T3. The 5% is a statutory deeming provision; the actual non-business use need not be quantified separately. Businesses cannot substitute their own estimated non-business use percentage for the statutory 5%, even if the actual non-business element is demonstrably lower. The only way to reduce D2 is to reduce C2 itself — i.e., by allocating more invoices to T1 (wholly taxable) with supporting documentation.
What happens if I don't reverse ITC under Rule 42 — what is the penalty?
Failure to reverse ITC that was required to be reversed constitutes utilisation of excess ITC. This triggers a demand under Section 73 (without fraud, interest at 18% per annum + penalty of 10% of the tax amount, subject to waiver on early payment) or Section 74 (fraud/suppression, interest at 24% per annum + penalty of 100% of tax). Where the non-reversal results from a computation error rather than deliberate suppression, Section 73 applies. Interest under Section 50 accrues from the date the ITC was availed.
How does the annual reconciliation under Rule 42(2) work?
In the GSTR-3B for March of the financial year, you compute D1_annual using the full-year exempt/total turnover ratio applied to the aggregate of all 12 months' C2 values. Compare this with the sum of all monthly D1 provisionals. A shortfall means an additional reversal in the March GSTR-3B (output tax liability). A surplus means you reclaim ITC. The annual adjustment is also disclosed in GSTR-9 Table 7B, and GSTN reconciles this against the March GSTR-3B entry.
Can a GSTR-9 amendment cure a wrong Rule 42 provisional reversal?
GSTR-9 is an annual return that allows disclosure of missed reversals or incorrect reversals for the financial year. Disclosing additional reversals in GSTR-9 (where the monthly GSTR-3B reversals were insufficient) does attract interest from the date of original ITC availment — GSTR-9 does not have a built-in interest exemption. However, voluntarily disclosing the shortfall in GSTR-9 (rather than waiting for a notice) typically results in the demand being treated under Section 73 (without fraud), limiting the penalty exposure. For excess reversals that were not reclaimed in the March GSTR-3B annual adjustment, GSTR-9A (Annual Return for composition taxpayers) or a rectification application may be the appropriate remedy depending on circumstances.
Source attribution: Based on Rule 42 and Rule 43 of the Central Goods and Services Tax Rules, 2017 (G.S.R. 610(E) dated 28 June 2017, as amended), and Section 17(1) and Section 17(2) of the Central Goods and Services Tax Act, 2017. Exemption for interest income: Notification 12/2017-Central Tax (Rate) dated 28 June 2017, Entry 27. Supreme Court judgment: Safari Retreats Pvt Ltd v. Chief Commissioner of Central Goods and Service Tax, Civil Appeal No. 2835 of 2020 (decided 3 October 2024).
Beyond this brief Preview The private Veritect Legal AI corpus contains the complete Rule 42 and Rule 43 text verbatim, detailed worked examples for the BFSI, real estate, and manufacturing sectors, a step-by-step annual reconciliation with the interest clock calculation, leading High Court rulings on exempt turnover disputes, the capital goods register template, and a monthly compliance checklist for GSTR-3B Table 4(B)(2) entries. For practitioners managing clients across sectors with mixed supplies, the full corpus also cross-references Rule 37A (non-payment reversal), Rule 36(4) (GSTR-2B mismatch provisional ITC), and Section 17(5) blocked credits. Access Veritect →
Related on Veritect: ITC reversal and blocked credits — the full mechanics