A large pharmaceutical company in Ahmedabad had been claiming full ITC on its marketing overheads for two years. When a GST audit team arrived in March 2024, the very first question they asked was: “Show us your Rule 42 and 43 workings for FY 2022-23.” The company produced nothing. The audit resulted in a reversal demand of ₹1.2 crores — plus 18% interest from the date of original ITC claim.
ITC reversal is not a fringe issue. It is a core GST compliance obligation that most businesses either ignore or handle incorrectly — and the department knows it.
Why ITC Must Sometimes Be Reversed
Under Section 17 of the CGST Act, a registered person who makes both taxable and exempt supplies cannot claim full ITC on inputs that are used for both categories. The ITC attributable to exempt supplies and non-business use must be reversed. Rules 42 and 43 specify exactly how to calculate this reversal.
Rule 42 covers inputs and input services (goods purchased and services received). It requires you to first identify ITC that is directly attributable to taxable supplies (keep it), directly attributable to exempt supplies (reverse it), and ITC used for both (calculate proportional reversal based on the ratio of exempt turnover to total turnover).
Rule 43 covers capital goods. The calculation is similar in structure but uses a useful life of 60 months, spreading the attribution across the asset’s life rather than the month of purchase.
The Annual True-Up in April
Both rules require a provisional monthly reversal — calculated on the basis of the previous year’s exempt/taxable ratio — and then a final annual reversal in April (GSTR-3B for March or the annual return), once the actual full-year figures are known. If the provisional reversals were insufficient, additional ITC must be reversed with interest. If they were excessive, the excess can be reclaimed.
This annual true-up in GSTR-9 (the annual return) is where most audit discrepancies originate — businesses that never did monthly reversals face a sudden large number in April.
An AAR Decision Worth Noting
In In re: Torrent Power Ltd (AAR Gujarat, 2021), a power company with taxable and exempt electricity supply sought clarity on how to calculate exempt turnover for Rule 42. The AAR held that duty-free fuel and government-mandated free power supply to certain categories counted as “exempt supply” for purposes of Rule 42 — significantly increasing the amount of ITC that had to be reversed.
Three Practical Takeaways
- If you have any exempt supplies, prepare a Rule 42 working every single month. Even if the reversal amount seems small, the documentation proves you considered it — which is your defence in an audit.
- Build the annual true-up into your April filing calendar. Treat the March GSTR-3B as the reversal reconciliation month, not an afterthought. The numbers need to match GSTR-9.
- Identify “partially common” inputs carefully. Marketing, office overheads, IT services — many of these straddle taxable and exempt activity. A defensible allocation methodology (square footage, headcount, revenue ratio) documented in a policy note is far stronger than a post-hoc estimate.
Quick Quiz
A company’s total turnover is ₹10 crores. Exempt supply turnover is ₹2 crores. Common ITC for the year (inputs + input services) is ₹50 lakhs. What is the approximate ITC reversal required under Rule 42?
A) ₹50 lakhs B) ₹10 lakhs C) ₹40 lakhs D) Nil — Rule 42 does not apply to services