How ITC Reversal Rules 42 and 43 Apply to Common Credit

How is ITC reversal calculated under Rule 42? Under Rule 42 of the CGST Rules, ITC on inputs and input services is split each tax period. From total input tax (T) you remove credit used exclusively for non-business purposes (T1), exclusively for exempt supplies (T2) and blocked under Section 17(5) (T3), leaving C1. From C1 you remove credit used exclusively for taxable supplies (T4), leaving common credit C2. The exempt share D1 = (E / F) x C2. Where common inputs are also used partly for non-business purposes, a further D2 = 5% of C2 applies. D1 and D2 are reversed in GSTR-3B each period, and the whole year is recalculated before the due date of the September return.

Every GST-registered business that makes both taxable and exempt supplies faces a basic question: how much of the ITC on shared inputs can you keep? The answer sits in Rules 42 and 43 of the CGST Rules, 2017, made under Section 17(1) and 17(2) of the CGST Act. These rules prescribe the formula that splits common credit between taxable use (eligible) and exempt or non-business use (to be reversed).

The stakes are real. Under-reversal means ITC wrongly availed, which can lead to a demand under Section 73 or 74 (Section 74A for FY 2024-25 onwards) with interest at 18% under Section 50(3) where the credit was utilised, plus penalties. Over-reversal means you pay more GST than the law requires. Both are common because the formula, while mechanical, has many variables that move each month with your turnover mix.

This guide walks through Rule 42 (inputs and input services) and Rule 43 (capital goods) step by step, with worked examples, the exempt turnover definition that trips up financial services firms, the annual recalculation, and the GSTR-3B table where these reversals are reported.

When Do Rules 42 and 43 Apply?

Rules 42 and 43 apply only when ITC is attributable to a mix of taxable and exempt (or non-business) use. Credit that serves only taxable supplies is kept in full, and credit that serves only exempt supplies or non-business purposes is not available at all. Only the common portion is apportioned.

Common scenarios include:

• A bank or NBFC earning interest income (exempt under Notification 12/2017-CT(Rate)) alongside fee-based taxable services such as processing charges or locker rent. Office rent, software and stationery serve both lines. Banks, financial institutions and NBFCs can instead opt under Section 17(4) to take 50% of eligible ITC every month and let the rest lapse.
• A real estate developer selling some units during construction (a taxable supply) and others after the completion certificate (not a supply, but counted in exempt value under Section 17(3)). Rules 42 and 43 have separate project-wise, carpet-area based provisions for such developers.
• A dairy or food business selling both taxable processed products and exempt fresh produce, with shared warehousing, logistics and testing costs.
• A supplier making some supplies on which the recipient pays tax under the reverse charge mechanism. Section 17(3) counts those supplies as exempt for this purpose.

Rule 42 governs inputs (raw materials, consumables) and input services (rent, professional fees, software). Rule 43 governs capital goods (machinery, equipment, goods vehicles). The formulas differ, and you apply each rule separately.

Rule 42: Step-by-Step Common Credit Calculation

T1, T2, T3 and T4 are declared at summary level in GSTR-3B (Rule 42(1)(g)). C3, D1 and D2 are computed separately for CGST, SGST/UTGST and IGST (Rule 42(1)(l)), and D1 + D2 is reversed in GSTR-3B or through DRC-03 (Rule 42(1)(m); before 1 April 2019 the rule said "added to output tax liability"). If you have no turnover in a period, E/F is taken from the last period for which figures are available.

A common T3 item: goods and services for construction of an immovable property on your own account, other than plant and machinery (Section 17(5)(d)). The Finance Act 2025 substituted "plant and machinery" for "plant or machinery" in clause (d) retrospectively from 1 July 2017, so a building cannot be treated as "plant" to claim this credit.

Worked Example: Rule 42 in Practice

Consider a dairy company in Telangana that sells taxable products such as ghee and butter and exempt fresh milk. Its figures for July 2026 are:

Step-by-step computation:

Result: The company keeps T4 (Rs 2,40,000) and C3 (Rs 96,000), a total of Rs 3,36,000 out of Rs 4,80,000. T2 (Rs 80,000) is not available and D1 (Rs 64,000) is reversed. In GSTR-3B, where the full Rs 4,80,000 flows into Table 4(A) from GSTR-2B, Table 4(B)(1) shows Rs 1,44,000 (T2 + D1), leaving net ITC of Rs 3,36,000.

If some common inputs were also used for non-business purposes (for example, a shared office also used privately by the owner), D2 would be 5% x Rs 1,60,000 = Rs 8,000, and C3 would fall to Rs 88,000.

What Counts as Exempt Turnover? (The E in the Formula)

E is broader than most businesses expect. Section 2(47) defines exempt supply as a nil-rated or wholly exempt supply, including a non-taxable supply, and Section 17(3) adds more. E includes:

1. Supplies exempted by notification under Section 11 of the CGST Act (or Section 6 of the IGST Act), such as those in Notification 2/2017-CT(Rate) for goods and Notification 12/2017-CT(Rate) for services: fresh milk, unprocessed agricultural produce, specified educational and healthcare services.

2. Non-taxable supplies. Alcoholic liquor for human consumption, and the five petroleum products (petroleum crude, petrol, high-speed diesel, natural gas and aviation turbine fuel) on which GST is not yet levied. For both E and F, the excise duty and VAT on these goods are left out (Explanation to Rule 42(1)(i)).

3. Supplies on which the recipient pays tax under reverse charge (Section 17(3)).

4. Transactions in securities, valued at 1% of the sale value of the securities (Explanation at the end of Rule 45, which applies to this chapter of the rules). A treasury desk with Rs 500 crore of securities sales therefore adds Rs 5 crore, not Rs 500 crore, to E.

5. Sale of land, and sale of a building after its completion certificate or first occupation, valued at the value adopted for stamp duty (same Explanation to Rule 45).

What is left out of E:

• Other Schedule III transactions (such as high-sea sales and sale of warehoused goods before home clearance), except sale of land and buildings and the value of supplies from duty-free shops at arrival terminals to incoming passengers (Explanation to Section 17(3) and Explanation 3 to Rule 43, from 1 October 2023).
• Interest or discount on deposits, loans and advances, except for a banking company, financial institution or NBFC engaged in that business (Explanation 1(b) to Rule 43). A trading company that earns interest on a loan to a group company leaves that interest out of E.
• Supplies of duty credit scrips (Explanation 1(d) to Rule 43).

The 5% Non-Business Deemed Use (D2)

Under Rule 42(1)(j), D2 is 5% of C2. It applies only where common inputs and input services are used partly for business and partly for non-business purposes.

Key points about D2:

• Where D2 applies, the rule fixes it at 5% of C2. It does not provide for replacing the 5% with your actual non-business share.
• Where common inputs serve only taxable and exempt business supplies, there is no D2; the reversal is D1 alone.
• D2 is calculated on C2 itself, not on C2 after D1. Both are subtracted from C2 together: C3 = C2 - (D1 + D2).
• If D2 applies to a business with Rs 10,00,000 of common credit in a month, D2 is Rs 50,000 for that month, regardless of the exempt ratio.
• D2, like D1 and C3, is computed separately for CGST, SGST/UTGST and IGST.

Input tax on items used exclusively for non-business purposes is not part of D2; it is T1 and is not credited at all.

Annual Recalculation Under Rule 42(2)

Rule 42(2) requires D1 and D2 to be calculated finally for the financial year, using the full year's figures, before the due date for furnishing the return for the month of September following the end of that year. This corrects the effect of month-to-month swings in the turnover mix.

How the recalculation works:

1. Compute C2 for the full financial year from the year's T, T1, T2, T3 and T4.
2. Compute D1 using the year's E divided by the year's F, multiplied by the year's C2.
3. Compute D2 as 5% of the year's C2, where D2 applies.
4. Compare the final D1 + D2 with the total of the monthly D1 + D2 already reversed.

If the final figure exceeds the monthly total: reverse the excess in GSTR-3B or through DRC-03, no later than the September return, and pay interest at the rate in Section 50(1) (18% per annum, Notification 13/2017-CT) from 1 April of the following financial year until the date of payment. For FY 2025-26, the excess must be reversed by the September 2026 GSTR-3B (due 20 October 2026 for monthly filers), with interest running from 1 April 2026.

If the monthly total exceeds the final figure: claim the excess as credit in a return for a month no later than September following the end of the year.

The recalculation is compulsory. It does not apply to real estate projects covered by clause (b) of paragraph 5 of Schedule II, which follow the project-completion calculation in Rule 42(3) to (6). Officers routinely check it during audits under Section 65/66 and in scrutiny.

Rule 43: ITC Reversal for Capital Goods

Rule 43 handles capital goods used partly for exempt supplies or non-business purposes. It works differently from Rule 42 because capital goods have a long useful life, which Rule 43 fixes at five years from the date of the invoice.

How Rule 43 Works: The 60-Month Framework

1. Exclusively exempt or non-business capital goods (Rule 43(1)(a)): the input tax is shown in GSTR-3B but not credited.
2. Exclusively taxable capital goods (Rule 43(1)(b)): the input tax is credited in full.
3. Common capital goods (Rule 43(1)(c)): the input tax on the invoice, called A, is credited directly to the electronic credit ledger.
4. Common credit (Tc): the total A of all common capital goods whose five-year useful life is still running in the period (Rule 43(1)(d)).
5. Monthly share (Tm): Tm = Tc / 60 (Rule 43(1)(e)).
6. Exempt share (Te): Te = (E / F) x Tm, using the period's exempt supplies and total turnover in the State (Rule 43(1)(g)).
7. Reversal: Te, along with the applicable interest, is added to output tax liability in every tax period of the useful life, computed separately for each tax head and declared in GSTR-3B (Rule 43(1)(h) and (i)).

Rule 43 is subject to Section 16(3): if you claim depreciation on the tax component of a capital good under the Income-tax Act, no ITC is allowed on that tax.

Exclusively Exempt Use to Common Use

If a capital good was used only for exempt supplies or non-business purposes (no ITC taken) and later becomes common, the first proviso to Rule 43(1)(c) lets you credit A. But the ineligible credit for the period of exempt use, called Tie, is calculated at 5 percentage points for every quarter or part of a quarter and added to output tax liability in the period the credit is claimed.

For example, if a machine with GST of Rs 1,80,000 was used only for exempt supplies for 2 years (8 quarters), Tie is 8 x 5% = 40% of Rs 1,80,000 = Rs 72,000. You credit Rs 1,80,000 and add Rs 72,000 to output tax, a net gain of Rs 1,08,000. From then on, the machine is part of Tc for the rest of its five-year useful life, so its monthly share (Rs 1,80,000 / 60 = Rs 3,000) is also subject to the Te reversal in each remaining month.

Exclusively Taxable Use to Common Use

If a capital good was used only for taxable supplies (full ITC taken) and later also serves exempt supplies, the proviso to Rule 43(1)(d) adds its ITC to Tc. From that month, its Tm is apportioned and Te is reversed for the remaining useful life.

Rule 43 Worked Example: Capital Goods Switching Use

A logistics company buys a goods vehicle for Rs 25,00,000 plus GST of Rs 4,50,000 (18%) in April 2026. The vehicle is used only for taxable transport services, and full ITC of Rs 4,50,000 is claimed.

From October 2027, 18 months later, the vehicle is also used for exempt transport of agricultural produce. From that month the company's exempt ratio (E/F) is 30%.

Result: From October 2027, the company adds Rs 2,250 a month to output tax for the remaining 42 months, recalculated each month with that month's actual E/F. At a constant 30%, the total is 42 x Rs 2,250 = Rs 94,500, and the company keeps Rs 4,50,000 - Rs 94,500 = Rs 3,55,500 of the original credit.

Reporting in GSTR-3B: Table 4(B)(1)

Rule 42 and Rule 43 reversals are reported in Table 4(B)(1) of GSTR-3B, the row for reversals "as per rules 38, 42 and 43 of CGST Rules and section 17(5)". This row structure applies since the July 2022 changes to Table 4 (Notification 14/2022-CT, Circular 170/02/2022-GST).

What to enter:

Important points for GSTR-3B reporting:

• The auto-drafted GSTR-3B does not compute Rule 42 or 43 reversals. Work them out yourself and enter them each period.
• Credit in GSTR-2B flows into Table 4(A). The reversals in Table 4(B)(1) reduce your net ITC in Table 4(C). If your ITC before reversal is Rs 5,00,000 and your Rule 42/43 reversal is Rs 72,000, net ITC is Rs 4,28,000.
• Keep a monthly working sheet with T, T1, T2, T3, T4, C1, C2, D1, D2, C3 and, for capital goods, Tc, Tm and Te. Officers ask for it in audit and scrutiny.
• An excess found in the Rule 42(2) annual recalculation is reversed in Table 4(B)(1) (or through DRC-03) by the September return; a shortfall is claimed as credit, usually in Table 4(A)(5), by the same return.

Common Mistakes in Rule 42/43 Compliance

1. Not segregating credit at invoice level. Many businesses put all ITC into one pool and apply the exempt ratio to all of it. This inflates the reversal, because T4 (exclusively taxable) should never enter the apportionment. Tag each purchase as exclusively taxable, exclusively exempt, non-business, blocked, or common. Where one invoice is partly for each and you can split it, the proviso to Rule 42(1)(m) lets you put the parts into T1, T2 and T4.

2. Leaving reverse charge supplies out of exempt value. Supplies on which your recipient pays GST under reverse charge are exempt value (E) for you. Leaving them out understates D1.

3. Using the full securities value instead of 1%. Securities are valued at 1% of their sale value for E. Using the full value grossly inflates D1.

4. Putting interest income into E when you are not a lender. Unless you are a bank, financial institution or NBFC, interest or discount on deposits, loans and advances is excluded from E.

5. Applying D2 automatically. D2 applies only where common inputs are partly used for non-business purposes. Reversing 5% on every business adds cost the rule does not require.

6. Skipping the annual recalculation. The Rule 42(2) final calculation is a statutory requirement, with interest from 1 April on any excess reversed late.

7. Applying the Rule 42 formula to capital goods. Capital goods follow Rule 43's 60-month method, with no D2 and no annual true-up.

8. Not adjusting Rule 43 when use changes. When a capital good moves from exclusively taxable to common use, it enters Tc from that month. Continuing to keep full credit creates a liability with interest.

9. Blending tax heads. C3, D1, D2 and Te must be computed separately for CGST, SGST/UTGST and IGST.

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Sources: Rules 42, 43 and the Explanation at the end of Rule 45 of the CGST Rules, 2017, as amended by Notifications 16/2019-CT, 16/2020-CT and 38/2023-CT (taxinformation.cbic.gov.in); Sections 2(47), 16(3), 17(1) to 17(5) and 50 of the CGST Act, 2017, including the Finance Act 2025 amendment to Section 17(5)(d); Notification 13/2017-CT (interest rates); Notification 14/2022-CT and Circular 170/02/2022-GST (GSTR-3B Table 4 reporting). Verify the current rule text on taxinformation.cbic.gov.in before relying on this guide for a specific filing period.

Tax Garden handles Rule 42/43 ITC reversal calculations as part of its GST compliance service. The platform computes your D1, D2 and capital goods reversals monthly, performs the annual recalculation at year-end, and reports the figures in GSTR-3B Table 4(B)(1). If you make both taxable and exempt supplies, talk to the Tax Garden compliance team.