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 used for both taxable and exempt supplies is apportioned using a formula. Total ITC (T) is split into exclusively-taxable (T1), exclusively-exempt (T2), and common credit (C2 = T - T1 - T2). The reversal amount D1 equals exempt turnover divided by total turnover, multiplied by C2. An additional 5% of C2 (called D2) is reversed as deemed non-business use. The eligible common credit is C3 = C2 - D1 - D2. D1 and D2 are added to output tax liability each month, with an annual true-up using full financial year figures.

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

The stakes are real. Under-reversal triggers demand under Section 73 or 74 with 18% annual interest and potential penalties. Over-reversal means you are paying more GST than the law requires, tying up working capital that belongs in your business. Both outcomes are common because the formula, while mechanical, involves multiple variables that shift 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 numerical examples, the exempt turnover definition that trips up financial services firms, the mandatory annual true-up, and the exact GSTR ThreeB 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. If you can identify every input as exclusively for taxable supplies or exclusively for exempt supplies, these rules do not apply. You claim full ITC on the taxable portion and take zero ITC on the exempt portion.

The rules kick in when you have common inputs, input services, or capital goods that serve both sides. Common scenarios include:

• A bank or NBFC earning interest income (exempt under Notification 12/2017) alongside fee-based taxable services such as processing charges, locker rent, or advisory fees. The office rent, software subscriptions, and stationery serve both lines.
• A real estate developer constructing both commercial properties (taxable at 12% or 18%) and affordable residential units (exempt or 1% without ITC). Cement, steel, architect fees, and labour serve both project types.
• A manufacturer selling both taxable finished goods and exempt agricultural produce. Shared warehousing, logistics, and quality-testing inputs trigger Rule 42.
• A trader dealing in standard-rated goods alongside supplies on which the recipient pays tax under reverse charge mechanism. The RCM supplies count as exempt turnover for the D1 formula.

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

Rule 42: Step-by-Step Common Credit Calculation

The critical output is D1 + D2. This combined amount is added to your output tax liability and reported in GSTR ThreeB Table 4(B) 1). You perform this calculation separately for CGST, SGST/UTGST, and IGST components.

Worked Example: Rule 42 in Practice

Consider a manufacturing company in Telangana that produces both taxable industrial chemicals 18% GST) and exempt agricultural fertilizers (NIL-rated). The figures for July 2026 are:

Step-by-step computation:

Result: The company claims T1 (Rs 2,40,000) in full, claims C3 (Rs 88,000) as eligible common credit, reverses Rs 72,000 in GSTR ThreeB Table 4(B) 1), and never credits T2 (Rs 80,000) at all. The total ITC available for the month is Rs 2,40,000 + Rs 88,000 = Rs 3,28,000 out of the original Rs 4,80,000.

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

The definition of exempt turnover (E) for the D1 formula is broader than what most businesses expect. It includes four categories:

1. Supplies exempt under Section 11 notifications. These are goods or services where the government has issued an exemption notification (e.g., Notification 2/2017-CT(Rate) for goods, Notification 12/2017-CT(Rate) for services). Agricultural produce, educational services, and healthcare services fall here.

2. Non-taxable supplies. Supplies that fall entirely outside the scope of GST, such as alcoholic liquor for human consumption, petroleum crude, motor spirit (petrol), high-speed diesel, natural gas, and aviation turbine fuel.

3. Supplies on which the recipient pays tax under reverse charge. When your customer pays GST under reverse charge on a supply you make, that supply counts as exempt turnover in your hands for the Rule 42 formula. This is because you, as the supplier, do not collect or remit tax on it.

4. Securities and shares trading. Here the Explanation to Rule 42 and Rule 43 provides a critical relief: only 1% of the sale value of securities is included in exempt turnover, not the full trading value. Without this carve-out, a bank with Rs 500 crore of securities turnover and Rs 50 crore of fee income would see the D1 formula attribute nearly all common credit to exempt use, producing an absurd result. With the 1% rule, only Rs 5 crore enters E, producing a proportionate reversal.

This securities valuation rule is one of the most frequently missed provisions. Financial services firms, NBFCs, and any entity with a treasury desk trading in securities should apply it.

The 5% Non-Business Deemed Use (D2)

D2 is a flat 5% reversal on common credit (C2) that applies to every taxpayer caught by Rule 42. It represents the government's statutory assumption that 5% of common inputs are used for non-business purposes.

Key points about D2:

• You cannot challenge or reduce D2 on the ground that your actual non-business use is zero. The 5% is a legal fiction embedded in Rule 42 1), not a rebuttable presumption.
• D2 applies on the full common credit, not on C2 after D1 has been removed. In the formula, both D1 and D2 are subtracted from C2 independently.
• For a business with Rs 10,00,000 of common credit, D2 is Rs 50,000 every month, regardless of the exempt ratio. Over 12 months, that amounts to Rs 6,00,000 of permanently reversed credit.
• D2 is computed separately for CGST, SGST, and IGST. If your common credit of Rs 10,00,000 comprises Rs 5,00,000 CGST and Rs 5,00,000 SGST, the D2 reversal is Rs 25,000 for each.

In practice, D2 is a modest cost for businesses with large common credit pools, but it adds up over a financial year. The annual true-up recalculates D2 using full-year common credit, so monthly rounding differences are corrected.

Annual True-Up: Mandatory Recalculation

Rule 42 2) requires a mandatory annual recalculation of D1 and D2 using the aggregate figures for the entire financial year (April to March). This annual true-up addresses the problem that monthly turnover ratios fluctuate with seasonal demand, one-off large orders, or inventory cycles.

How the true-up works:

1. Recalculate C2 for the full financial year: annual T minus annual T1 minus annual T2.
2. Recalculate D1 using annual E (total exempt turnover for the year) divided by annual F (total turnover for the year), multiplied by annual C2.
3. Recalculate D2 as 5% of annual C2.
4. Compare annual D1 + D2 against the sum of all monthly D1 + D2 amounts already reversed during the year.

If the annual figure exceeds the sum of monthly reversals: pay the difference along with interest under Section 50 (currently 18% per annum). This payment must be made in the GSTR ThreeB for September following the end of the financial year. For FY 2025-26, the true-up return is September 2026.

If the annual figure is less than the sum of monthly reversals: you have over-reversed during the year. Claim the excess as additional ITC in the same September return.

The annual true-up is not optional. Failing to perform it is a compliance gap that surfaces during audits under Section 65/66 and assessments, where the department recalculates using annual figures and raises demands for the shortfall with interest.

Rule 43: ITC Reversal for Capital Goods

Rule 43 handles capital goods used for both taxable and exempt supplies. The mechanism differs fundamentally from Rule 42 because capital goods have a long useful life, and their utilisation pattern can change over time.

How Rule 43 Works: The 60-Month Framework

When capital goods are used for both taxable and exempt supplies from the date of acquisition:

1. Total ITC on the capital good is noted at the time of purchase.
2. Monthly ITC installment = Total ITC / 60.
3. Monthly reversal = (Exempt turnover for the month / Total turnover for the month) x Monthly ITC installment.
4. This reversal is performed every month for 60 months (or until the asset is sold, scrapped, or fully depreciated under GST, whichever is earlier).

Capital Goods Exclusively for Exempt Supplies

If a capital good is used exclusively for making exempt supplies or for non-business purposes, the entire ITC is blocked. No credit is available at any point. This is straightforward: if a machine is purchased solely for producing exempt goods, its GST cannot be claimed.

Change in Use: Taxable to Exempt

If capital goods were initially used exclusively for taxable supplies (and full ITC was claimed), but are later shifted to making exempt supplies:

• Reversal begins from the month the use changes.
• The amount reversed per month = Total ITC / 60 x (Exempt turnover ratio for that month).
• The reversal continues monthly for the remaining useful life out of 60 months.

Change in Use: Exempt to Taxable

If capital goods were initially used exclusively for exempt supplies (zero ITC claimed), and are later shifted to taxable use:

• ITC can now be claimed on the capital good.
• However, the claimable ITC is reduced by 5% per quarter (or part thereof) of the period during which the asset was used for exempt supplies.
• For example, if a machine costing Rs 10,00,000 (GST Rs 1,80,000) was used for exempt supplies for 2 years 8 quarters), the reduction is 8 x 5% = 40%. The claimable ITC is Rs 1,80,000 x 1 - 40%) = Rs 1,08,000.

Rule 43 Worked Example: Capital Goods Switching Use

A logistics company purchases a heavy-duty vehicle for Rs 25,00,000 plus GST of Rs 4,50,000 18%) in April 2026. The vehicle is initially used entirely for taxable transport services, and full ITC of Rs 4,50,000 is claimed.

In October 2027 19 months later), the company starts using the vehicle partly for exempt agricultural transport. From October 2027 onward, the exempt turnover ratio is 30%.

Result: Starting October 2027, the company reverses Rs 2,250 per month for the remaining 42 months of useful life (subject to actual exempt turnover ratio each month). Total estimated reversal over 42 months at a constant 30% ratio = Rs 94,500. The company retains Rs 4,50,000 - Rs 94,500 = Rs 3,55,500 of the original credit.

If the exempt ratio changes month to month, the reversal amount adjusts accordingly. Each month uses that month's actual ratio.

Reporting in GSTR ThreeB: Table 4(B) 1)

The D1 + D2 reversal under Rule 42 and the monthly capital goods reversal under Rule 43 are reported in Table 4(B) 1) of GSTR ThreeB, under the row labelled "As per Rule 42 & 43 of CGST/SGST Rules".

What to enter:

Important points for GSTR ThreeB reporting:

• The auto-populated GSTR ThreeB does not fill Table 4(B) 1) automatically. You must compute these figures offline and enter them manually each month.
• The reversal reduces your net ITC for the period. If your total ITC before reversal is Rs 5,00,000 and your Rule 42/43 reversal is Rs 72,000, your net available ITC is Rs 4,28,000.
• Maintain a monthly working sheet showing the T, T1, T2, C2, D1, D2, and C3 breakdown. Attach this to your GSTR ThreeB working papers. During a GST audit or scrutiny, the officer will ask for this computation.
• The annual true-up adjustment (shortfall or excess) is reported in the September return's Table 4(B) 1) or Table 4(A) 5) respectively.

Common Mistakes in Rule 42/43 Compliance

Step 1: Not segregating T1 and T2 at source.** Many businesses dump all ITC into a single pool and apply the exempt ratio to the full amount. This inflates the reversal because T1 (exclusively taxable) should never enter the apportionment formula. Maintain separate ledger codes or tags for inputs used exclusively for taxable supplies, exclusively for exempt supplies, and common inputs.

Step 2: Omitting reverse charge supplies from exempt turnover.** Supplies on which the recipient pays GST under reverse charge count as exempt turnover (E) for the supplier. Forgetting to include these in E understates D1 and results in under-reversal.

Step 3: Using full securities trading value instead of 1%.** Financial services firms, NBFCs, and companies with treasury operations must use only 1% of the sale value of securities when computing E. Using the full trading value grossly inflates D1 and results in over-reversal, locking up legitimate credit.

Step 4: Skipping the annual true-up.** The annual recalculation under Rule 42 2) is not a best practice; it is a statutory requirement. Departments routinely compute annual D1 + D2 during assessments and raise demands when the annual figure exceeds the sum of monthly reversals.

Step 5: Applying Rule 42 formula to capital goods.** Rule 42 covers inputs and input services only. Capital goods follow Rule 43's 60-month useful-life method. Mixing the two produces incorrect reversal amounts.

Step 6: Not adjusting Rule 43 reversal when use changes.** When a capital good shifts from exclusively taxable to mixed or exempt use, the reversal must begin from the month of change. Continuing to claim full ITC after the shift creates a liability with interest.

Step 7: Forgetting separate CGST, SGST, IGST computation.** The D1 and D2 formula must be applied separately to each tax head. A single blended calculation does not satisfy the reporting requirement in Table 4(B) 1).

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Sources: Rules 42 and 43 of the Central Goods and Services Tax Rules, 2017 (cbic.gov.in); Section 17 1) and 17 2) of the CGST Act, 2017 (apportionment of credit for mixed-use); Explanation to Rule 42 and Rule 43 regarding valuation of exempt supplies including securities trading at 1% of sale value; Section 50 of the CGST Act (interest on delayed payment); GSTR ThreeB return format and instructions issued by CBIC (cbic-gst.gov.in). Verify the current rule text and any amendments on 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 files your D1, D2, and capital goods reversals monthly, performs the annual true-up at year-end, and populates the correct figures into GSTR ThreeB Table 4(B) 1). If you are making both taxable and exempt supplies and want to ensure your reversals are accurate every month, talk to the Tax Garden compliance team.