Rule 42 and 43 ITC reversal: the 5% D2 component most businesses never reverse

If part of your output is taxable and part is exempt — a coaching centre, a hospital, a housing society, an agri-trader, an insurance agent, or a hotel with some rooms at 5% — you have to reverse common credit.

And one component of that calculation is skipped far more often than it is applied.

# The full structure first

Rule 42 filters one month's ITC in stages. Each stage has a name, and the names matter:

And:

• E = aggregate value of exempt supplies for the tax period
• F = total turnover in the State for the tax period

# The two mistakes that cost the most

# Full worked example

One month's figures:

Step by step:

C1 = T − (T1 + T2 + T3)
   = 5,00,000 − (20,000 + 60,000 + 45,000)
   = ₹3,75,000

C2 = C1 − T4
   = 3,75,000 − 2,50,000
   = ₹1,25,000          ← common credit

E ÷ F = 15,00,000 ÷ 75,00,000 = 20%

D1 = 20% × 1,25,000  = ₹25,000
D2 =  5% × 1,25,000  = ₹6,250

C3 = 1,25,000 − (25,000 + 6,250) = ₹93,750

Total reversal = D1 + D2 = ₹31,250

Computing only D1 gives ₹25,000 — ₹6,250 short, which is 20% of the correct reversal.

# Rule 43 — capital goods work differently

Capital goods are not reversed in one month. They are spread over 60 months.

Useful life is 60 months from the invoice date.

Example: capital goods carrying ₹18,00,000 of common ITC, exempt ratio 20%.

Tm = 18,00,000 ÷ 60 = ₹30,000 per month
Te = 20% × 30,000   = ₹6,000 per month
Over 60 months      = ₹3,60,000

# Year-end recalculation — and the interest

Through the year you reverse on monthly figures. That is provisional.

Once the financial year closes, the calculation must be redone on actual full-year figures, and that has to be completed by the September return.

This is why dropping D2 costs twice: first the short reversal, then five or six months of interest on it.

# Where it goes in GSTR-3B

The reversal belongs in Table 4(B) — the ITC reversal section.

# One point where the position is not settled

A question that comes up constantly: is a 5%-without-ITC supply — a hotel room, a restaurant bill — an "exempt supply" for Rule 42?

Technically, no. It is a taxable supply. The credit restriction comes from a condition inside the rate notification, not from the supply being exempt.

But practice varies here, and E and F in Rule 42 are built on exempt supplies. If your business falls into this category, settle your treatment with your CA in writing and apply it consistently. This guide does not assert a default answer, because the point is not fully settled.

# What to do today

1. Pull your last three months' reversal workings — was D2 applied?
2. Check whether export or SEZ turnover has been included in E — if it has, you are destroying your own credit
3. Check the base for the 5% — it should be C2, not total ITC
4. Build a 60-month register for capital goods — from the invoice date, asset by asset
5. Put annual recalculation in the calendar — the September return, and remember that interest runs from April

Written by

Prabhakar Kumar

Chartered Accountant (ICAI, Nov 2019)

Founder of VittSphere Technologies. Practicing CA serving 200+ MSME clients across Pune. 86% win-rate at AO and CIT(A) level tax appeals. Writes on Indian taxation, capital gains, and personal finance.