Rules 42 and 43, reversing common credit when some supplies are exempt
A business with both taxable and exempt supplies keeps only the taxable share of its common credit. Rule 42 does it monthly for inputs and services, with a year-end recalculation that carries interest if the monthly figures were too low. Rule 43 spreads capital goods over sixty months. What counts as exempt turnover is where most of the disputes sit.
The principle in Section 17
Section 17(1) and (2) allow credit only to the extent that goods and services are used for the business and for taxable supplies, including zero-rated supplies. Where the same inputs serve both taxable and exempt supplies, the credit has to be apportioned. Section 17(3) defines what goes into the exempt side, and Rules 42 and 43 set out the arithmetic: Rule 42 for inputs and input services, Rule 43 for capital goods.
Rule 42: the monthly calculation
Rule 42 works through a fixed sequence of labels. In plain terms:
| Label | What it is |
|---|---|
| T | Total input tax on inputs and input services in the tax period |
| T1 | Used exclusively for non-business purposes (not credited) |
| T2 | Used exclusively for exempt supplies (not credited) |
| T3 | Blocked under Section 17(5) (not credited) |
| C1 | Credit taken to the ledger: T − (T1 + T2 + T3) |
| T4 | Used exclusively for taxable supplies, including zero-rated (kept in full) |
| C2 | Common credit: C1 − T4 |
| D1 | Attributable to exempt supplies: (E ÷ F) × C2 |
| D2 | Attributable to non-business use: 5% of C2 |
| C3 | Common credit kept: C2 − (D1 + D2) |
E is the value of exempt supplies in the tax period and F is the total turnover in the State in that period. Where there is no turnover in the period, the figures of the last period in which there was turnover are used. D1 and D2 are reversed in GSTR-3B (or through DRC-03), and C3, D1 and D2 are worked separately for IGST, CGST and SGST/UTGST.
Worked example. In a month, common credit C2 is ₹2,00,000. Exempt supplies are ₹30 lakh out of a total State turnover of ₹1.5 crore.
- D1 = ₹30,00,000 ÷ ₹1,50,00,000 × ₹2,00,000 = ₹40,000
- D2 = 5% × ₹2,00,000 = ₹10,000
- Reversal for the month: ₹50,000; C3 kept: ₹1,50,000.
The 5% D2 applies only where common inputs are used partly for non-business purposes. A business with no non-business use of common inputs has an arguable case that D2 is nil; the rule computes it as a flat percentage without saying so, so record the basis if it is left out.
Rule 42(2): the year-end recalculation
Monthly ratios move with the month's turnover, so Rule 42(2) requires D1 and D2 to be recalculated on the figures for the whole financial year, before the due date of the return for September following the year:
- If the final D1 + D2 is higher than the total reversed month by month, the excess is reversed in a return (or DRC-03) no later than September, with interest under Section 50(1) from 1 April of the next year to the date of payment.
- If the final figure is lower, the difference may be taken back as credit in a return no later than September.
The interest clock starts on 1 April regardless of when the September return is filed, so the recalculation is worth finishing early.
What counts as exempt supply
Most disputes are about E. Section 17(3) and its Explanation settle the main points:
- The value of exempt supply includes supplies on which the recipient pays tax on reverse charge, transactions in securities, and sale of land and (subject to paragraph 5(b) of Schedule II) sale of a building.
- It excludes the value of activities in Schedule III (activities that are neither supply of goods nor services), except the sale of land and completed buildings in paragraph 5. Since 1 October 2023, under the amendment by the Finance Act, 2023, it also includes such value as may be prescribed of paragraph 8(a) transactions (sale of warehoused goods before clearance for home consumption).
Two practical consequences follow:
- Interest income is left out. The Explanation to Rule 43, which applies for both rules, excludes from exempt supplies the value of services by way of accepting deposits or extending loans or advances, in so far as the consideration is interest or discount. A trading or manufacturing business does not put its interest on deposits or loans into E. Banks and financial institutions, including NBFCs, are the exception, and Section 17(4) gives them a separate option of availing 50% of eligible credit each month instead of applying Rule 42.
- Schedule III items stay out, apart from paragraph 5 and the prescribed part of paragraph 8(a). High-sea sales and merchant-trade transactions (goods moving between two places outside India) do not increase E.
Interest-free deposits and staff loans are not covered by the interest exclusion, and whether they are supplies at all is argued. Record the treatment adopted.
Real estate. Rule 42 carries separate provisions for construction projects, including a recalculation on completion or first occupation. Those are outside this article; apply the rule's project-specific clauses where they are relevant.
Rule 43: capital goods over sixty months
For capital goods the credit is spread over a notional useful life of five years (sixty months):
- Credit on capital goods used exclusively for non-business purposes or for exempt supplies is not taken; credit on capital goods used exclusively for taxable supplies is taken in full.
- For common capital goods, the credit is taken, and each month the share attributable to that month is Tm = Tc ÷ 60 for each item still within its sixty months. The total of those monthly shares is Tr.
- The amount to reverse for the month is Te = (E ÷ F) × Tr, using the same exempt and total turnover as Rule 42.
Worked example. A machine carrying credit of ₹6,00,000 is used for both kinds of supply. Tm = ₹6,00,000 ÷ 60 = ₹10,000 a month. With exempt turnover at 20% of total turnover in a month, Te for that month is ₹2,000.
Unlike Rule 42, Rule 43 is worked month by month without a separate year-end recalculation of the kind in Rule 42(2). The annual return reports the capital-goods credit at Table 6B of GSTR-9, which is what desktop check A11 reads.
For the working paper
Officer:
- Rebuild E and F from the returns. E starts from nil-rated and exempt supplies (GSTR-3B Table 3.1(c)). A supplier whose own outward supplies are taxed on reverse charge in the recipient's hands must add them to E; inward supplies on which the person itself pays reverse charge are not part of its E. Compare the resulting ratio with the reversal declared at Table 4(B)(1) (desktop check 11).
- Check whether the year-end recalculation under Rule 42(2) was done and, if the excess was reversed late, whether interest from 1 April was paid.
Practitioner:
- Document the split of credit into T1 to T4 each month; the reversal is only as defensible as that split.
- Run the annual recalculation as soon as the year's turnover is final; interest on any excess runs from 1 April.
- Keep a separate register of common capital goods with their start month, so that each drops out of Tr after sixty months.
Legal basis and links
Legal basis. Section 17(1), (2) and (3), CGST Act, 2017; Explanation to Section 17(3) inserted with effect from 01.02.2019 and amended by section 139 of the Finance Act, 2023 with effect from 01.10.2023 (Notification No. 28/2023-Central Tax); Rules 42 and 43, CGST Rules, 2017, as amended, including the provision in Rule 42(1)(l) and (m) for reversal through GSTR-3B or DRC-03; Section 50(1) (interest on the annual excess under Rule 42(2)).
Common pitfall. Treating every non-taxable receipt as exempt turnover. Activities in Schedule III are not supplies and are kept out of the value of exempt supply, except sale of land and completed buildings (paragraph 5) and, from 01.10.2023, the prescribed part of warehoused-goods sales (paragraph 8(a)). The reverse error is leaving out receipts the Act puts in, such as supplies on which the recipient pays tax on reverse charge.