Reversal of ITC Under Rule 42 of the CGST Rules

Input Tax Credit (ITC) is one of the biggest financial advantages offered under the GST regime. It allows businesses to reduce their tax outflow by claiming credit for the GST already paid on purchases. However, this benefit is not unconditional. Credit can be availed only when your purchases genuinely support taxable business operations.

But many businesses, especially MSMEs use the same inputs and services for a mix of taxable supplies, exempt supplies, or even some non-business use. In these cases, the law does not allow you to take the entire ITC. Instead, a part of it must be reversed.

This proportional reversal is governed by Rule 42 of the CGST Rules, which outlines how to identify and deduct the ineligible portion of ITC.

This blog breaks down Rule 42 in a simple, human, and business-ready format to help you apply it accurately without getting tangled in confusing formulas.

Why Does Rule 42 Exist?

The purpose of Rule 42 is to make sure that ITC is claimed only for what the law intends taxable business activities. Reversal is required for three major reasons 

1. Fairness in the GST ecosystem

If businesses dealing in exempt supplies also claim full ITC, it creates inequality. Rule 42 ensures that only the portion of credit linked to taxable supplies is allowed.

2. Avoiding incorrect credit utilisation

ITC is not meant for personal consumption, exempt activities, or non-GST income. Rule 42 prevents accidental or intentional over-claiming.

3. Audit readiness

During departmental audits, ITC reversal is always examined closely. Proper Rule 42 calculations reduce the risk of notices, interest, and penalties.

Understanding Rule 42 the Easy Way

Rule 42 may appear technical, but the logic is simple:

If inputs or input services are used for both taxable and non-taxable purposes, only the proportion related to taxable supplies can be claimed as ITC. The rest must be reversed.

Let’s break it down step-by-step.

Step 1: Start with Total ITC

Your total monthly ITC includes GST paid on all inputs and input services during the month.

Step 2: Remove Credit That Is Clearly Ineligible

Some ITC is not allowed to begin with:

• Used for personal or non-business use
  
  
• Used exclusively for exempt supplies
  
  
• Falling under blocked credits (e.g., motor vehicles, personal consumption, works contract restrictions)

This must be removed before you calculate anything else.

Step 3: Identify Common ITC

After subtracting ineligible credits, the remaining amount is common credit meaning it relates to both taxable and exempt/non-business activities.

This is the amount that needs proportionate reversal.

Step 4: Calculate the Portion to Reverse

Rule 42 requires two types of reversals from common ITC

A. Reversal for exempt turnover

A ratio is applied:

Exempt Turnover ÷ Total Turnover × Common ITC

‍

This gives the amount of credit linked to exempt activities.

B. Reversal for non-business use

The law expects that a small fraction of common credit is generally used for non-business purposes.
This is treated as a fixed percentage unless proven otherwise.

Step 5: What Remains Is Eligible ITC

After deducting the ineligible portions, the balance is the ITC you can legitimately claim in your GSTR-3B.

Rule 42 Made More Practical An Illustrative Example

Imagine a business that:

• Has ₹1,20,000 total ITC in a month
  
  
• Uses ₹12,000 exclusively for exempt supplies
  
  
• Uses ₹8,000 for personal/non-business purposes
  
  
• Has ₹5,000 blocked credits

The remaining credit becomes common ITC.

Exempt turnover ratio, usage pattern, and non-business adjustments will determine how much of this common pool is reversed. The final figure after proportional deductions is what the taxpayer can keep.

This structure ensures fairness without penalising businesses.

Monthly vs Annual Reversal

Rule 42 requires two layers of compliance:

1. Monthly reversal

Calculated and reported in each GSTR-3B.

2. Annual adjustment

After the financial year, businesses must recompute using full-year turnover.
Any shortfall must be paid with interest, while excess reversal can be reclaimed.

Missing this adjustment is a common reason for GST notices.

How Rule 42 Impacts Businesses

Businesses dealing in medical services, education, real estate, financial services, and mixed supply models frequently face ITC reversal issues. Common challenges include:

• Difficulty in segregating taxable and exempt inputs
  
  
• Miscalculations in turnover proportions
  
  
• Ignoring blocked credits
  
  
• Missing annual reconciliation deadlines
  
  
• Lack of documentation to justify credit allocation

These errors can lead to ITC accumulation issues, mismatches, or notices from GST authorities.

The Role of Digital Tools in Simplifying Rule 42

Manual ITC reversal tracking is extremely time-consuming, especially for businesses handling large volumes of invoices.

Platforms like CashFlo solve this by:

• Auto-reading and classifying ITC from 2B and purchase registers
  
  
• Identifying common vs. exclusively exempt ITC
  
  
• Applying the correct Rule 42 logic consistently
  
  
• Maintaining an audit-ready trail of calculations
  
  
• Reducing chances of human error

Automation not only improves accuracy but also saves significant compliance time.

How CashFlo Simplifies ITC Reversal Under Rule 42

Rule 42 calculations are notoriously tedious when done manually. CashFlo’s GST automation platform removes this complexity entirely by digitising and automating every step of the reversal workflow.

CashFlo’s Rule 42 Engine Helps You

• Auto-read ITC from GSTR-2B and your purchase register
  
  
• Segregates exclusive taxable, exclusive exempt, and common ITC based on given inputs
  
  
• Run GST-compliant Rule 42 formulas
  
  
• Auto-calculate monthly reversals without spreadsheets
  
  
• Maintain complete audit trails for every computation
  
  
• Detect blocked credits instantly
  
  
• Prevent over-claim or under - claim 

With CashFlo, businesses eliminate manual errors, accelerate GST compliance cycles, and keep working capital flowing smoothly.

Rule 42 compliance once a time-consuming burden becomes a completely automated, transparent, and audit-ready process.

Conclusion

Rule 42 forms the backbone of accurate ITC utilisation for any business that deals in both taxable and exempt supplies. While the rule may seem mathematical, the intention is straightforward claim credit only for taxable transactions.

By following the reversal mechanism carefully, maintaining clean records, and using automation where needed, businesses can stay compliant, avoid penalties, and improve working capital flow.