ITC Reversal under Rule 42 and 43: Formula, Working and Example
- If you use inputs for both taxable and exempt supplies, Rule 42 forces you to reverse ITC proportionate to your exempt turnover — calculate this every month and true-up annually.
- Rule 43 applies the same logic to capital goods, but spreads the reversal over 60 months (5 years) at 1/60th per month.
- Missing the annual true-up in September GSTR-3B can trigger interest from the original month of credit, not just from September.
If your business makes both taxable and exempt supplies — say you sell software (taxable) and also earn bank interest or trade in securities (exempt) — you cannot keep 100% of the Input Tax Credit (ITC) you claimed. Rules 42 and 43 of the CGST Rules, 2017 force you to reverse the portion of ITC that relates to exempt supplies. Get this wrong and you face interest, penalties, and scrutiny in annual audits. This article walks you through the exact formula, a full worked example with rupee numbers, and the mistakes that trip up most small businesses.
What Rule 42 Covers (Inputs and Input Services)
Rule 42 applies to ITC on inputs and input services — raw materials, consumables, professional fees, software subscriptions, and similar day-to-day purchases. It does not cover capital goods (machinery, computers, vehicles); those fall under Rule 43.
The starting point is to split your total ITC into three buckets:
- T1: ITC exclusively for exempt supplies — reverse 100%, no formula needed.
- T2: ITC exclusively for non-business purposes — reverse 100%.
- T3: ITC exclusively for taxable supplies (including zero-rated) — keep 100%.
- C1 (common credit): Everything left after removing T1, T2, T3. This is what Rule 42 actually works on.
The Rule 42 Formula, Step by Step
Once you have C1 (common credit), the reversal amount is:
D1 = C1 × (Exempt Turnover ÷ Total Turnover)
Where:
- D1 = ITC to be reversed for exempt supplies
- Exempt Turnover = value of exempt supplies in the tax period
- Total Turnover = aggregate turnover in the same tax period (taxable + exempt + zero-rated, but excluding Schedule III supplies)
You also compute D2 = 5% of C1, which is treated as ITC attributable to non-business use if you have not separately identified T2. D2 is reversed separately.
Net ITC you can keep: C2 = C1 − D1 − D2
Worked Example: Rule 42 with Real Numbers (FY 2026-27)
Assume Priya Enterprises is a small trading firm. In April 2026, their figures are:
| Particulars | Amount (₹) |
|---|---|
| Total ITC claimed during the month | 3,00,000 |
| ITC exclusively for exempt supplies (T1) | 40,000 |
| ITC exclusively for non-business use (T2) | 10,000 |
| ITC exclusively for taxable supplies (T3) | 80,000 |
| Common credit C1 = 3,00,000 − 40,000 − 10,000 − 80,000 | 1,70,000 |
| Taxable turnover (April 2026) | 12,00,000 |
| Exempt turnover (bank interest earned) | 3,00,000 |
| Total turnover | 15,00,000 |
Step 1 — Calculate D1:
D1 = 1,70,000 × (3,00,000 ÷ 15,00,000)
D1 = 1,70,000 × 0.20
D1 = ₹34,000
Step 2 — Calculate D2 (non-business use, if not tracked separately):
D2 = 5% of C1 = 5% × 1,70,000 = ₹8,500
Step 3 — Net ITC (C2):
C2 = 1,70,000 − 34,000 − 8,500 = ₹1,27,500
Total reversal for April 2026: T1 + T2 + D1 + D2 = 40,000 + 10,000 + 34,000 + 8,500 = ₹92,500
This reversal is reported in Table 4(B) of GSTR-3B each month.
Annual True-Up: The September Deadline
Monthly calculations use the month's turnover ratio, which fluctuates. The law requires you to compute the final annual ratio using full-year figures and true-up the total reversal. This must be done by the due date of the GSTR-3B for September of the following financial year (i.e., by October 2027 for FY 2026-27). If the annual reversal is higher than the sum of monthly reversals, you pay the difference with interest. If it is lower, you can reclaim the excess as ITC — but only if you have not crossed the filing deadline.
What Rule 43 Covers (Capital Goods)
Rule 43 handles ITC on capital goods — machinery, computers, furniture, vehicles used in the business. The core difference from Rule 42 is the time spread: capital goods ITC is reversed at 1/60th per month (i.e., over 60 months / 5 years), reflecting the useful life assumption under GST law.
The reversal formula for each month is:
Tc (monthly reversal) = (Total ITC on capital good ÷ 60) × (Exempt Turnover ÷ Total Turnover)
Capital goods used exclusively for exempt supplies: reverse the entire ITC upfront (no 60-month spread). Capital goods used exclusively for taxable supplies: keep all ITC, no reversal. Only capital goods used for both get the 1/60th treatment.
Rule 42 vs Rule 43: Quick Comparison
| Feature | Rule 42 | Rule 43 |
|---|---|---|
| Applies to | Inputs & input services | Capital goods |
| Reversal period | Same month (monthly ratio) | Spread over 60 months (1/60th per month) |
| Annual true-up | Yes, by September GSTR-3B | Yes, by September GSTR-3B |
| Exclusively exempt use | Full reversal (T1) | Full reversal in the month of receipt |
| GSTR-3B table | Table 4(B) | Table 4(B) |
Common Mistakes Businesses Make
- Forgetting to include interest income, dividend, or rental income as exempt turnover. Many small businesses treat these as "non-GST" and leave them out of the denominator. The GSTIN officer will not. This leads to a lower reversal and a demand later.
- Skipping the annual true-up. Monthly reversals based on monthly ratios are provisional. Missing the September true-up means you lose the right to reclaim any excess reversal — money left permanently on the table.
- Applying Rule 42 to capital goods. Inputs and capital goods are governed by different rules. Using Rule 42's formula on a machine purchase is a common error that distorts both the reversal amount and the 5-year tracking.
- Not maintaining separate ITC ledgers for T1, T2, and T3. Without clean books, you cannot prove which credits are "exclusively taxable." Everything spills into the common credit pool, inflating your reversal unnecessarily.
- Using gross receipts instead of GST-defined "aggregate turnover." Schedule III items (like salary income, land sale in certain cases) must be excluded from both numerator and denominator. Using raw accounting totals gives a wrong ratio.
Tools That Help
Computing these reversals monthly across multiple tax periods is tedious and error-prone in a spreadsheet. KyaTax's GST Set-off Calculator lets you enter your turnover split and total ITC figures and instantly shows the D1, D2, and net ITC figures — reducing the chance of a calculation mistake before you file GSTR-3B.
Do it yourself in minutes — free to try, no login needed.
Open GST Set-off Calculator →Frequently asked questions
Who needs to do ITC reversal under Rule 42?
Any GST-registered business that makes both taxable and exempt supplies in the same period must reverse ITC under Rule 42. Common examples include businesses earning bank interest, rental income from residential property, or trading in securities alongside their taxable business.
Is interest payable if I miss the Rule 42 reversal in a month?
Yes. If you under-reverse ITC in a month and correct it later, interest under Section 50 of the CGST Act is payable from the original month of credit, not from the date of correction. This makes timely monthly reversals very important.
What is the exempt turnover ratio for the annual true-up and when must it be filed?
The annual true-up uses the full financial year's exempt turnover divided by the full year's total turnover. For FY 2026-27, this must be reflected in the GSTR-3B filed for September 2027 (due in October 2027). Any additional reversal must be paid with interest; any excess reversal can be reclaimed as ITC.
Does Rule 43 apply to all capital goods or only some?
Rule 43 applies only to capital goods used for both taxable and exempt supplies. If a capital good is exclusively used for taxable supplies, you keep 100% of the ITC. If it is exclusively used for exempt supplies, you reverse the full ITC immediately. Only mixed-use capital goods get the 1/60th monthly treatment.
General information for FY 2026-27, not professional advice for your specific case. Rules change — verify against the latest notification or ask a KyaTax expert.
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