GST Refund Under Inverted Duty Structure: Rule 89(5) Policy Shift

An inverted duty structure arises where the rate of tax on inputs is higher than the rate of tax on output supplies, causing input tax credit (ITC) to accumulate. Section 54(3) of the Central Goods and Services Tax Act, 2017 (CGST Act) permits a registered person to claim refund of unutilized ITC in specified cases, including accumulation arising from such rate inversion, except where the output supplies are nil-rated or wholly exempt and subject to notified exclusions. For sectors such as footwear, textiles, fertilizers and renewable-energy equipment, the refund mechanism is not merely procedural: it determines whether tax remains embedded in cost and whether working capital is locked in the electronic credit ledger.

The controversy around Rule 89(5) of the Central Goods and Services Tax Rules, 2017 (CGST Rules)

Rule 89(5) of the CGST Rules prescribes the formula for computing the “maximum refund amount” in inverted-duty cases. The central controversy was that “Net ITC” in the formula covered credit on input goods but excluded credit on input services. At the same time, the formula's output-tax component related to the inverted-rated turnover as a whole. Businesses argued that this asymmetry depressed the refund and stranded legitimate service-related credits, even though the wider expression “input tax credit” ordinarily includes tax paid on both goods and services. Revenue authorities maintained that clause (ii) of the proviso to Section 54(3) uses the word “inputs”, a term statutorily confined to goods other than capital goods and therefore authorizes the narrower treatment.

VKC Footsteps: validity upheld, anomaly acknowledged by the Apex Court

The dispute reached the Supreme Court after conflicting High Court decisions. The Gujarat High Court, in VKC Footsteps India Pvt. Ltd. vs. Union of India [2020 (43) G.S.T.L. 336 (Guj.)], had held that excluding input-service ITC from the refund computation was contrary to Section 54(3), whereas the Madras High Court in Tvl. Transtonnelstroy Afcons Joint Venture vs. Union of India [2020 (43) G.S.T.L. 433 (Mad.)] upheld the restriction.

In Union of India vs. VKC Footsteps India Pvt. Ltd. [2021 (52) G.S.T.L. 513 (S.C.)], the Supreme Court set aside the Gujarat High Court judgment, affirmed the Madras High Court view and upheld Rule 89(5). It held that Section 54(3) does not confer an unrestricted right to refund of every component of unutilized ITC and that clause (ii) of its proviso, read with the statutory definition of “inputs”, permits refund in an inverted-duty case by reference to input goods rather than input services. Rule 89(5) was therefore not ultra vires Section 54(3), the Apex Court concluded.

Importantly, though, the Supreme Court did not endorse the formula as economically ideal. It recognized the anomalies demonstrated by taxpayers but declined to invalidate a fiscal rule merely because it produced inequitable or imperfect results. Institutional restraint, the Court said, required such policy choices to be left to the executive and legislature. It therefore strongly urged the GST Council to reconsider the formula and make a considered policy decision. This observation became the focal point for subsequent advocacy.

Trade and industry representations

Trade bodies and industry associations repeatedly represented that modern manufacturing is service-intensive. Freight, warehousing, job work, testing, design, rentals, professional services, information technology and maintenance can form a significant part of the cost base. Denying refund of the related ITC, they argued, contradicts GST’s promise of tax neutrality, penalizes domestic value addition and disadvantages businesses operating under rate structures fixed by the Government rather than by commercial choice. Representations sought either inclusion of ITC of input services in the refund pool or a redesigned formula that fairly attributes common credit and output tax. They also pressed for prospective clarity, simplified documentation, and relief from recurring litigation.

A partial response came in 2022. Following deliberations at the 47th GST Council meeting, Notification No. 14/2022–Central Tax amended Rule 89(5) with effect from 5 July 2022. Under the revised formula, the tax payable on inverted-rated supplies is adjusted by the ratio of Net ITC to the ITC availed on inputs and input services. Circular No. 181/13/2022-GST dated 10 November 2022 subsequently clarified that the amended formula is prospective and applies to refund applications filed on or after 5 July 2022. The amendment reduced one distortion but did not include input services ITC in “Net ITC”; the principal controversy therefore survived.

The 57th GST Council recommendation: a policy reset

At its 57th meeting on 8 October 2026, the GST Council recommended amending clause (ii) of the proviso to Section 54(3) of the CGST Act and Rule 89(5) of the CGST Rules to permit refund of accumulated ITC on input services and capital goods in inverted-duty cases.

For input services, the proposed benefit would apply to ITC availed on or after 1 November 2026. For capital goods, refund would be available for ITC availed on or after 1 April 2027 and spread over 60 months. The capital goods proposal also extends to zero-rated supplies. The recommendation directly addresses the exclusion sustained in VKC Footsteps and responds to the Supreme Court’s invitation to reconsider the policy.

The announcement is significant, but it is not self-executing. Until Parliament, the State legislatures, and the rule-making authorities implement the recommendation through amendments and notifications, taxpayers must continue to apply the existing law. Implementation details will be critical: the revised formula, treatment of common credits, transition for pre-cut-off balances, documentary requirements, and interaction with sector-specific refund exclusions (Chapters 15 and 27) could materially affect the relief.