Last updated: 17 September 2026. If your business makes exempt supplies alongside taxable ones, Rule 42 requires you to reverse a slice of your common input tax credit every tax period, and Rule 42(2) requires you to redo that calculation once for the whole financial year. For FY 2025-26, the final calculation has to be settled before the due date for furnishing the return for September 2026 — 20 October 2026 for monthly filers. A shortfall carries interest from 1 April 2026.
Applicability Note: This guide reflects the CGST Act and Rules as they stood on 17 September 2026, read from CBIC's active repository that day. Always verify the current position on gst.gov.in or with a GST professional before reversing or re-claiming credit.
Who Should Care?
This guide applies to:
- Anyone with a mixed supply profile — taxable sales plus exempt or nil-rated sales, or supplies where your buyer pays under reverse charge
- Businesses with common capital goods, and anyone using business inputs partly for non-business purposes
- Banks, financial institutions and NBFCs, who have a separate option under Section 17(4)
- Real estate promoters, whose apportionment runs on entirely different sub-rules
1. What Section 17(2) Actually Requires
Two sub-sections do the restricting. Section 17(1) restricts credit to the input tax attributable to business purposes where goods or services are used partly for business and partly for something else. Section 17(2) restricts it to the input tax attributable to taxable supplies, including zero-rated supplies, where you make both taxable and exempt supplies. Section 17(6) is the rule-making power behind Rules 42 and 43.
The catch is what counts as an exempt supply. Under Section 2(47) it is a supply attracting a nil rate or wholly exempt under Section 11 of the CGST Act or Section 6 of the IGST Act, and it includes a non-taxable supply. Section 17(3) widens it further:
Section 17(3). The value of exempt supply "shall be such as may be prescribed, and shall include supplies on which the recipient is liable to pay tax on reverse charge basis, transactions in securities, sale of land and, subject to clause (b) of paragraph 5 of Schedule II, sale of building."
That first limb surprises people: if your buyer pays the tax under reverse charge, the turnover is exempt supply in your hands for this calculation.
2. The Rule 42 Formula, Month by Month
Rule 42(1) works through lettered clauses: take the total input tax on inputs and input services for the tax period, strip out what is exclusively attributable, and apportion what is left.
| Symbol | What it is | Clause |
|---|---|---|
| T | Total input tax on inputs and input services in the tax period | 42(1)(a) |
| T1, T2, T3 | Input tax used exclusively for non-business purposes; exclusively for exempt supplies; and blocked under Section 17(5) | 42(1)(b)–(d) |
| C1 | Credit to the electronic credit ledger = T − (T1+T2+T3) | 42(1)(e) |
| T4 | Used exclusively for taxable, including zero-rated, supplies | 42(1)(f) |
| C2 | Common credit = C1 − T4 | 42(1)(h) |
| D1 | Attributable to exempt supplies = (E ÷ F) × C2 | 42(1)(i) |
| D2 | Five per cent of C2, where common inputs are also used for non-business purposes | 42(1)(j) |
| C3 | Eligible common credit = C2 − (D1 + D2) | 42(1)(k) |
D2 is written conditionally — "the amount of credit attributable to non-business purposes if common inputs and input services are used partly for business and partly for non-business purposes". It is not a standing five per cent haircut on every taxpayer's common credit.
E is the aggregate value of exempt supplies during the tax period and F your total turnover in the State for the same period, both excluding any duty or tax levied under entry 84 and entry 92A of List I and entries 51 and 54 of List II. No turnover that period? The second proviso to clause (i) says use E and F from the last period for which those figures exist.
3. What Drops Out of "Exempt Supplies"
This is where most of the money is, and it is easy to miss because the carve-outs sit in an Explanation to Rule 43 expressed to apply to Rule 42 as well.
- Interest and discount income. The value of accepting deposits or extending loans or advances, to the extent the consideration is interest or discount, is excluded. A manufacturer that parks surplus in fixed deposits does not drag that interest into E. The exception is a banking company, financial institution or NBFC engaged in supplying those services — for them it stays in.
- Duty Credit Scrips, excluded by a clause inserted by Notification No. 14/2022-Central Tax dated 5 July 2022.
- Land and buildings enter at the value adopted for stamp duty and securities at one per cent of sale value, under the Explanation to Chapter V of the CGST Rules printed at the foot of Rule 45. Sell ₹5 crore of mutual fund units and you add ₹5 lakh to E, not ₹5 crore.
Section 17(4) gives banks, financial institutions and NBFCs a different option: take a flat fifty per cent of eligible credit each month and let the rest lapse, with the procedure in Rule 38. It cannot be withdrawn for the rest of the financial year, and the fifty per cent restriction does not apply to supplies between two registrations holding the same PAN.
4. Rule 43: Capital Goods Over Sixty Months
Capital goods run on a different clock. Input tax on a common capital good, denoted A, goes into the credit ledger in full, and its useful life extends to five years from the invoice date. Then Tc is the aggregate of A for common capital goods whose useful life remains during the tax period; Tm = Tc ÷ 60 is the slice for one period; and Te = (E ÷ F) × Tr is the part attributable to exempt supplies, added to output tax liability along with the applicable interest in every tax period of the useful life.
A drafting wrinkle worth knowing: Tr was defined in clause (f), which Notification No. 16/2020-Central Tax dated 23 March 2020 omitted with effect from 1 April 2020, while clause (g) still refers to it. The restriction clause (f) carried — capital goods whose useful life remains in the period — moved into Tc, and the monthly amount that goes into the formula is the Tm figure built from Tc.
Rule 43(1) also opens "Subject to the provisions of sub-section (3) of section 16": claim income-tax depreciation on the tax component of an asset's cost and there is no credit on that component to apportion at all.
Rule 43 has no annual true-up for ordinary capital goods. The final calculation in Rule 43(2) applies only to construction services under clause (b) of paragraph 5 of Schedule II, and is keyed to the project, not repeated every financial year. A good deal of published commentary says otherwise. The rule's own text does not.
5. The FY 2025-26 True-Up
Rule 42(2) requires the sub-rule (1) figures to be "calculated finally for the financial year before the due date for furnishing of the return for the month of September following the end of the financial year to which such credit relates". You rebuild D1 and D2 on full-year values of E, F and C2, and compare them with the twelve monthly figures already reversed.
| What happened | Rule | Treatment |
|---|---|---|
| Under-reversed during the year | 42(2)(a) | Reverse the shortfall in GSTR-3B or DRC-03, with interest at the Section 50(1) rate from 1 April 2026 to the date of payment |
| Over-reversed during the year | 42(2)(b) | Claim the excess back as credit. The rule provides for no interest in your favour |
Both limbs run out at the same point: a return for a month not later than September following the financial year — the September 2026 GSTR-3B, due 20 October 2026 for monthly filers. The asymmetry is the point: the department's money carries interest from the first day of the new financial year, and yours does not.
Why would the two figures differ at all, if you ran the formula every month? Because each month applies its own E/F ratio to that month's common credit, while the final calculation uses the year's aggregates. Any month where the exempt share swung — a one-off land sale, a bunched export month, a mid-year change in what your output is taxed at — pulls the two apart. FY 2025-26 is an unusually likely year for that: the rate changes recommended by the 56th GST Council took effect on 22 September 2025, splitting the year into two supply profiles for many businesses.
Rate cut or exemption? The CBIC/PIB FAQ on the 56th Council's decisions, posted 3 September 2025, separates them. A supply that merely moved to a lower rate leaves credit in the ledger usable under Section 49(4). Where the supply became exempt, the FAQ says that "for supplies made on or after i.e 22nd September, 2025 when the rate change is effected, ITC will have to be reversed as per provisions of CGST Act, 2017." It names no mechanism; where you still make taxable supplies too, that mechanism is Section 17(2) with Rules 42 and 43.
Worked example
A manufacturer with taxable and exempt output. In one month: T = ₹10,00,000, of which T1 = ₹50,000, T2 = ₹1,50,000 and T3 = ₹40,000, so C1 = ₹7,60,000. T4 = ₹4,60,000, leaving common credit C2 = ₹3,00,000. Exempt turnover E = ₹20,00,000 against total turnover F = ₹80,00,000, so E/F = 0.25. D1 = ₹75,000 and D2 = ₹15,000, so ₹90,000 is reversed that month and C3 = ₹2,10,000 stays.
Across FY 2025-26 the monthly D1s total ₹7,80,000 and the D2s ₹1,80,000 — ₹9,60,000 reversed. The final calculation runs on full-year figures: common credit ₹36,00,000, exempt turnover ₹2.70 crore against total turnover ₹9 crore, an annual ratio of 0.30 rather than the 0.25 several months carried.
- Final D1 = ₹10,80,000 and final D2 = ₹1,80,000, so ₹12,60,000 against ₹9,60,000 already reversed — a shortfall of ₹3,00,000
- Interest at 18% per annum from 1 April 2026 to payment on 20 October 2026, 203 days: ₹3,00,000 × 18% × 203 ÷ 365 = ₹30,033
On the Rule 43 side, a machine invoiced in April 2025 carrying ₹6,00,000 of input tax gives Tm = ₹10,000 a month, and stays in the pool until March 2030.
6. Where the Reversal Is Reported
Rule 42(1)(m) gives two routes: FORM GSTR-3B or FORM GST DRC-03. In the return, reversals under Rules 38, 42 and 43 and Section 17(5) belong in Table 4(B)(1), the row for reversals that are permanent and cannot be reclaimed later, per Circular No. 170/02/2022-GST dated 6 July 2022. Our guide to Table 4 reversals and reclaims covers the rest of that table.
Two deadlines that are easy to conflate: Rule 42(2)(b) closes the re-claim of an over-reversal at the September return, while Section 16(4) separately bars credit on an invoice or debit note after 30 November following the financial year "or furnishing of the relevant annual return, whichever is earlier". Different provisions — a Rule 42(2)(b) re-claim is credit you already took and gave back, not fresh credit on an invoice.
QRMP filers face a wrinkle in the wording: Rule 42(2) fixes its outer date by reference to "the return for the month of September", and a quarterly filer furnishes no return for the month of September. Treating the July–September 2026 quarterly GSTR-3B, due 22 or 24 October 2026 by State, as that return is settled practice rather than something the rule says.
7. Three Situations That Are Not Rule 42
- Your output becomes wholly exempt. That is Section 18(4) read with Rule 44: pay an amount equal to the credit on inputs in stock and on capital goods, computed for capital goods on the remaining useful life out of sixty months, through FORM GST ITC-03, on the day before the exemption takes effect. Credit left in the ledger then lapses.
- You are a real estate promoter. Rule 42(2) expressly excludes construction services under paragraph 5(b) of Schedule II; sub-rules (3) to (6) take over, with carpet area replacing turnover in the ratio, and sub-rule (5) says a transitioned residential project is not to be calculated finally at all.
- An officer proposes a round-figure reversal. In Hemraj Rice Mill & Anr. v. The Assistant Commissioner, CGST & CX, Bardhaman Division, Bardhaman & Ors. (Calcutta High Court, WPA 3159 of 2025, judgment dated 16 June 2025, reported at [2025] 175 taxmann.com 788), a Section 17(2) demand of ₹55,11,115 was raised without applying the Rules 42 and 43 formulae; the orders were set aside and sent back for recomputation under the Rules. A procedural remand rather than a ruling on the formulae, but useful to have on hand.
Key Takeaways
- Rule 42 runs every tax period: reverse D1 + D2, keep C3. The Rule 42(2) annual recomputation is separate and additional.
- For FY 2025-26, settle it before the September 2026 return — 20 October 2026 for monthly filers, 22 or 24 October for QRMP filers by State.
- A shortfall carries 18% interest from 1 April 2026. An over-reversal comes back with no interest, and only if claimed by that same return.
- Interest income is not in E for anyone except banks, financial institutions and NBFCs; securities enter at 1% of sale value, land and buildings at stamp duty value.
- Rule 43 has no annual true-up for ordinary capital goods — Te runs monthly for sixty months, with interest.
- Reversals are permanent: Table 4(B)(1) of GSTR-3B, or DRC-03. Unsure whether your exempt turnover was computed correctly all year? Ask our GST experts before the September return closes.
Frequently Asked Questions
What is the last date for the Rule 42 annual reversal for FY 2025-26?
Before the due date for furnishing the return for the month of September following the financial year — the September 2026 GSTR-3B, due 20 October 2026 for monthly filers.
Do I have to reverse 5% of common credit every month?
No. D2 under Rule 42(1)(j) is five per cent of common credit only where common inputs and input services are used partly for business and partly for non-business purposes.
Is interest income from fixed deposits an exempt supply for Rule 42?
Interest or discount on deposits, loans and advances is excluded from the aggregate value of exempt supplies for Rules 42 and 43 by Explanation 1 to Rule 43, unless you are a banking company, financial institution or NBFC supplying those services.
Disclaimer: This article is for informational purposes only and does not constitute professional tax advice. GST rules are subject to frequent changes through notifications and circulars. Please consult a qualified tax professional or verify the current provisions on the official GST portal (gst.gov.in) before making any compliance decisions.
Have a specific question about common credit reversal under Rules 42 and 43? Our GST experts can help → gstconsultancy.com