What Happens to ITC After GST Rate Changes? A Comprehensive Guide

The GST Council’s 56th Meeting held on 3 Sept 2025 introduced a major rate restructuring, collapsing multiple slabs into principally 5% (merit rate) and 18% (standard rate), with a special 40% “de‑merit” rate on select items.

These changes have significant consequences for ITC. Under Section 18(4) of the CGST Act, if a registered person’s taxable supply becomes wholly exempt, they must reverse ITC on inputs/capital goods held in stock immediately prior to the change. Rule 44 of the CGST Rules prescribes the calculation method (pro rata by invoice and remaining useful life) and requires filing Form GST ITC-03 for such reversals.

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By contrast, mere rate reductions (e.g. 18%→5%) do not trigger reversal under Section 18(4) of the Goods and Services Tax Act. However, they can create inverted duty situations (inputs taxed higher than outputs), leading to unutilized credits that may require refunds as per GST law.

Scenario 1: Goods Shifting from Taxable to Exempt

When the Council moved items from a positive GST rate to nil (exempt), businesses must reverse related input credits. As Sec 18(4) mandates, any ITC on inputs and capital goods in stock on the “day immediately preceding” the exemption date must be paid back.

Rule 44 details that this reversed amount is calculated pro‑rata on purchase invoices (and, for capital goods, prorated over a 5‑year life). For example, Ultra-High-Temperature (UHT) milk (previously 5%) and prepackaged chhena/paneer (5%) were moved to nil rate.

A dairy holding stock of UHT milk packs must thus compute the credit on its input ingredients (milk, cultures, packaging) attributable to those packs and debit that from its credit ledger as per Sec 18(4) and Rule 44. Failure to reverse would violate the law, since exempt supplies cannot carry forward credit.

Example (Goods → Exempt): A dairy has ₹1 lakh of UHT milk in stock (taxed at 5%). It must reverse the ITC on the inputs used for this stock. If ITC was 5% of purchase cost, the dairy would pay back that amount via ITC‑03. (Similarly, if any drug for rare diseases was shifted from 5% to 0%, a pharmaceutical company would reverse credits on its finished-goods inventory of that drug.)

Scenario 2: Taxable Goods with Reduced Rates

Many consumer goods dropped from 12% or 18% down to 5%. Examples include hair oil, soap bars, shampoos, toothbrushes, toothpaste, bicycles, tableware and other household items.

Such rate cuts do not render supplies exempt, so Sec 18(4) does not apply – no mandatory credit reversal is triggered by a mere rate change. Instead, businesses continue claiming ITC on inputs as before, but face lower output tax. This often leads to an inverted duty structure (inputs taxed at 12–18% versus output at 5%), causing cumulative unutilized credits. The GST law allows refunds in genuine inverted cases.

Example (Goods → Lower Rate): A cosmetics manufacturer producing shampoo (formerly 18%) now sells at 5% GST. It will still claim ITC on raw materials and packaging (which may continue to carry 18% tax). Since output tax on shampoo is now lower, the manufacturer may accumulate excess ITC. The company should file for an inverted-duty refund of the unutilized credit rather than reverse it, as the supply remains taxable.

Scenario 3: Compensation Cess Removal for Car Dealers

The GST 2.0 reform abolished compensation cess on automobiles, effectively merging cess into the GST rates (e.g. many cars now attract 40% GST with no separate cess). For consumers, this cuts prices, but car dealers face a unique ITC issue: unlike CGST/SGST, compensation cess paid on purchases was not creditable against output GST.

Dealers who bought vehicles under the old regime paid substantial cess out of pocket. With the cess gone after Sept 22, they can no longer recover that cess in sales. The large balances of unused cess credits (in cess-ledgers) simply lapse under current law . Dealers have warned that this locks up working capital (estimated ₹2,500 Cr industry-wide) and may even need transitional relief.

Example (Cess Removal): A dealer purchased 50 SUVs at 28% GST + 18% cess. On a ₹20 Cr stock, cess paid was ~₹3.6 Cr (non-creditable). After Sept 22, with cess abolished, the dealer cannot charge customers cess nor use it as ITC – effectively, the ₹3.6 Cr cess cost is sunk. The dealer must absorb this loss or seek government relief. (By contrast, if the government had allowed cess‑ledger balances to transfer to IGST/CGST, the dealer could have utilized them for regular GST).

Scenario 4: Services Moved from 12% with ITC to 5% without ITC

A few services have been reclassified from “12% with ITC” to “5% without ITC”. Notable entries include small hotels (room < ₹7,500) and certain transport services.

Under the new rule, these supplies are taxed at 5%, but the supplier forgoes any ITC on inputs and input services (i.e. credit is blocked even though the rate is positive). This resembles the old composition scheme’s credit restriction. Providers of such services must reverse or refrain from claiming credit on related inputs – effectively absorbing taxes on inputs.

Example (Services 12%→5% no ITC): A budget hotel charges ₹7,000/night (previously 12% with full ITC).

Now it charges ₹7,000 + 5% tax, but cannot claim credit on inputs like laundry or utilities. The hotel must therefore pay full tax on these inputs from pocket. In accounting terms, the ITC on its input costs would be reversed or blocked moving forward. Similarly, a small passenger bus (fuel-cost-included) that was 12% with ITC may shift to 5% without ITC, requiring the operator to absorb more cost.

Sector-Specific Guidance

Traders/Dealers: Traders should audit their inventory against the new tax schedule. For goods now exempt (e.g. UHT milk, paneer), ensure reversal of ITC on stock via form GST ITC-03. For goods at 5%, update billing systems and price lists (passing savings or absorbing them) and monitor for refund claims on any inverted-credit balances.

Traders holding car inventory must urgently address compensation-cess credits: they may lobby or petition for legislative relief, as current law forbids using those credits.

Manufacturers: Producers of goods moved to nil must reverse ITC on finished goods and inputs . Where outputs carry lower rates, analyze the inverted duty impact: manufacturers of now-5% products should quantify excess ITC and claim refunds under inverted-duty provisions. They should also re-evaluate costing and pricing (input costs remain with higher taxes). Robust accounting entries (Form ITC-03 details, GSTR-3B adjustments) are critical.

Service Providers: Services newly exempt (e.g. life and health insurance) must follow Sec 18(4) procedures – reverse ITC on pre-paid expenses, commissions, etc. Providers of services that shifted to 5% without ITC (like low-end hotels or certain transports) need to block credits: they should amend invoice templates and books to exclude ITC on those inputs going forward. Conversely, if a service’s rate simply fell (12→5% with ITC intact), suppliers can continue full ITC claiming but should plan for any inverted-credit situation (e.g. refurbishments using high-rated inputs).

Automobile Dealers: Apart from the cess issue, dealers face new GST slabs: e.g. small cars at 18% (from 28%), large cars at 40% (no cess).

Dealers must update pricing, finance and loan calculations accordingly. Critically, they should engage tax consultants about the locked compensation-cess credits. Possible strategies include filing for compensation cess refund (if any carry‐forward is allowed in law) or pushing for rule changes. Currently, car dealers have petitioned the government to allow “cess credit transfer” to CGST/IGST.

Maintaining clear records of pre‑change cess payments will be essential for any future relief measures.

Impact on Inverted Duty Structure

The rate changes intensify inverted duty in many sectors. When inputs remain at 18% but finished goods are taxed at 5%, businesses accumulate ITC that cannot be immediately set off. Under GST, such excess ITC can be refunded. For example, a textile manufacturer using plastic components (18%) to make geotextiles (5%) now faces deeper inversion. The government has noted that refund mechanisms exist for inverted credits. Firms should therefore meticulously document input-output tax mismatches.

Section 54 refunds and provisions like Form GSTR-3B allow claiming back such credits. Taxpayers in inverted scenarios must ensure all credit utilization rules are followed and file refund claims promptly with the exact ITC accumulation details. The Council’s FAQ explicitly affirms refunds for inverted ITC balances.

Compliance Checklist for Tax Professionals

• Inventory Assessment: Identify all goods/services in stock affected by rate changes. Classify each item by the new rate (exempt/NIL, 5% with/without ITC, 18%/40%).
• ITC Reversal under Sec 18(4): For supplies now exempt, calculate ITC on inputs/capital goods in stock and advise clients to debit that via Form GST ITC-03 within 60 days of FY start. Document the calculation (invoices, pro-rata method per Rule 44).
• Refund Claims (Inverted Duty): For products with new lower tax where inputs were higher-rated, prepare and file refund applications for unutilized credits. Ensure Form GSTR‑3B clearly shows excess ITC and file Form RFD-01/ITC.
• Invoice/System Updates: Advise clients to update ERP/billing for new HSN/rates. For services now 5% without ITC, ensure invoices explicitly mention the ITC restriction.
• Compensation Cess Advisory: Counsel auto industry clients on the cess credit issue. Track any CBIC guidance on cess-ledger adjustments. Inform them of statutory limitations (cess credit cannot offset CGST/SGST under Sec 18) and strategies (e.g. representation).
• Communication & Documentation: Instruct businesses to notify vendors/customers of tax changes (e.g. via debit/credit notes if contracts spanned the change date). Keep complete records of stock and credits as of 21 Sept 2025 (day before implementation).
• Law & Circulars: Refer to official notifications (e.g. CBIC Rate Notifications dated 17.09.2025) for precise rates. Keep updated with any follow-up circulars (CBIC FAQs).
• Advisory Updates: Keep clients informed of the legal basis (Sec 18(4), Rule 44) for reversals , and evolving administrative guidance.

Compliance Checklist for Business Owners and Taxpayers

• Review Stock and Services: Examine inventory and unbilled services as of 22 Sept 2025. Identify items that moved to exempt or changed rates.
• Reverse ITC if Required: For goods now exempt, calculate the credit on stock and reverse it (debit to GST credit ledger). File Form ITC-03 along with the next annual return. If unsure how to compute, consult your tax advisor (Rule 44 calculation).
• Update Billing and Price Lists: Reprint or configure bills with new GST rates. Notify customers if prices change. Ensure service invoices reflect “5% no ITC” where applicable.
• Claim Inverted Duty Refunds: If your output tax rate fell (creating excess ITC), prepare refund claims as per GST rules. Gather evidence of ITC accumulation and file Form RFD on time.
• Manage Cess Credits: Auto dealers should tally all cess paid on current inventory. Monitor announcements for any relief; otherwise, treat those amounts as non-recoverable costs in accounting
• Liaise with Bankers/Financiers: Inform lenders of working-capital impact (especially dealers with locked credit). Seek extension or restructuring if necessary.
• Training and Systems: Brief your accounting team on the new slabs and ITC rules. Upgrade accounting software/rate masters to avoid manual errors.
• Compliance Checks: Cross-verify that blocked credit (e.g. on 5%–no-ITC services) is not inadvertently claimed. Ensure timely filing of returns showing these changes.
• Keep Documentation: Maintain clear records of all tax adjustments – reversal entries, invoices with new rates, refund applications, etc. These will be essential for audit or future clarifications.
• Seek Professional Advice: Given the complexity of the imminent changes (Sec 18(4) compliance, Rule 44 apportionment, cess issues), consider engaging a tax professional for accurate computation and filing.

The 56th GST Council’s rate rationalisation demands careful accounting of ITC. Where goods become exempt, Section 18(4) mandates credit reversal; where rates fall, plan for inverted-duty refunds.

Service providers must note any “no-ITC” designations. Dealers should urgently address the cess credit lock-up. By following the above steps (and filing the prescribed forms per Rules 42-44), tax professionals and businesses can ensure compliance and mitigate cash-flow shocks.

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