Exempt Yet Refundable: Decoding ITC Refund On Zero-Rated Supplies Under GST With Illustrations

Zero-rated supplies under the Goods and Services Tax (GST) permit exporters and Special Economic Zone (SEZ) units to claim refunds of unutilized input tax credits, even when the outward supply is otherwise exempt under GST law. This position emerges from a combined reading of Sections 16(1) and 16(2) of the IGST Act, 2017, the definition of "exempt supply" under Section 2(47) of the CGST Act, 2017, and the proviso to Section 54(3) of the CGST Act, 2017. This sophisticated statutory framework supersedes the general Input Tax Credit (ITC) restrictions applicable to exempt supplies and addresses a longstanding area of professional discourse. The subsequent comprehensive analysis offers detailed statutory interpretation, judicial perspectives, practical implications, and illustrative examples to facilitate a thorough understanding and confident application in professional practice.

Zero-Rated Supply under Section 16(1) of the IGST Act, 2017

Section 16(1) of the IGST Act, 2017 explicitly defines "zero-rated supply" to encompass two categories of supplies:(a) any supply of goods or services or both made to a recipient located outside India, i.e., exports; and(b) any supply of goods or services or both for authorised operations to a Special Economic Zone developer or a Special Economic Zone unit.

This definition signifies a deliberate departure from conventional VAT and export-incentive systems, in which exports were typically classified as exempt supplies. Under the Goods and Services Tax (GST), exports and Special Economic Zone (SEZ) supplies are incorporated within the taxable supply framework but are subject to a zero rate. This implies that although no output tax is due, the supply continues to be recognised as a taxable supply for credit purposes. Consequently, this approach prevents input taxes from being incorporated into export pricing, thereby maintaining international competitiveness.

The legislative intent underlying this framework is to eradicate the cascading impact of domestic taxes on international commerce. Input taxes, if not reimbursed, elevate export prices and diminish India's competitive standing in global markets. For example, exports encompass merchant exports, in which procurement originates from domestic suppliers but the actual export is executed by the merchant exporter in his own name, with proper export documentation. Similarly, exports of services may involve services associated with goods (such as installation or commissioning abroad) or purely service-oriented offerings such as software development, consulting, or technical support provided to international clients.

Supplies provided to Special Economic Zone (SEZ) developers or units are also granted zero-rated treatment, despite being physically provided in India, because they are considered inter-State supplies under Section 7(5) of the IGST Act. This legal provision serves to uphold the policy objective of promoting manufacturing, processing, and service hubs within designated SEZs as outlined in the SEZ Act, 2005.

A significant intersection occurs wherein exported goods or services are exempt under GST notifications. Numerous products, especially agricultural produce and essential commodities, are exempt under domestic GST legislation. Nevertheless, upon export or supply to an SEZ, such exempt goods acquire the legal status of zero-rated supplies under Section 16(1), which is vital for determining the entitlement to Input Tax Credit (ITC).

Judicial acknowledgement of export refunds as an inherent aspect of the Goods and Services Tax's (GST) destination-based taxation principle is evident in Union of India v. VKC Footsteps India Pvt. Ltd. (2021) 13 SCC 153. In this case, the Supreme Court recognised that refund mechanisms are crucial to mitigate the burden of domestic taxes on exports, although the case primarily concerned the computation of refunds under inverted duty structures. Consequently, Section 16(1) serves as the fundamental gateway that determines the eligibility of a supply for special credit treatment under Section 16(2).

Section 16(2) of the IGST Act - Statutory Override in Favour of ITC

Section 16(2) of the IGST Act, 2017 provides as under:

"Subject to the provisions of sub-section (5) of section 17 of the Central Goods and Services Tax Act, credit of input tax may be availed for making zero-rated supplies, notwithstanding that such supply may be an exempt supply."

This provision constitutes the most critical component of the entire statutory framework. The expression "notwithstanding that such supply may be an exempt supply" explicitly signifies a legislative override of the general restriction outlined in Section 17(2) of the CGST Act, which would otherwise require the proportionate reversal of Input Tax Credit (ITC) attributable to exempt supplies.

A careful statutory reading reveals the following architecture:(i) ITC is allowed on all inputs and input services used in making zero-rated supplies;(ii) The only limitation is the blocked credit list under Section 17(5) of the CGST Act; and(iii) Exemption status of the outward supply does not restrict ITC entitlement where zero-rating applies.

Credits for packaging materials, testing services, logistics, freight, inspection, or quality certification used for the export of exempt goods, such as agricultural produce, remain fully claimable. Normally, Section 17(2) would restrict these if used for exempt domestic supplies, but Section 16(2) explicitly overrides that restriction for zero-rated supplies.

There is no provision in the CGST or IGST Acts, other than Section 17(5), that restricts Input Tax Credit (ITC) once Section 16(2) applies. Consequently, assertions that exemption notifications prohibit ITC even in the case of exports demonstrate a misunderstanding of the legislative hierarchy. The CBIC Circular No. 37/11/2018-GST, although primarily addressing refund procedures, also acknowledges that ITC remains available for zero-rated supplies irrespective of exemption status.

From a policy perspective, this design aligns with internationally acknowledged principles of border tax neutrality as outlined in various trade agreements. These principles state that exports should be exempt from domestic consumption taxes to prevent interference with trade competitiveness.

Meaning of Exempt Supply under Section 2(47) of the CGST Act, 2017

Section 2(47) of the CGST Act defines "exempt supply" to include:(i) supplies attracting nil rate of tax,(ii) supplies wholly exempt under Section 11 of the CGST Act or Section 6 of the IGST Act, and(iii) non-taxable supplies, such as alcohol for human consumption.

This broad definition is noteworthy because it classifies supplies not solely by rate but also by legislative exclusion from GST. Under typical circumstances, exempt supplies prevent the claiming of Input Tax Credit (ITC) under Section 17(2) to prevent the accumulation of unrecoverable credits within the system.

However, when such exempt supplies are exported or supplied to SEZ, they simultaneously fall within the definition of "zero-rated supply" under Section 16(1) of the IGST Act. This results in a dual legal characterisation: exempt according to the domestic rate structure, yet zero-rated due to export policy considerations. To precisely address this overlap, Section 16(2) explicitly states that Input Tax Credit (ITC) shall be available notwithstanding the exemption.

Rule 89(4B) of the CGST Rules, 2017, further operationalises this principle in the computation of refunds by protecting eligible credits arising from zero-rated supplies, even where outward supplies are exempt under domestic notifications.

Judicial support for the entitlement to a refund, even for exempt exports, is evident in Patson Papers Pvt. Ltd. v. Union of India (2020) (Gujarat High Court), where the court permitted the refund of compensation cess on exempt exports, thereby reinforcing the view that zero-rating supersedes exemption in refund situations.

Refund Mechanism under Proviso to Section 54(3) of the CGST Act

Section 54(3) generally prohibits the refund of unutilised Input Tax Credit (ITC), except in specified circumstances. The proviso to this subsection, however, explicitly permits a refund where:

"The input tax credit has accumulated on account of zero-rated supplies made without payment of tax."

This proviso explicitly supplements Section 16(2) of the IGST Act, ensuring that exporters using the LUT or bond mechanism can monetise their accumulated input tax credits, even if their outward supplies are otherwise exempt from tax.

While the main body of Section 54(3) restricts refunds for exempt and nil-rated supplies, the proviso constitutes a specific carve-out for zero-rated supplies. Under principles of statutory interpretation, a specific provision overrides general restrictions, particularly where supported by a "notwithstanding" clause in the parent eligibility provision.

Refund computation is governed by Rule 89(4), which applies the formula:

Refund Amount = (Turnover of zero-rated supply of goods + services / Adjusted Total Turnover) × Net ITC

For zero-rated supplies that are otherwise exempt, eligible ITC forms part of Net ITC after excluding blocked credits under Section 17(5) and after applying proportionate reversals under Rules 42 and 43, wherever common credits exist.

Confusion in professional contexts frequently occurs when the bar on refunds for exempt supplies, as outlined in the main part of Section 54(3), is conflated with the zero-rated carve-out specified in the proviso, without recognising that Section 16(2) of the IGST Act functions as a special provision that supersedes exemption-based restrictions.

The IGST provisions governing inter-State and export supplies are enforced by applying the CGST provisions under Section 20 of the IGST Act, thereby ensuring seamless integration of both Acts.

Appellate rulings, such as those by Columbia Sportswear Company Pvt. Ltd. (Maharashtra AAAR), further affirm that refunds cannot be denied solely on the basis that the outward supply is exempt, provided that it qualifies as zero-rated and that Input Tax Credit (ITC) is not barred under Section 17(5).

Illustrations

To turn this statutory framework into practice, the following illustrations show that the right to a refund persists even when outward supplies are exempt.

Illustration 1 - Export of Exempt Fresh Fruits

Scenario:Kirti Exports procures taxable plastic crates valued at Rs 10 lakh, subject to GST at 18% (ITC accruing to Rs 1.8 lakh), and exports 100 metric tonnes of fresh apples. These goods are classified as exempt under the revised exemption schedule notified in Notification No. 10/2025-Central Tax (Rate) dated 17.09.2025, which becomes effective from 22.09.2025, superseding the previous Notification No. 2/2017-Central Tax (Rate).

Supply Nature:The export of fresh apples qualifies as a zero-rated supply pursuant to Section 16(1) of the IGST Act, 2017, as it constitutes a supply of goods to a recipient outside India with no IGST payable under LUT or bond.

ITC Treatment:Kirti Exports possesses an eligible Input Tax Credit (ITC) of Rs 1.8 lakh attributable to plastic crates used as packing inputs for export. As the outward supply is classified as zero-rated under Section 16(1), the provisions of Section 16(2) of IGST facilitate the availment of ITC despite the fresh apples being exempt under domestic exemption legislation. The sole restriction is that no input tax is obstructed under Section 17(5).

Refund Claim:

Under the proviso to Section 54(3) of the CGST Act, the exporter may claim a refund of the unutilised ITC of Rs 1.8 lakh attributable to the zero-rated supply. The exempt status of fresh apples under domestic laws as per Notification No. 10/2025-Central Tax (Rate) does not deprive Kirti Exports of this refund because Section 16(2) operates as a statutory override.

Computation:Turnover of zero-rated supply: 100% → Eligible ITC for refund ≈ Rs 1.8 lakh (subject only to blocked credits).

Illustration 2 - SEZ Supply of Otherwise Exempt Services (Inter-State Supply)

Scenario:

Harpreet Limited provides services by way of storage or warehousing of cereals, pulses, fruits, and vegetables to a unit located within a Special Economic Zone (SEZ). Supplies to an SEZ unit are treated as inter-State supplies under Section 7(5) of the IGST Act, 2017. Such services, being services relating to agricultural produce, are exempt for the purpose of IGST under Notification No. 09/2017-Integrated Tax (Rate) dated 28.06.2017, as amended from time to time, which governs the exemption of specified inter-State supplies of services.

Harpreet Limited has availed Input Tax Credit (ITC) of Rs 2,00,000 in respect of renting of immovable property used for providing these warehousing services, which is otherwise a taxable inward supply.

Supply Nature:

Although these services are otherwise exempt when supplied in domestic territory, the supply made to an SEZ unit qualifies as a zero-rated supply under Section 16(1)(b) of the IGST Act, 2017, since any supply of goods or services to an SEZ developer or SEZ unit is statutorily treated as zero-rated.

ITC Treatment:

By virtue of Section 16(2) of the IGST Act, ITC is admissible on inputs and input services used for making zero-rated supplies, notwithstanding that the outward supply may otherwise be an exempt supply. The only restriction applicable is under Section 17(5) of the CGST Act, which relates to blocked credits. Since ITC on renting of immovable property is not blocked, Harpreet Limited is entitled to avail ITC of Rs 2,00,000.

Refund Claim:

As the supply is made without payment of IGST under LUT, refund of the unutilised ITC of Rs 2,00,000 is admissible under the proviso to Section 54(3) of the CGST Act, read with Rule 89 of the CGST Rules, subject to fulfilment of procedural requirements.

Illustration 3 - Blocked Credit in Zero-Rated Export of Exempt Goods

Scenario:

A textile exporter exports cotton fabrics, which are exempt for domestic supplies under Notification No. 10/2025-Central Tax (Rate) dated 17.09.2025 (effective from 22.09.2025), being goods covered under the updated exemption schedule.The exporter uses the following inward supplies:

• Raw materials and packing inputs with eligible ITC of Rs 3,00,000, and
• A motor car used for business visits, on which ITC of Rs 7,40,000 has been charged.

Supply Nature:

Export of goods is treated as an inter-State supply under Section 7(5) of the IGST Act, 2017 and qualifies as a zero-rated supply under Section 16(1)(a) of the IGST Act, irrespective of the fact that the goods are exempt for domestic supplies under Notification No. 10/2025-Central Tax (Rate). The exporter undertakes exports without payment of IGST under LUT.

ITC Treatment:

By virtue of Section 16(2) of the IGST Act, ITC is admissible on inputs and input services used in making zero-rated supplies, notwithstanding that the outward supply may otherwise be an exempt supply. However, Section 16(2) itself is made subject to Section 17(5) of the CGST Act, which prescribes blocked credits.

Accordingly:

• ITC of Rs 3,00,000 on raw materials and packing inputs is eligible, as it is not covered under blocked credit provisions.
• ITC of Rs 7,40,000 on the motor car is ineligible, being blocked under Section 17(5)(a) of the CGST Act, 2017 since the vehicle is not used for any of the specified taxable purposes such as transportation of passengers or further supply of motor vehicles.

Refund Claim:

Under the proviso to Section 54(3) of the CGST Act, refund of unutilised ITC accumulated on account of zero-rated supplies made without payment of tax is admissible. However, the refund is restricted only to the eligible ITC. Therefore, the exporter is entitled to claim a refund of Rs 3,00,000, while the blocked credit of Rs 7,40,000 remains permanently ineligible for credit or refund, despite the outward supply being zero-rated.

Illustration 4 - Mixed Portfolio with Domestic Exempt Supplies and Exempt Exports

Scenario:

During a tax period, Naman Limited, a registered person, has the following turnover:

Total common ITC availed during the period on inputs and input services: Rs 12 lakh.

Supply Nature:

Domestic exempt supplies are exempt under Notification No. 10/2025-Central Tax (Rate) dated 17.09.2025 (effective from 22.09.2025) and therefore attract ITC reversal under Section 17(2) of the CGST Act read with Rule 42 of the CGST Rules

Exports are treated as inter-State supplies under Section 7(5) of the IGST Act and qualify as zero-rated supplies under Section 16(1)(a) of the IGST Act, even though the goods are otherwise exempt for domestic supplies under Notification No. 10/2025-CT(R).

ITC Apportionment under Rule 42:

For the purpose of Rule 42, zero-rated supplies are excluded from the category of exempt supplies owing to the overriding effect of Section 16(2) of the IGST Act , 2017. Accordingly, only domestic exempt supplies are taken into account for reversal.

Exempt domestic turnover = Rs 30 lakhTaxable + Zero-rated turnover = Rs 70 lakh

Eligible ITC after reversal:Rs 12 lakh × (70 / 100) = Rs 8.4 lakh

Refund Computation under Rule 89(4) for Naman Limited:

Refund of unutilised ITC is available in respect of zero-rated supplies made without payment of tax under LUT, as per the proviso to Section 54(3) of the CGST Act read with Rule 89(4) of the CGST Rules.

Refund Amount = (Turnover of zero-rated supply / Adjusted Total Turnover) × Net ITC

Refund = (Rs 10 lakh / Rs 70 lakh) × Rs 8.4 lakh ≈ Rs 1.2 lakh

Result:

Although the exported goods are exempt for domestic supplies under Notification No. 10/2025-Central Tax (Rate), the export turnover is treated as zero-rated and not as exempt for ITC purposes. Accordingly:

• ITC attributable to domestic exempt supplies is reversed under Rule 42, and
• ITC attributable to zero-rated exports remains fully eligible for refund.

Illustration 5 - Zero-Rated Exports of Otherwise Exempt Goods and Refund of ITC (Not an Inverted Duty Refund Case)

Scenario

An exporter, Anish Limited, manufactures and exports chemical dyes (synthetic organic colouring matter classifiable under HSN Chapter 32), which are exempt for domestic supplies under Notification No. 10/2025-Central Tax (Rate) dated 17.09.2025, effective from 22.09.2025. Anish Limited, procures the following inputs for manufacturing:

(A)Dyes and chemical intermediates taxed at 18% GST, and

(B)Packaging materials taxed at 5% GST,

and avails total eligible Input Tax Credit (ITC) of Rs 5,00,000 on such inward supplies.

Exports are made without payment of IGST under a valid LUT.

Nature of Outward Supply

(A) Export of goods is treated as an inter-State supply under Section 7(5) of the IGST Act, 2017.

(B)Export of goods qualifies as a zero-rated supply under Section 16(1)(a) of the IGST Act, 2017, irrespective of the fact that the same goods may be exempt when supplied domestically under an exemption notification.

Thus, even though dyes are exempt in domestic supplies, their export continues to enjoy the benefit of statutory zero-rating.

Whether This Is a Case of Inverted Duty Refund?

Refund of unutilised ITC on account of inverted duty structure is governed by the first proviso to Section 54(3) of the CGST Act, 2017, which restricts refund where the outward supply is:

• Nil-rated, or
• Fully exempt.

Since the outward supply (domestic) of dyes is exempt, a refund under the inverted duty category is not admissible. However, this restriction applies only to inverted duty refunds, not to refunds arising from zero-rated supplies. Therefore, the refund is not claimable under the inverted duty structure route in this case.

Refund Under Zero-Rated Supply Category

The second proviso to Section 54(3) of the CGST Act, 2017, expressly permits the refund of unutilised ITC arising from accumulation due to zero-rated supplies made without payment of tax. Further, Section 16(2) of the IGST Act, 2017 allows availment of ITC on zero-rated supplies notwithstanding that such supplies may otherwise be exempt, subject only to restrictions under Section 17(5) of the CGST Act (blocked credits).

In the present case of Anish Limited:

(A)The outward supply is zero-rated export;

(B) ITC relates to inputs and packing materials used in manufacture, and

(C) The ITC is not blocked under Section 17(5).

Hence, the refund is fully admissible under the zero-rated export refund mechanism and not barred by the exemption applicable to domestic supplies.

Eligibility and Quantum of Refund

Accordingly, Anish Limited is entitled to a refund of the entire eligible ITC of Rs 5,00,000, since:

(A)The supply qualifies as zero-rated under Section 16(1) of the IGST Act,

(B)Accumulation of ITC is attributable to export of goods without payment of tax, and

(C)Refund is claimed under zero-rated supply provisions, not under the inverted duty structure.

Resolving Professional Differences and Practical Implications

Professional disagreement largely arises from a literal interpretation of Section 17(2) and the principal part of Section 54(3), without considering the provisions of Section 16(2) of the IGST Act. According to principles of harmonious construction, specific provisions take precedence over general prohibitions. The Supreme Court, in the case of CIT v. Hindustan Bulk Carriers (2003) 3 SCC 57, established that statutory provisions should be interpreted in a manner that effectuates legislative intent, rather than being hindered by strict literalism.

CBIC FAQs and GST Council deliberations also recognise that zero-rated supplies must not bear embedded taxes. The GST portal architecture itself enables refund claims through RFD-01 even where outward supply is exempt but declared as zero-rated.

From a business perspective, this framework prevents exporters from absorbing 5% to 18% input tax costs, improves liquidity through LUT mechanisms, and supports India's export competitiveness. However, strict compliance is necessary - accurate classification in GSTR-1, correct ITC apportionment under Rules 42 and 43, and proper documentation of export or SEZ endorsements are essential to withstand audit scrutiny.

Closing Reflection

Under the GST architecture, exports are not intended to bear domestic tax obligations. Section 16 is not an exception; rather, it epitomises this principle. When correctly interpreted, the law clearly establishes that zero-rated supplies cannot be treated as exempt for credit purposes. Professionals who recognise this framework will not only prevent unnecessary reversals but also safeguard exporters' and SEZ suppliers' legitimate working capital - precisely as the GST framework intends.