Inverted Duty Refund: Focus on the Rate Structure, Not the Taxpayer's Identity

Refund claims under the inverted duty structure sometimes raise questions that are not determinative under the statutory scheme. Is the taxpayer a manufacturer or a trader? Do the inputs and output supplies fall under the same HSN? Does value addition result in a commercially distinct product? These questions may be relevant for other purposes, but refund eligibility must ultimately be tested against the conditions prescribed under Section 54(3)(ii) of the CGST Act, 2017.

The GST Appellate Tribunal examined these issues in Commissioner of CGST and Central Excise, Kolkata North Commissionerate v. M/s HP Cotton Casuals Private Limited, 2026-VIL-90-GSTAT-KLK, dated 10.09.2026. The Tribunal held that refund eligibility depends on whether unutilised ITC has accumulated because the rate of tax on inputs is higher than the rate of tax on output supplies. It does not depend on whether the taxpayer is described as a manufacturer or a trader. Similarly, refund cannot be denied merely because the inputs and output supplies fall under the same HSN.

However, eligibility for refund and the calculation of the refund are separate matters. Rule 89(5) of the CGST Rules, 2017 requires the refund to be calculated for the relevant tax period in accordance with the prescribed formula. Annual figures may assist in verifying the nature of the transactions, but they cannot replace the tax-period-wise calculation required under Rule 89(5).

Processing of Apparel and the Refund Dispute

M/s HP Cotton Casuals Private Limited was engaged in the production of wearing apparel. It purchased fabric, readymade garments and raw or semi-finished cotton cloth and carried out various processes such as bleaching, dyeing, printing, cutting, stitching, branding, labelling and packing. The finished products included suits, tops, shorts, night suits and joggers.

The principal fabric input attracted GST at 5%. However, several other materials used in the processing, such as dyes, chemicals, printing and packaging materials and stores, attracted GST at rates ranging from 12% to 28% , while the finished apparel was generally supplied at 5% . This difference in tax rates resulted in accumulation of input tax credit.

The taxpayer claimed refund of Rs. 34,47,623 for March 2024 and Rs. 7,86,037 for February 2024 under Section 54(3)(ii) of the CGST Act, 2017. The Original Adjudicating Authority rejected the claims mainly on the ground that the inputs and outputs were the same goods falling under the same HSN and, therefore, refund under the inverted duty structure was not available.

The First Appellate Authority set aside the rejection orders. It found that the taxpayer carried out substantial processing and value addition and also used inputs taxable at higher rates for making finished goods taxable at 5%. The Department challenged these orders before the GST Appellate Tribunal, raising issues relating to refund eligibility, verification of invoices, treatment of zero-rated supplies and use of annual figures for calculating the refund.

GST Applies to Supply, Not to the Status of the Supplier

The Department argued that the taxpayer was merely a trader and had not established that it was engaged in manufacturing. However, this distinction is not decisive for refund under Section 54(3)(ii). GST is levied on the supply of goods or services, not on manufacture, and the definition of a “registered person” under Section 2(94) does not distinguish between a manufacturer and a trader.

Section 54(3) allows a registered person to claim refund of unutilised ITC, subject to the prescribed conditions. Under clause (ii), refund is available where ITC accumulates because the rate of tax on inputs is higher than the rate of tax on output supplies, except in respect of supplies notified by the Government. The provision does not require the taxpayer to manufacture the output goods or undertake any particular level of processing.

The real question, therefore, is whether the taxpayer is a registered person, whether eligible ITC has accumulated, and whether such accumulation has arisen because of the rate difference contemplated by Section 54(3)(ii).

In the present case, the processes of bleaching, dyeing, printing, cutting, stitching, branding, labelling and packing were relevant in showing how the finished apparel emerged and how the ITC accumulated. However, these activities supported the factual basis of the refund claim; they were not separate statutory conditions for claiming refund.

Thus, refund cannot be denied merely by describing the taxpayer as a trader, nor can it be allowed merely because the taxpayer describes itself as a manufacturer. The entitlement must depend upon the conditions prescribed under Section 54(3)(ii), with the refund amount calculated in accordance with Rule 89(5)

HSN Overlap Is Not a Statutory Disqualification

The Department also relied on the fact that some inputs and finished products shared the same or overlapping HSN classification. The Department treated this as sufficient to characterise the input and output as the “same goods” and to deny the refund.

This approach gives undue importance to the HSN classification, whereas Section 54(3)(ii) focuses on the difference between the tax rates on inputs and output supplies and the resulting accumulation of ITC. A single HSN heading may cover goods at different stages of processing. Therefore, merely because an input and the finished product fall under the same broad HSN heading does not mean that the taxpayer purchased and resold the same goods without any processing. Neither Section 54(3)(ii) nor Rule 89(5) denies a refund solely because the principal input and the output share an HSN classification. Denying a refund on this ground would introduce a restriction that the law itself does not contain.

In the present case, the accumulation did not arise solely from the tax rate on fabric. The taxpayer used dyes, chemicals, printing ink, packaging material and other inputs attracting rates substantially higher than the 5% applicable to the finished apparel. The refund claim therefore had to be tested by considering all eligible inputs entering the statutory computation, not merely by comparing the HSN and rate of the principal fabric with those of the output.

The decision consequently rejects a classification-driven shortcut. An overlapping HSN may invite scrutiny of the transaction, but it cannot substitute the statutory examination of the inputs used, their tax rates, the output supplies and the actual source of accumulated credit.

Circular No. 135 Targets Rate Reduction on the Same Goods

The Department placed substantial reliance on paragraph 3.2 of Circular No. 135/05/2020-GST dated 31.03.2020. That paragraph clarifies that a refund is unavailable where the input and output supplies are the same goods, even if they attract different rates at different points in time.

Read in isolation, the expression “input and output supplies are the same” may appear broad. Its meaning, however, becomes clear from the heading, context and illustration in paragraph 3 of the Circular. The clarification addresses accumulation arising from a reduction in the GST rate on the same goods. Its illustration concerns goods purchased at 18% and subsequently sold at 12% after the Government reduces the rate.

The critical elements are the identity of the goods and a change in their applicable rate over time. In such a situation, accumulation arises because stock purchased when the rate was higher is sold after the rate has been reduced. The Circular clarifies that this temporal rate change does not constitute an inverted duty structure within Section 54(3)(ii).

The HP Cotton Casuals case involved neither element. No intervening reduction in the rate applicable to the finished apparel occurred. The claim was also not based on the resale of unchanged stock. The taxpayer used multiple inputs at different rates and carried out substantial processing before supplying finished products at 5%.

Circular No. No. 135/05/2020-GST dated 31.03.2020 could not be extended beyond its stated context to create a general prohibition whenever an input and output shared a tariff description. Such an extension would convert a clarification on rate reduction into a substantive restriction on statutory refund entitlement.

Administrative circulars may explain how to implement the law, but they cannot narrow the scope of a refund expressly available under the Act and Rules. Where the statutory requirements are satisfied, a circular must be read consistently with those provisions, not used to introduce an additional disqualification.

Every Eligible Input Counts Under Rule 89(5)

The Department’s argument also assumed that the comparison should be made primarily between the main input and the finished product. On that reasoning, if the fabric and apparel attracted the same rate, higher tax paid on dyes, chemicals, packing materials and other inputs would not produce a refundable inversion.

Neither Section 54(3)(ii) nor Rule 89(5) recognises a distinction between principal and ancillary inputs. The formula under Rule 89(5) refers to “Net ITC”, subject to the definition and exclusions prescribed by the Rule. It does not direct the officer to identify a single dominant input and disregard the rates borne by other eligible inputs used in making the output supplies.

This aspect is supported by the Madras High Court’s decision in M/S Vindhya Spinning Mills Private Limited v. Assistant Commissioner of CGST and Central Excise, 2026-VIL-731-MAD. The High Court rejected an attempt to deny an inverted-duty refund merely because the principal input and output attracted the same rate. Higher-taxed chemicals, packing materials and other inputs remained relevant to the accumulation, and the statutory formula provided the mechanism for determining the refundable amount.

The principle is commercially significant. Modern production rarely depends on a single input. A finished product may use raw materials, chemicals, consumables, packing materials and several other goods carrying different tax rates. Restricting the comparison to the principal input would leave genuine credit accumulation unaddressed and produce a result inconsistent with Rule 89(5).

Hence, the proper approach is to include all eligible inputs within Net ITC, exclude items that the Rule does not permit, and apply the formula to the relevant turnover. The refund may then rise or fall on the statutory calculation, rather than on an ill-defined distinction between major and minor components.

Period-Wise Computation Remains Mandatory

Although the decision supports the taxpayer’s eligibility, it does not permit flexibility in the quantification method. Rule 89(5) requires calculating the refund by applying the prescribed formula to the data for the relevant tax period.

The Department argued that the First Appellate Authority had impermissibly relied on annual turnover and annual ITC figures. Had annual figures replaced tax-period data in the actual calculation, the objection would have carried force. The refund for February or March could not be determined merely by aggregating the figures for the entire financial year.

The records, however, showed that the Original Adjudicating Authority had verified Net ITC and calculated the refund using the data of each relevant period. The taxpayer made two separate claims, quantified for February 2024 and March 2024.

The annual figures were used only as corroborative material. They helped determine whether the taxpayer’s business model genuinely generated an inverted duty structure and whether variations in monthly accumulation could be explained by fluctuations in purchases and sales. They did not replace the statutory formula or become the operative basis of the refund amount.

The distinction between computation and verification is therefore decisive. Period-specific data must control the calculation. Annual data may help test consistency, identify anomalies, or understand commercial patterns, provided it does not alter the refund determined under Rule 89(5).

Refund Verification Must Be Based on Records, Not Mere Allegations

The Department raised several other objections relating to capital-goods invoices, alleged personal-use purchases, differences with Form GSTR-2B and ITC relating to zero-rated supplies. It also contended that the orders of the First Appellate Authority were non-speaking.

However, the records did not support these objections. The taxpayer clarified that ITC relating to capital goods had been excluded from Net ITC. Even the orders of the Original Adjudicating Authority recorded that ITC on capital goods and input services had not been included in the refund calculation. Similarly, the invoices alleged to relate to personal use were issued in the company’s name and were explained as expenses incurred for business purposes.

The differences between Annexure-B and Form GSTR-2B had also been reconciled. The First Appellate Authority examined Forms GSTR-2A and GSTR-2B, Annexure-B and the relevant invoices and identified the inputs used in producing the finished goods. The Department did not produce any contrary documentary evidence before the Tribunal to show that these findings were incorrect.

As regards zero-rated supplies, the taxpayer relied upon the mechanism already built into the formula under Rule 89(5). Since adjusted total turnover forms part of the statutory formula, the refund attributable to inverted-rated supplies is determined proportionately. A separate invoice-wise exclusion should not be imposed as an additional requirement unless it is required by the statutory provisions or becomes necessary on the particular facts of the claim.

The decision therefore highlights an important principle of refund adjudication. Once the taxpayer has furnished the relevant records and reconciliations and these have been examined by the authorities, the Department must point out a specific error in the verification or computation if it seeks to challenge the refund. Mere repetition of objections or general allegations of inadequate verification cannot, by themselves, establish that the refund has been wrongly allowed.

Inverted-Duty Refund Depends on the Cause of ITC Accumulation

The decision reinforces that entitlement to a refund under the inverted duty structure must be examined by identifying the real cause of the accumulation of input tax credit. The relevant question is whether eligible ITC has accumulated because the rate of tax on inputs is higher than the rate of tax on output supplies, as contemplated under Section 54(3)(ii) of the CGST Act, 2017. Once this condition is satisfied, the amount of refund has to be determined by applying the formula prescribed under Rule 89(5) of the CGST Rules, 2017.

Refund cannot be denied merely because the taxpayer is described as a trader rather than a manufacturer. Similarly, the fact that the principal input and the output supply may fall under the same HSN does not, by itself, defeat the refund claim. These factors may be relevant for examining the factual nature of the transactions, but they cannot substitute the statutory test prescribed under Section 54(3)(ii).

At the same time, the taxpayer must establish that the ITC claimed is eligible and that its accumulation has actually arisen from the relevant rate inversion. The refund must also be calculated for the relevant tax period in accordance with Rule 89(5), supported by proper records, invoices and reconciliation wherever required. Thus, eligibility for refund and computation of the amount must both be established on the basis of the statutory provisions and the underlying records.

In the present case, the taxpayer established the use of eligible inputs taxable at higher rates, furnished the required period-wise computation and reconciled the invoices questioned by the Department. The Tribunal, therefore, found no sufficient ground to interfere with the relief granted by the First Appellate Authority and dismissed the Department’s appeals.

The broader principle emerging from the decision is clear: an inverted-duty refund must follow the actual source of ITC accumulation and the statutory formula, not labels such as manufacturer or trader, nor HSN similarity viewed in isolation.