Section 18 of The CGST Act, 2017 (Part II) - Reversal And Adjustment Of ITC in Special Circumstances

Opening Perspective - Completing the Circle of Credit

In Part I of this two-part discussion, we explored the fascinating journey of input tax credit (ITC) - from its origins to its movement between entities - as described in Sections 18(1) to 18(3) of the CGST Act, 2017. We learned that, unlike the usual rules in Section 16, Section 18 highlights four exceptional cases where ITC can be claimed. These include situations in which someone becomes liable to register for the first time, chooses to register voluntarily, exits the composition scheme, or starts making taxable supplies after a period of exemption. These provisions help ensure that honest taxpayers entering or transitioning into the GST system are not unfairly denied the credit simply because their tax circumstances change.

Part I also explains the critical time limit set by Section 18(2), which keeps the claim window to just one year from the invoice date. This helps maintain the freshness and traceability of every credit entry. It then highlights how credit continues under Section 18(3), allowing unutilized balances to smoothly transfer during events such as mergers, demergers, amalgamations, or business transfers - a process managed under Rules 41 and 41A. Essentially, the first part of Section 18 shows the positive side of ITC: how credit is created, maintained, and flows with the business, ensuring that GST is a tax on consumption, not on business changes.

In this part of the article, we focus on the disciplinary side of Section 18 - highlighting the importance of repayment, recalibration, and honesty when reversing credit. We'll look into Sections 18(4) to 18(6), which together emphasise the idea of balance in credit: that ITC is a revolving trust, not an absolute asset.

Reversal of ITC When Shifting to Composition or When Supplies Become Wholly Exempt - Section 18(4)

Section 18(4) explains an essential aspect for registered persons. If their tax situation changes-such as moving to a different scheme where they can no longer claim input tax credits-they need to reverse or repay any credits they've already claimed. This ensures fairness in the system. The law outlines two similar but separate situations in which this applies, helping keep the process transparent and equitable.

(A) Opting for the Composition Levy

When a registered person who is currently on the regular scheme with ITC decides to switch to the composition levy under Section 10, it's helpful to remember to pay an amount that reflects the credit related to inputs held in stock, along with those in semi-finished or finished goods, and capital goods as of the day before making this switch. Since the composition scheme provides a more straightforward way to pay tax at a lower rate without claiming ITC benefits, it's essential to reverse the earlier credit to avoid any double-counting benefit.

(B) Supplies Becoming Wholly Exempt

Similarly, when someone's supplies of goods or services become fully exempt from tax due to a notification or a statutory change, they need to reverse the (ITC for inputs, semi-finished or finished goods, and capital goods held just before the exemption takes effect. Since an exemption relieves taxpayers of tax, it can't be combined with ITC, which assumes tax has already been paid on inputs. The method for determining the amount to be reversed is outlined in Rule 44 of the CGST Rules, 2017. This Rule specifies:

• For inputs and input components, reversal on a pro-rata invoice basis, depending on the quantity of stock held; and
• For capital goods, reversal proportionate to the remaining useful life, computed on a five-year life cycle - effectively reducing the eligible credit by five percentage points for every quarter or part thereof since purchase.

If the tax invoices for the relevant inputs aren't available, don't worry-taxpayers can estimate the reversal amount based on the current market value of those goods as of the date of change. It's a good idea to have a qualified Chartered Accountant or Cost Accountant certify this estimate. The amount calculated will be included as part of your output tax liability, so make sure to provide all necessary details in FORM GST ITC-03 within the specified deadline. If you cancel your registration later, remember to report these reversals using FORM GSTR-10 (Final Return).

Once the reversal amount has been paid-whether through a debit in the electronic credit ledger or the electronic cash ledger, any remaining ITC balance on the taxpayer's account will automatically lapse. This process helps neatly close the credit chain wherever the taxable activity ends, ensuring everything is clear and properly settled.

Section 18(4) respects the GST principle of fairness - you can only enjoy credit as long as the output remains taxable. Once the tax on outward supply stops, the system balances things out through reversal. This approach helps keep credit accurate and prevents it from building up or leaking away.

Computation Mechanism for Availment and Reversal - Section 18(5)

Section 18(5) serves as a connective tissue between the entitlement provisions of Section 18(1) and the reversal provisions of Section 18(4). The provision states that the amount of credit in respect of inputs or capital goods shall be calculated in the manner prescribed. This prescription is governed by two complementary rules-Rule 40 for fresh availment and Rule 44 for reversal. Both rules adopt a uniform percentage-based reduction model for capital goods and an invoice-based approach for inputs, thereby ensuring that the same logic applies when credit enters or exits the ledger.

Rule 40 - The Positive Side (Availment)

Rule 40 sets out the steps for availing of ITC under Section 18(1). It requires the eligible person to:

• File a declaration in FORM GST ITC-01 within 30 days of becoming eligible to claim ITC (e.g., on registration, opting out of composition, etc.);
• Furnish details of inputs and capital goods held in stock as on the relevant date;
• Obtain a CA/CMA certificate if the claim exceeds ₹2,00,000 in total value; and
• For capital goods, reduce credit by five percentage points per quarter from the date of invoice, recognising gradual consumption of value.

This ensures that the system grants ITC only to the extent of unexhausted utility of capital goods and prevents retrospective enrichment.

Rule 44 - The Negative Side (Reversal)

Conversely, Rule 44 applies when the taxpayer ceases to be eligible for credit (Section 18(4)) or when registration is cancelled (Section 29(5)). It uses the same logic in reverse. The rule prescribes a proportionate reversal of ITC for inputs, semi-finished goods, finished goods, and capital goods based on the corresponding invoices or the remaining useful life. In the absence of invoices, the taxpayer must rely on market valuation certified by a professional accountant.

The two rules thus operate as mirror images-one permitting entry of credit into the system, the other ensuring its graceful exit when circumstances change.

Payment of ITC on Disposal of Capital Goods or Plant and Machinery - Section 18(6)

Section 18(6) marks the culmination of the ITC life cycle under GST. After the law permits credit to be claimed, transferred, and adjusted under the earlier subsections, this clause ensures that the benefit is returned to the system when the asset that generated it ceases to exist within the taxable framework. It represents the law's final act of equilibrium - the point where the credit that once entered the books finds its logical closure.

From an economic perspective, capital goods are meant to provide benefits over time. The ITC claimed on them is designed to be tax-neutral throughout their useful life. However, if these assets are sold or transferred before their assumed five-year period, it wouldn't be fair for the taxpayer to retain the full credit when they've only used part of the asset. That's why Section 18(6) introduces a fair way to adjust the credit by proportionally recouping it, not as a penalty, but to ensure fairness.

This balance is achieved through the dual test embedded in the provision. The taxpayer must pay the higher of:

1. The input tax credit originally availed, reduced by five percentage points per quarter or part thereof from the date of invoice; or
2. The tax on the transaction value of such capital goods or plant and machinery as determined under Section 15.

This "higher of two" test acts as a built-in safeguard against underpayment. It ensures that the Government recovers tax at least equivalent to the unutilised portion of credit or the value realised on sale, whichever is greater.

For instance, suppose Sonia Ltd. purchased machinery on 1st July 2023 for ₹10,00,000 plus GST of ₹1,80,000 (18%). The machine is sold on 15th December 2025 for ₹6,00,000 plus 18% GST. Between purchase and sale, 10 quarters have elapsed out of the total 20 quarters of deemed life. The unexpired life equals 10 quarters, and hence, the ITC attributable to that remaining period is ₹1,80,000 × (10/20) = ₹90,000. The tax on the sale value is ₹1,08,000 (₹6,00,000 × 18%). Accordingly, Sonia Ltd. must pay ₹1,08,000, being the higher of the two values.

The computation mechanism is codified under Rule 40(2) and Rule 44(6) of the CGST Rules, 2017. Rule 40(2) prescribes the five-per-cent-per-quarter reduction formula for determining the portion of ITC to be repaid, assuming a useful life of 5 years (20 quarters). Rule 44(6) complements it by stipulating that such computation must be made separately for CGST, SGST/UTGST, and IGST components, and that if the amount so determined exceeds the tax payable on the transaction value, the excess must be added to the output tax liability and disclosed in FORM GSTR-1.

All supporting documentation - including purchase and sale invoices, working sheets showing the ITC reduction, and, where applicable, a Chartered Accountant or Cost Accountant certificate - should be retained for audit. If the aggregate reversal exceeds ₹2,00,000, certification is not merely advisable but mandatory, confirming that the reversal has been correctly computed under Rule 44(6).

It is noteworthy that the law provides a special dispensation for specific categories of assets such as refractory bricks, moulds, dies, jigs, and fixtures, which are typically short-lived and often disposed of as scrap. In such cases, instead of applying the 5% quarterly reduction formula, the taxpayer pays GST on the transaction value under Section 15. This practical exception reflects legislative realism - acknowledging that the useful life of such assets cannot always be meaningfully measured.

An additional interpretational nuance arises when capital goods are transferred between distinct persons (different registrations under the same PAN) or related parties. Such transactions qualify as "supply" even without consideration, thereby triggering Section 18(6). Conversely, where capital goods are destroyed, lost, or permanently written off, the reversal is governed by Section 17(5)(h), not this section. Similarly, if such goods are transferred as part of an entire business sale with liabilities, Section 18(3) applies instead, and no reversal is required since credit flows with the business.

To illustrate the fairness of this provision, consider a second example. A company purchases a machine on 1st April 2022 for ₹8,00,000, plus GST @ 18% (₹1,44,000). It is sold as scrap on 31st March 2025 for ₹2,00,000 plus GST @18%. The period of use is 12 quarters; the unexpired life is 8 quarters. The reduced ITC works out to ₹1,44,000 × (8 ÷ 20) = ₹57,600, whereas tax on the sale value amounts to ₹36,000. The company must pay the higher amount of ₹ 57,600. This computation confirms that credit reversals under Section 18(6) are not tied to profit or loss on sale but to the unconsumed life of the asset.

Section 18(6), therefore, completes the ITC cycle that began with Section 16 and was refined by Section 18(1). If entitlement is the expression of trust, Section 18(6) is its redemption. It ensures that credit flows in and out of the system in perfect balance - neither retained beyond its life nor reclaimed before its time. In doing so, it transforms the mechanical act of reversal into a moral exercise in fiscal discipline - where the taxpayer honours the same fairness that once granted them the benefit of credit.

Compliance in One Glance - From Entitlement to Equilibrium

1. Forms & Timelines
   • ITC-01: Claim credit within 30 days under Section 18(1).
   • ITC-02 / 02A: Transfer credit on reorganisation or new registration (acceptance mandatory by transferee).
   • ITC-03: Reverse credit on opting for composition or exemption under Section 18(4).
   • GSTR-10: Final return upon cancellation of registration.
2. Certification & Audit Trail
   • CA/CMA certification mandatory if total credit claimed or reversed exceeds ₹ 2 lakh.
   • Maintain invoices, valuation sheets, and computation workings for 6 years from annual return due date.
3. Capital Goods Adjustment
   • Uniform 5 percent per quarter rule for both availment and reversal.
4. Ledger and Return Consistency
   • Ensure reconciliation among GSTR-1, GSTR-3B, and electronic credit ledger.
   • Mismatches commonly trigger DGGI enquiries under Sections 73 or 74.
5. Practical Tip
   • Before filing ITC-01 or ITC-03, cross-verify credit values with GSTR-2B to avoid system rejections and auto-notices.

Closing Reflection - The Law of Equilibrium and the Spirit of Fair Credit

With Sections 18(4) to 18(6), the circle of ITC under GST closes where it began - in fairness and balance. The first part of this article showed how credit arises and flows; the present part shows how it returns to its source when circumstances change. Section 18, taken as a whole, is therefore not merely procedural - it is the ethical grammar of credit. It grants, transfers, and withdraws with equal clarity, ensuring that the system remains revenue-neutral.

The law here speaks with quiet dignity: every right carries a duty, and every benefit finds closure in responsibility. Whether it is reversal on opting for composition, adjustment upon exemption, or payment when capital goods are sold, each act reflects the same economic truth - that ITC is not permanent wealth but a conditional trust extended to businesses. This trust must be honoured with the same integrity with which it was earned.

In a deeper sense, Section 18 transforms compliance into a moral discipline. It asks taxpayers not merely to account but to balance. The supporting Rules - 40, 41, 41A, 44, and 44A - give this principle mechanical form, converting fairness into verifiable numbers and documentation. They ensure that credit, like energy, is neither created nor destroyed, but only transferred or reversed in accordance with lawful conduct.

Section 18 thus completes the GST story of entitlement, continuity, and closure. It reminds professionals that true mastery of credit lies not in claiming more, but in reconciling correctly - that precision is a form of ethics. In the rhythm of GST, Section 18 is both the opening note of opportunity and the final chord of integrity - proving that in taxation, as in life, equilibrium is the highest form of order.

In the rhythm of GST, Section 18 is both the opening note of opportunity and the final chord of integrity - proving that in taxation, as in life, equilibrium is the highest form of order.

जो कर का हक़ लिया है, वो लौटाना भी सलीका है,जीएसटी की धारा अठारह, संतुलन का तरीका है।