Govt working on mechanism to allow refund of ITC on capital goods

An inverted duty structure arises when the tax rate on inputs is higher than that on finished goods, leading to accumulation of unutilised ITC

The Centre is actively exploring ways to allow refunds of unutilised input tax credit (ITC) on capital goods under the inverted duty structure (IDS), signalling a move towards rationalising credit flow for manufacturing sectors affected by inverted duty rates, a senior official told Business Standard. An IDS arises when the tax rate on inputs is higher than that on finished goods, leading to the accumulation of unutilised ITC — the tax paid on inputs that businesses can normally offset against their output liability.

“The government has the appetite and is examining how a refund of unutilised ITC on capital goods can be enabled under IDS,” the official said, adding that a similar move for input services may take longer. 

An email sent to the finance ministry remained unanswered until the time of going to press. 

A second official concurred, observing that ITC is emerging as “the next big reform agenda before the government”. He acknowledged that the current framework creates imbalances. “The fact that refunds of ITC on services and capital goods are not permitted under IDS is a structural distortion,” the official said, adding that “this needs to be addressed”. 

Officials, however, indicated that the proposal is unlikely to be implemented immediately, as the focus remains on allowing the recently launched Goods and Services Tax (GST) 2.0 framework to stabilise before introducing new policy changes. 

Under the GST law, businesses can claim refunds of unutilised ITC on inputs (raw materials) in cases of IDS, but such refunds are not permitted for input services or capital goods under Section 54(3) of the Central GST Act. As a result, manufacturers investing heavily in machinery or availing of high-value services often face blocked credits that strain liquidity. The industry has consistently urged the government to address this anomaly, calling it a key structural gap in the tax framework. 

Industry experts welcomed the Centre’s openness to revisit the rule but said that refunds of ITC on input services should also be taken up alongside capital goods to provide comprehensive relief. 

“It’s a welcome step that the government is looking to allow refunds of unutilised ITC on capital goods under IDS. But refunds of ITC on input services should also be considered simultaneously, as they directly impact working capital,” said Bimal Jain, partner at A2Z Taxcorp LLP. 

“While a refund on capital goods would correct a structural imbalance over time, refunding credit on input services could immediately ease cashflow strain for manufacturing and export-oriented sectors,” Jain added. 

Abhishek Jain, indirect tax partner and head, KPMG, said: “Currently, there is significant credit accumulation on account of capital goods and input services, particularly for businesses operating under IDS and for exporters of goods, especially those taxed at lower rates. A mechanism for refunding such accumulated credits is the need of the hour and would go a long way in ensuring a seamless GST framework. While this is the immediate priority, the industry also looks forward to rationalisation of blocked credits, especially those related to construction services, which are critical for greenfield and brownfield projects”. 

According to Shivam Mehta, executive partner at Lakshmikumaran & Sridharan, as things stand, state schemes provide reimbursement to assessees based on the net cash GST paid by them — that is, the amount paid from the electronic cash ledger after exhausting the balance in the electronic credit ledger.

 

“With the reduction in GST rates, the output tax liability of the assessee will fall, leaving a large balance accumulated in the electronic credit ledger, much of it related to capital goods. Thus, the reduction in taxes will also reduce or even eliminate state incentives for assessees. The government should take note of these challenges and allow refunds of ITC on capital goods,” he said.

Unravelling tax knots

• Govt official said a similar move for input services may take longer
• It is currently examining how refund of unutilised ITC on capital goods can be enabled under the inverted duty structure
• Industry experts welcomed govt’s openness to revisit current rule
• However, they said refund of ITC on input services should also be taken up to provide comprehensive relief
• Officials also indicated that the proposal is unlikely to be implemented immediately