Inverted Duty Structure Under GST

An inverted duty structure is a situation where the tax on what a business buys (its inputs) is higher than the tax on what it sells (its output). For example, a fabric maker may pay 18% GST on dyes and chemicals but charge only 5% GST on the fabric it sells. Because it collects less tax than it has already paid, unused credit keeps piling up in its account. This piled-up credit is money that is stuck with the government.

Why does it matter?

Under GST, a business recovers the tax paid on inputs by setting it off against tax on its sales. Think of it like a wallet. Every purchase puts tax money into the wallet as credit. Every sale takes tax money out of it. If more goes in than comes out, the wallet keeps growing and the business cannot spend it.

That is cash the business could have used to buy raw materials, pay workers or expand. For a small textile unit or a medicine maker, this blocked money can be a large share of its working capital.

Why does it happen?

The main causes are:

• Low rates on final goods for social reasons: The government keeps a low rate on essential items (food, medicines, basic textiles, fertilisers) or on goods it wants to promote (electric vehicles). Their inputs, however, are often taxed at the standard rate.
• Services and capital goods at higher rates: Rent, transport, telecom and machinery often carry 18%, while the final good may be at 5%.
• Multiple slabs: The more slabs there are, the more chances that inputs and outputs fall in different slabs. Reducing slabs from four to two in September 2025 removed some inversions. But it also moved many goods to 5% while some of their inputs stayed at 18%.

What does the law say about refunds?

GST allows a refund of this stuck credit, with limits:

• Section 54(3) of the CGST Act, 2017 allows a refund of unutilised ITC in only two cases: (i) zero-rated supplies (exports and supplies to SEZs) made without paying tax, and (ii) where credit has piled up because the rate on inputs is higher than the rate on output supplies (other than nil-rated or fully exempt supplies).
• The government, on the Council's recommendation, can notify goods or services for which this refund will not be given.
• Rule 89(5) of the CGST Rules, 2017 gives the formula for how much can be refunded. In simple terms, it allows refund of the extra credit that comes from inputs (goods used to make the product), in proportion to the turnover of the inverted product.
• Credit on input services and capital goods is not refunded under this route. So a business with high tax on rent, transport or machinery still gets stuck credit.
• A refund claim must be filed within two years from the relevant date (Section 54(1)).

The VKC Footsteps case

In Union of India v. VKC Footsteps India Pvt. Ltd. (decided 13 September 2021), footwear makers argued that refunds should also cover input services. The Supreme Court held that Parliament can choose to limit the refund to credit on inputs (goods), and upheld the rule that leaves out input services. The Court said this was a policy choice, and it suggested that the GST Council reconsider the formula.

In July 2022 (Notification No. 14/2022-Central Tax, dated 5 July 2022), the formula in Rule 89(5) was amended to remove an anomaly in how the refund was calculated, but input services still stayed out.

How are refunds being sped up?

Refund delays add to the pain of inversion. The 56th GST Council meeting (3 September 2025) recommended that 90% of refund claims arising from inverted duty structure be sanctioned provisionally (paid first, checked later), using automated, risk-based checks by the system. This began from 1 November 2025, first through administrative steps pending changes in the CGST Act. Low-risk claims get money fast; only risky claims face detailed checks.

India's examples

The sectors most often hit are:

• Textiles: fabrics at 5%, while chemicals, dyes and machinery services cost more
• Pharmaceuticals: many medicines at low rates, inputs at higher rates
• Food processing and fertilisers: low output rates for affordability
• Electric vehicles: EVs at 5%, while batteries, parts and services often carry higher rates
• Telecom, refining, gas distribution: heavy capital spending on towers and pipelines that, under Section 17(5), often did not earn credit at all

Commonly confused concepts

• Inverted duty structure vs blocked credit: In an inversion, the credit is allowed but cannot be used up because output tax is too low. In blocked credit (Section 17(5)), the credit is not allowed at all.
• Inverted duty under GST vs under customs: In customs, inversion means imported raw materials pay a higher customs duty than the imported finished product. This makes it cheaper to import the finished good than to make it in India. Under GST, inversion is about domestic tax on inputs versus outputs.
• Refund under 54(3) for inversion vs for exports: Exporters can get refunds of credit on inputs, input services and capital goods used in zero-rated supplies. The inversion refund is narrower: only inputs.
• Exempt vs nil-rated vs inverted: If the output is fully exempt or nil-rated, no refund is allowed even though inputs were taxed. The inversion refund applies only where the output carries some positive tax rate.

Issues, criticism and the way forward

• Working capital locked: Industry bodies say large sums stay stuck, which raises costs and makes Indian goods less competitive abroad.
• Narrow refund formula: Leaving out input services and capital goods means the refund does not fully remove the problem.
• Fraud risk: Refunds are a target for fake invoice rings. So the government has been careful about widening them.
• Rate design is the real fix: Most experts argue that the lasting solution is to correct the rates themselves, so that inputs are not taxed more than outputs. In December 2021, the Council deferred a planned correction of textile rates after several states opposed it.
• Way forward: Commonly suggested steps are fully automated, data-driven refunds; a wider formula that includes input services; refund of credit on capital goods over time; and aligning input and output rates sector by sector.

Concepts to Know

• Input / output: Inputs are the goods and services a business buys to make its product. Output is what it sells.
• Unutilised ITC: Credit that sits in a business's GST account because there is not enough output tax to set it off against.
• Nil-rated vs exempt supply: A nil-rated supply has a GST rate of 0%. An exempt supply is fully freed from GST by a government notification. In both cases, the seller usually cannot claim credit on its inputs.
• Provisional refund: A refund paid first, based on the claim and a quick system check, with a detailed check later if needed.
• Capital goods: Machinery, equipment and tools used for many years to make products, as opposed to raw materials used up once.