By CA Surekha S Ahuja
Input Tax Credit (ITC) forms the foundation of the Goods and Services Tax (GST) framework. It ensures tax neutrality and prevents cascading by allowing credit of taxes paid on inputs and input services. However, in recent years, departmental audits and investigations have increasingly resulted in arbitrary ITC blockings and reversal proposals, often without adequate legal basis or proper appreciation of facts.
This guidance note presents a comprehensive legal, procedural, and judicial analysis of ITC blocking, reversal, and eligibility under GST, viewed from the taxpayer’s standpoint. It also integrates case law, departmental practices, and strategic responses during audits.
Statutory Framework Governing ITC
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Section 16 of the CGST Act, 2017: Grants entitlement to ITC when four conditions are satisfied—
(a) Possession of a valid tax invoice;
(b) Receipt of goods or services;
(c) Tax charged has been actually paid to the Government; and
(d) Returns have been duly filed. -
Section 17(5): Enumerates specific cases where ITC is blocked (e.g., personal use, food and beverages, motor vehicles, club memberships, etc.). These restrictions are exceptions and must be strictly construed.
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Rule 86A of the CGST Rules, 2017: Authorizes the proper officer to block ITC in the Electronic Credit Ledger (ECL) where he has “reasons to believe” that such credit has been fraudulently availed or is ineligible. However, this power is conditional upon recording such reasons in writing and is valid only for a period of one year unless extended through lawful proceedings.
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Sections 65 and 66: Empower the department to conduct audits and special audits, respectively, and form the practical basis for ITC-related verifications.
Eligible and Ineligible ITC: Core Distinction
| Category | Eligibility | Legal Reference | Remarks |
|---|---|---|---|
| Inputs and input services used for business | Eligible | Section 16(1) | ITC is allowable if used for taxable output supplies. |
| Inputs used for personal consumption or exempt supplies | Not eligible | Section 17(1) & (2) | Proportionate reversal required where used partly for exempt output. |
| Motor vehicles and personal consumption items | Not eligible | Section 17(5)(a)–(h) | Exceptions apply where used for transport or supply. |
| Capital goods used in business | Eligible | Section 16(1) | ITC admissible; depreciation cannot include GST portion. |
| Fund-raising and share issue expenses | Eligible | Section 16(1); supported by Sutherland Global Services v. ACIT | ITC allowable if directly linked with business activities. |
| Surplus temporarily invested in mutual funds | Partially eligible | Section 17(1)/(2) | ITC not to be reversed unless business ceases to be principal activity. |
ITC Blocking Under Rule 86A: Legal Discipline and Judicial Limits
Rule 86A empowers tax officers to block credit where there are valid “reasons to believe” that ITC has been availed fraudulently. However, several courts have emphasized that this provision cannot be exercised mechanically or on generic alerts.
In M/s Pilcon Infrastructure Pvt. Ltd. v. State of U.P. (2025), the Allahabad High Court held that mere receipt of a generic DGGI alert alleging a supplier to be non-operational does not constitute “reasons to believe.” The Court ruled that absence of recorded, specific reasons in writing renders ITC blocking illegal.
Similarly, in Tata Steel Ltd. v. State of Jharkhand (2020), it was observed that blocking ITC without proper verification violates the principle of reasonableness and cannot continue indefinitely.
The expression “reasons to believe” has been judicially interpreted to mean an objective satisfaction based on tangible material, not mere suspicion or departmental communication. The taxpayer has a right under Rule 86A(2) to submit representation for unblocking.
Departmental Audit and ITC Verification
During a GST audit under Section 65, officers typically examine:
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Invoice-level matching between GSTR-2B, GSTR-3B, and books of accounts.
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Payment evidence to suppliers.
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Validity of suppliers’ GST registration.
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Purpose and nature of goods or services utilized.
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Linkage of ITC to taxable business output.
Where discrepancies are noticed, officers may propose reversal or invoke Rule 86A. However, reversal or blocking can only be justified when statutory conditions under Section 16(2) or restrictions under Section 17(5) are demonstrably violated. A mismatch or alert by itself does not constitute sufficient ground.
Judicial Precedents Supporting Taxpayer Entitlement
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Dai Ichi Karkaria Ltd. v. CCE (1999) 7 SCC 448 — ITC, once validly availed, is a vested and indefeasible right that cannot be curtailed arbitrarily.
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Arise India Ltd. v. Commissioner of Trade & Taxes (Delhi HC) (2018) 97 VST 471 — Bona fide purchasers cannot be denied ITC for supplier default when tax has been paid and transactions are genuine.
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Safari Retreats Pvt. Ltd. v. Union of India (2019) 70 GSTR 500 — ITC on construction activities allowed when used for business; liberal interpretation preferred.
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Gujarat Narmada Fertilizers Co. Ltd. v. CCE (2009) 19 STR 409 — ITC disallowance requires direct nexus between input and exempt output; incidental use does not warrant reversal.
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Sutherland Global Services v. ACIT (2020) 117 taxmann.com 247 — Legal and professional services used for business expansion and fund raising are eligible for ITC.
Fund-Raising Expenses and Surplus Investments
1. Fund-Raising Expenses:
Legal, professional, and consulting costs incurred for raising equity or debt are eligible for ITC if the funds are utilized for business operations or expansion. The rationale is that such activities contribute directly to taxable business output and form part of the overall value creation process.
2. Temporary Investment of Surplus in Mutual Funds:
Temporary parking of surplus funds does not transform a trading or manufacturing entity into an investment business. Therefore, ITC reversal cannot be justified merely because a portion of the working capital was invested in mutual funds. Reversal may only be considered proportionately if inputs are used in relation to exempt activities, following the principle established in Gujarat Narmada Fertilizers.
Common Departmental Objections and Taxpayer Responses
| Departmental Ground | Legal Counter and Reasoning |
|---|---|
| Supplier not traceable or inactive | Buyer cannot be penalised if bona fide; ITC allowable under Arise India. |
| ITC blocked based on alert | Jurisdictional officer must record independent reasons in writing; Pilcon Infrastructure applicable. |
| ITC on capital/fund-raising expenses | Direct business nexus exists; covered under Sutherland Global Services. |
| Proportionate reversal due to surplus investments | Predominant use test applies; temporary investments not a basis for reversal. |
| Time-barred invoice or payment delay | ITC can be reclaimed upon subsequent payment; Rule 37 compliance suffices. |
| Procedural discrepancies | Substantial compliance doctrine applies; minor errors cannot defeat substantive rights (Dai Ichi Karkaria). |
Audit-Stage Defence Strategy for Taxpayers
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Documentation Discipline: Maintain invoice-wise reconciliation, supplier confirmations, and proof of tax payment.
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Seek Written Grounds: Always request the officer to provide the statutory basis for proposed reversal or blocking.
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Submit Detailed Representation: Explain business nexus and bona fide compliance; quote case law.
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Proportional Approach: Where any part of input relates to exempt or non-business use, offer only proportionate reversal.
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Challenge Arbitrary Blocking: File representation under Rule 86A(2); if ignored, approach appellate or writ remedy.
Legal and Compliance Perspective
Courts across jurisdictions have consistently reaffirmed that ITC is a fundamental component of GST’s value chain. Blocking or reversal without statutory justification undermines the seamless credit flow and contradicts legislative intent. The Supreme Court in Dai Ichi Karkaria Ltd. categorically held that once credit accrues legitimately, it cannot be withdrawn or restricted arbitrarily.
Tax officers must, therefore, exercise powers under Rule 86A with circumspection, ensuring that “reasons to believe” are objectively recorded. Taxpayers, on their part, should maintain a high standard of compliance, documentation, and audit preparedness to defend their claims effectively.
Conclusion
Input Tax Credit is a statutory right, not a concession. It reflects the essence of GST — a unified, value-added tax system designed to eliminate cascading and promote transparency. Any action by the department that blocks or reverses ITC without clear legal basis disrupts this equilibrium and burdens honest taxpayers.
Taxpayers should approach audits with clarity, confidence, and preparedness — equipped with sound legal understanding and documentary evidence. In parallel, the administration must apply the law judiciously, distinguishing genuine transactions from fraudulent ones based on objective material rather than suspicion.
A balanced, evidence-based approach on both sides is essential to preserve the integrity of the ITC mechanism — the true “soul” of the GST regime.
