If everything you supply is taxable, this article is not for you. Take the credit and move on.
The moment any part of your turnover is exempt, Section 17(2) applies, and the credit on anything used for both streams has to be split. Rule 42 does that for inputs and input services, Rule 43 for capital goods. Both are mechanical. Both are misapplied constantly, and usually in the same two ways.
Sort the credit into three piles first
Before any formula, every credit belongs in one of three categories, and getting this wrong makes the arithmetic irrelevant.
Exclusively for taxable or zero-rated supplies. Fully available. Nothing to apportion.
Exclusively for exempt supplies, or for non-business purposes. Fully blocked. Not apportioned, just gone.
Common to both. Only this pile goes through the formula.
Most errors originate here rather than in the calculation. Credit that could and should have been identified with a specific stream gets swept into the common pool, and a portion of it is then needlessly reversed. If your factory makes one exempt product on a dedicated line, the inputs for that line are exclusively exempt, and the inputs for the other lines are exclusively taxable. Only genuinely shared costs, the shared utilities, the head office, the audit fee, are common.
The single highest-value control in this whole area is upstream of the formula: tag purchases to a stream at the point of entry. Every rupee you can attribute directly is a rupee that never enters the pool.
Rule 42, in the order the rule does it
Rule 42 works through a sequence of defined amounts. In plain terms:
Start with total input tax on inputs and input services for the period. Remove the credit attributable exclusively to non-business use, and the credit attributable exclusively to exempt supplies, and the credit blocked by Section 17(5). Then remove the credit attributable exclusively to taxable and zero-rated supplies, which you keep in full.
What remains is the common credit.
Of that common credit, the portion attributable to exempt supplies is:
Common credit × (exempt turnover ÷ total turnover), for the period.
Rule 42 also attributes a flat five per cent of common credit to non-business purposes where inputs are partly used for non-business ends.
The result is added to your output liability in that month’s GSTR-3B. It is a reversal, not a negative credit.
The annual rework is the step that gets missed
The monthly computation uses that month’s turnover ratio. Turnover ratios move about month to month, sometimes sharply, and the monthly figure is therefore provisional.
Rule 42 requires the whole calculation to be redone for the financial year as a whole, using the annual turnover ratio, and the difference settled. The rework must be completed by the due date of the return for September following the end of the financial year.
The direction of the difference decides what happens next.
If the annual rework shows you reversed too little, the shortfall is added to output liability, with interest under Section 50.
If it shows you reversed too much, you claim the excess back as credit. No interest is payable to you.
The asymmetry is the point, and it is why the rework is not optional housekeeping. A business whose exempt turnover was seasonally concentrated can easily find that the monthly reversals, computed on months when exempt turnover was low, understated the annual position substantially. That difference carries interest from the original periods.
The rework is also easy to forget precisely because nothing prompts it. There is no separate return for it. It happens in an ordinary monthly GSTR-3B, and if nobody has diarised it, it does not happen at all.
Rule 43, and the sixty-month clock
Capital goods are handled separately because their use extends over years.
Where a capital item is used exclusively for exempt supplies, no credit. Exclusively for taxable supplies, full credit. Common use, and the credit is spread over a useful life of sixty months from the date of invoice, with the exempt portion reversed each month on the same turnover ratio.
Two situations require attention.
A change of use. A machine bought for taxable production and later switched to exempt output, or the reverse, moves between categories, and the remaining months of its sixty-month life are treated on the new basis. This needs a fixed asset register that records use and not merely cost.
Disposal within sixty months. Selling capital goods on which credit was taken triggers Section 18(6): you pay the higher of the credit attributable to the remaining useful life, or the tax on the transaction value. This is a real cost on early disposals and it is frequently overlooked when equipment is sold or scrapped.
What counts as exempt turnover, and why it is wider than you think
Section 17(3) extends the meaning of exempt supply beyond the obvious, and each extension catches somebody out.
Supplies on which the recipient pays under reverse charge. From your side as supplier there is no output tax, and the turnover counts as exempt for apportionment.
Transactions in securities. The value taken is one per cent of the sale value of the securities. A treasury operation that buys and sells securities routinely can generate meaningful exempt turnover without anyone in the finance team thinking of it as turnover at all.
Sale of land, and sale of a building after completion. These are outside GST under Schedule III, and they enter the exempt turnover figure for apportionment. A one-off property sale can move a company’s ratio dramatically for a year, and the effect is felt in the annual rework rather than in the month of sale.
Interest income. Interest on deposits, loans and advances is exempt. This is the one that surprises manufacturers most often. A company with substantial fixed deposits earning interest has exempt turnover, and therefore a Rule 42 obligation, even though its entire product range is taxable and it has never thought of itself as making exempt supplies. It is worth checking, because a business that has never done a Rule 42 computation and has significant interest income has an exposure it does not know about.
Zero-rated supplies, exports and supplies to a special economic zone, are not exempt for this purpose. Credit on those is fully available. Confusing the two is a common and expensive error in the opposite direction, reversing credit that was never required to be reversed.
Practical points
Fix the definition of exempt turnover before you compute anything. Every downstream figure depends on it, and Section 17(3) is where the mistakes are.
Diarise the annual rework for September. Put it in the compliance calendar with a named owner. It is the only step that carries interest.
Keep the working papers by period. The annual rework requires the monthly figures. Reconstructing twelve months of apportionment in September because nobody saved the workings is a bad week.
Note the changes in the annual return. Notification 13/2025-Central Tax revised GSTR-9 with clearer placement of reversals and reclaims, referencing Rules 37, 37A, 38, 39, 42 and 43 explicitly. Reversals now have a designated home in the annual return, which makes their absence more visible than it once was.
The summary
Split credit into exclusive-taxable, exclusive-exempt and common before you touch a formula, and attribute as much as you honestly can so the common pool stays small. Apply the turnover ratio monthly, redo it annually by the September due date, and expect interest only where you under-reversed. Capital goods run on a sixty-month clock with a Section 18(6) charge on early disposal. And check your interest income, because that is where businesses discover they have been making exempt supplies for years.
