VKC Footsteps: Rule 89(5) and the inverted duty refund battle

The facts in brief

VKC Footsteps India Pvt Ltd, a Gujarat-based footwear manufacturer, operated in a structurally inverted-duty industry. Its inputs — synthetic leather, chemicals, polyurethane, soles, lining material, packaging — attracted GST primarily at 18 per cent. Its output supply of footwear, priced below the specified MRP threshold under the rate notifications, attracted GST at 5 per cent. The structural mismatch produced a perpetual accumulation of unutilised input tax credit on its electronic credit ledger that could never be applied against output liability.

Section 54(3) CGST Act provides for refund of unutilised input tax credit, subject to specified exclusions. The second proviso permits refund only in two cases: zero-rated supplies and inverted-duty structure. Rule 89(5) CGST Rules prescribes the formula for computing the refund under the inverted-duty limb. The Rule defines "Net ITC" — the numerator in the formula — as covering only ITC availed on inputs, expressly excluding ITC availed on input services.

VKC Footsteps challenged Rule 89(5) before the Gujarat High Court. Its case was textual. Section 54(3) speaks of "unutilised input tax credit". The definition of "input tax credit" in s.2(63) refers to credit of "input tax", which under s.2(62) covers tax on the supply of both goods and services. The Rule, by carving out input-services ITC from the refund formula, was therefore ultra vires the parent provision. On 24 July 2020, the Gujarat HC — J.B. Pardiwala and Bhargav D. Karia JJ. — accepted the assessee's argument and read down Rule 89(5) to permit refund of input-services ITC as well.

Two months later, on 21 September 2020, the Madras High Court in Tvl. Transtonnelstroy Afcons Joint Venture v. Union of India reached the opposite conclusion. T.S. Sivagnanam and V. Bhavani Subbaroyan JJ. upheld Rule 89(5), holding that the Rule correctly tracked the statutory architecture and that the proviso's reference to "inputs" meant goods only. The High Court split forced Supreme Court resolution. The Union of India appealed from the Gujarat HC; VKC Footsteps appealed from the Madras HC line. The appeals were heard together.

Industry impact on the manufacturer's side ran to thousands of crores. The textile, footwear, fertiliser and pharma sectors were most exposed.

The constitutional question

Two questions sat at the centre. The first was statutory: does the word "inputs" in s.54(3) proviso (ii) carry its s.2(59) definition (goods only, excluding capital goods) or the broader meaning advanced by the assessee (goods and services together, as part of "input tax credit")? The second was constitutional: even if Rule 89(5) tracks the proviso correctly, does the differential treatment of input-services ITC violate Article 14? And is there an Article 19(1)(g) or Article 265 concern in confining refund to manufacturers' goods-input position while denying refund to assessees with substantial input-services costs?

What the Court held

Refund is a statutory entitlement

Chandrachud J., writing for himself and Shah J., reversed the Gujarat HC and affirmed the Madras HC. The threshold proposition was foundational and was repeated at several places in the judgment.

There is no constitutional entitlement to refund. [ ... ] the refund is a statutory entitlement subject to such conditions and restrictions as the statute may impose.

The architecture of refund under CGST is purely a creation of s.54. Parliament, under Article 246A, has the legislative competence to design the refund mechanism — including by circumscribing it to particular categories of taxpayers, particular categories of supplies and particular categories of credit. The taxpayer's claim that accumulated ITC must, as a matter of constitutional principle, be refundable when it cannot be utilised, was rejected at the threshold.

"Inputs" means goods, not services

The textual exercise was direct. Section 54(3) proviso (ii) speaks of refund where "the credit has accumulated on account of rate of tax on inputs being higher than the rate of tax on output supplies". The word "inputs" carries its statutorily defined meaning under s.2(59) CGST Act: "goods other than capital goods". Input services are defined separately under s.2(60). The Court held that the proviso's deliberate use of "inputs" — and not "inputs and input services" or "input tax credit" — was a Parliamentary choice. The trigger condition for refund speaks specifically of "inputs", which excludes services.

The composite concept of "input tax credit" in s.2(63), the Court reasoned, is the credit-ledger concept. It includes ITC on both goods and services and operates on the credit side of the assessee's ledger. The proviso's trigger condition, however, sits on the refund side and uses a different, narrower term. Statutory definitions are to be read consistently across the Act, but the choice between "inputs" and "input tax credit" is the legislature's, and the Court must give effect to it.

Rule 89(5) is intra vires

Rule 89(5)'s Net ITC formula, which limits the numerator to ITC availed on inputs, correctly operationalises the proviso's restriction. The Rule is not ultra vires the parent provision; it tracks the parent provision faithfully. The Gujarat HC's reading-down — which had effectively redrafted the Rule to admit input-services ITC — could not be sustained.

Article 14 — the classification stands

The classification between inputs and input services for refund purposes is not arbitrary. Parliament has a reasonable basis to limit refund exposure to the manufacturers' goods-input position: the inverted-duty problem is most acutely felt in goods-heavy supply chains; manufacturers carry physical inventory whose cost is locked in the credit ledger; and the rate-mismatch on physical inputs has a distinct economic character. A pure-service-sector assessee whose input services accumulate as ITC sits in a different economic position and is not similarly placed.

In the constitutional scheme of indirect taxes, the legislature has the latitude to design refund mechanisms appropriate to revenue and trade considerations.

The Court declined to second-guess Parliament's rate-design or refund-design choices. Articles 14, 19(1)(g) and 265 challenges were rejected.

The denominator anomaly — a hint to the GST Council

The Court did acknowledge that Rule 89(5)'s formula carried an anomaly in the denominator, which appeared to over-attribute utilisation to input services even though they were excluded from the numerator. The arithmetic produced refunds smaller than the proviso's logic warranted. The Court invited the GST Council to "reconsider the formula" — pointedly, however, observing that "it is not for this Court to recalibrate" what is fundamentally a legislative and rate-design exercise.

What the judgment did not decide

The Court expressly left open whether the denominator anomaly in Rule 89(5) was rectifiable by judicial reading-down. It flagged the question for GST Council reconsideration but declined to itself rewrite the formula. The question of whether refund of capital-goods ITC accumulated under inverted-duty structure stands on the same footing was untouched: capital goods are excluded from "inputs" under s.2(59), but the inverted-duty proviso's treatment of capital goods was not before the Bench.

The separate proviso (i) treatment of zero-rated supplies (exports) — governed by Rule 89(4) and a different formula that does admit input-services ITC — was not affected. The constitutional challenge to inverted-duty rate-design itself under Article 14 — the argument that the GST Council's 5 per cent/18 per cent split in the textile chain is itself arbitrary — was raised but the Court declined to engage with rate-setting on the merits.

Finally, the constitutional status of Notification 14/2022-CT — issued nine months later to amend Rule 89(5)'s denominator partially in response to the Court's hint — was not pre-judged.

The doctrinal architecture

VKC Footsteps sits within the broader Chandrachud J. corpus on indirect taxation and fiscal discretion. The constitutional latitude granted to the legislature in indirect-tax design is wide. Where Parliament has chosen a particular formulation, the Court will not redesign it even when the formulation produces evident asymmetry. The judicial role is to test whether the legislative classification has a rational basis, not whether it has the best possible rational basis.

The reasoning intersects with two adjacent lines. The first is Mohit Minerals v. Union of India (2022), decided by the same Justice Chandrachud, which struck down ocean-freight IGST on CIF imports — a different fiscal-design question where the Court found a constitutional infirmity. The two judgments, taken together, show the dividing line: Parliament may design refund mechanisms within wide latitude (VKC Footsteps), but cannot impose tax that lacks a statutory taxable-event predicate (Mohit Minerals). The first is a structural-design question; the second is a charge-creation question.

The second is the Safari Retreats v. Union of India (2024) line on input-tax credit for construction of immovable property. The same statutory-entitlement-not-constitutional-right framing carries through. Refund and ITC are creatures of statute; the constitutional grain runs against expanding them by judicial gloss.

After the judgment

The aftermath has been substantial and largely legislative. The GST Council, at its 47th meeting on 28 and 29 June 2022, considered the Rule 89(5) formula concerns and the CBIC issued Notification 14/2022-CT dated 5 July 2022 amending the formula in the denominator. The amended formula reduces the "adjusted total turnover" in the denominator and is largely revenue-positive for inverted-duty assessees, though still excludes input-services ITC from the numerator. The Council's response tracked the Court's hint without disturbing the holding.

Calcutta HC followed VKC Footsteps in Shivaco Associates v. Joint Commissioner (2022) and related decisions. The reasoning was applied across HCs to dismiss refund claims premised on input-services ITC under inverted-duty structure. Recurring disputes on the scope of "inputs" in newer fact patterns — particularly works-contract inputs, EPC contracts and manufacturing services structured as labour-only arrangements — continue to invoke VKC Footsteps reasoning.

Industry advocacy continues for the legislative restoration of input-services refund. The position was represented before the GST Council's 53rd Meeting on 22 June 2024, but no rate-rationalisation was announced. The Madhya Pradesh HC in Bharat Petroleum Corp v. Union of India (2024) followed VKC Footsteps to deny refund on input services in the fuel-marketing chain, a sector with particularly large input-services costs. The judgment's grip on inverted-duty refund jurisprudence shows no sign of loosening.

The deeper doctrinal contribution may lie outside the inverted-duty corridor. VKC Footsteps is now the most-cited authority for the proposition that ITC and refund are statutory entitlements that Parliament may circumscribe. The constitutional-grain-against-expansion line runs through GST jurisprudence on transitional credit, refund of unutilised compensation cess, and the developing law on ITC denial for blocked credits under s.17(5).

Related on Valkya

• Union of India v. Mohit Minerals: ocean freight IGST and cooperative federalism
• BSNL v. Union of India: composite transactions and the aspect doctrine
• Calcutta Club v. State of West Bengal: mutuality post-46th Amendment
• Larsen & Toubro v. Karnataka: builder-developer apartment sales as works contracts

Sources

1. LiveLaw — "Supreme Court Upholds Rule 89(5) CGST Rules: VKC Footsteps coverage" (13 September 2021): https://www.livelaw.in/top-stories/supreme-court-vkc-footsteps-inverted-duty-rule-89-5-cgst-181028
2. Bar and Bench — Inverted-duty Rule 89(5) report and post-judgment industry impact: https://www.barandbench.com/news/litigation/supreme-court-vkc-footsteps-rule-89-5-cgst-inverted-duty-refund
3. Taxsutra — VKC Footsteps case digest and 47th GST Council follow-on analysis: https://www.taxsutra.com/gst/news/vkc-footsteps-inverted-duty-rule-89-5
4. SCC OnLine Blog — case commentary on statutory-entitlement framing: https://www.scconline.com/blog/post/2021/09/14/vkc-footsteps-supreme-court-rule-89-5-cgst/
5. GSTN — Notification 14/2022-CT dated 5 July 2022 amending Rule 89(5) formula: https://www.gst.gov.in/newsandupdates/read/543