Inverted Duty Refund Is a Rate Test, Not a Principal-Input Test

When Higher-Rated Ancillary Inputs Locked the Credit

The Madras High Court's decision in M/s. Vindhya Spinning Mills Private Limited Versus The Assistant Commissioner of CGST and Central Excise, Thiruthangal - 2026 (7) TMI 1337 - MADRAS HIGH COURT, is an important ruling on refund of unutilised input tax credit under Section 54(3) of the CGST Act, 2017. The case addresses a recurring practical issue in inverted duty refund claims. Can a refund be denied merely because the principal input and the output supply carry the same GST rate, even though other inputs used in the manufacturing process carry a higher rate and cause accumulation of credit?

The petitioner manufactured combed cotton yarn. The principal input, raw cotton yarn, was subject to a 5% tax. The output product, combed cotton yarn, was also subject to a 5% tax. However, the manufacturing activity required other inputs, such as chemicals, consumables, packaging materials, and ancillary materials. These inputs attracted GST at 12% and 18%. As a result, even though the principal input and output product carried the same rate, credit accumulated because some inputs were taxed at a higher rate than the output supply. The petitioner therefore claimed a refund of unutilised ITC under Section 54(3)(ii) of the CGST Act, 2017. The Department rejected the claims for January 2023 and March 2023, leading to the writ petitions.

Section 54(3) Looks at Input Rate, Not Input Importance

Section 54(3) permits a registered person to claim a refund of any unutilised ITC at the end of any tax period, subject to statutory restrictions. The first major category comprises zero-rated supplies made without payment of tax. The second category, contained in clause (ii), covers cases where credit has accumulated because the rate of tax on inputs exceeds the rate on output supplies, excluding nil-rated or fully exempt supplies and subject to notified exclusions.

The statutory language is important. It speaks of 'inputs' and 'output supplies'. It does not say 'principal inputs'. It does not say 'major inputs'. It does not say that the principal input must carry a higher rate than the output. Therefore, once some inputs used in the business attract a higher GST rate than the output supply and credit accumulates on that account, the statutory condition requires proper examination under Section 54(3)(ii). The Department cannot add a principal-input test that the legislature has not written into the provision.

This is the heart of the judgment. In the petitioner's case, raw cotton yarn and combed cotton yarn may both have been taxable at 5%. But chemicals, consumables and packing materials were taxable at 12% and 18%. These were not irrelevant inputs. They were part of the manufacturing and supply chain. If their higher tax rate caused accumulation of ITC, the refund claim could not be rejected merely because the most important input was taxed at the same rate as the output.

Ancillary Inputs Are Still Inputs

A common practical mistake in inverted duty refund disputes is to treat ancillary inputs as commercially less important and therefore legally less relevant. That approach may seem attractive from a business-costing perspective, but it does not align with the text of Section 54(3)(ii). GST law does not say that only the dominant input matters. It does not ask whether the input is major or minor. It asks whether credit has accumulated because the tax rate on inputs is higher than the tax rate on output supplies.

The Madras High Court recognised this distinction. Chemicals, consumables and packing materials may not be the principal raw material for manufacturing combed cotton yarn, but they remain inputs. If they bear a higher GST rate and their credit remains unutilised because the output is taxable at a lower rate, the case falls within the logic of inverted duty refund. The refund mechanism is intended to address the accumulation of credit caused by rate inversion. It is not confined to cases where the main raw material is taxed at a higher rate than the final product.

This interpretation is also commercially realistic. Manufacturing does not happen only through the main raw material. Finished goods often require processing inputs, consumables, packing materials, chemicals, accessories or other supplies. If GST on such inputs is higher than GST on the output, credit accumulation may arise. Denying a refund merely because the principal input has the same rate as the output would leave genuine accumulated credit locked without a statutory basis.

Valuation of Finished Goods Is Not the Refund Test

The Department also contended that the value of outward supplies exceeded the value of inputs and that the cost of packing materials and ancillary inputs was absorbed into the value of finished goods. This argument may be relevant for costing or pricing, but it has no independent statutory bearing on refund entitlement under Section 54(3)(ii).

The provision is rate-based, not value-comparison-based. The question is not whether finished goods are more valuable than inputs. Finished goods will ordinarily be more valuable because they include raw material cost, processing cost, labour, overheads, margin and market value. That does not answer the statutory question. The relevant question is whether ITC has accumulated because the rate of tax on inputs is higher than the rate of tax on output supplies.

If valuation were treated as the controlling test, Section 54(3)(ii) would become uncertain and difficult to apply. The statute instead adopts a clearer test: compare the tax rate on inputs with the tax rate on output supplies and apply the prescribed refund formula. Therefore, the Department's valuation-based objection could not override the statutory rate-based scheme.

Circulars Cannot Rewrite Section 54(3)

The Department relied on Circular No.135/05/2020-GST dated 31.03.2020. The argument was that when the tax rate on the principal input and the output supply is the same, an inverted duty refund should not be granted. The difficulty with this approach is that a circular cannot impose a restriction not found in the statute. Executive instructions may clarify the law, but they cannot curtail a statutory refund right.

The petitioner relied on the principle that Section 54(3)(ii) itself must govern refund entitlement. If the provision does not distinguish between principal and ancillary inputs, a circular cannot create that distinction. The High Court accepted the statutory approach. It also noted the petitioner's reliance on Circular No.125/44/2019-GST dated 18.11.2019, particularly the clarification that where multiple inputs attract different rates of tax, the formula under Rule 89(5) has to be applied irrespective of the individual rates of tax on various inputs.

This part of the ruling is important for refund administration. Circulars are useful tools for uniformity. But they must operate within the Act and Rules. Where a circular narrows the statute, the statute prevails. Refund officers must therefore begin with Section 54(3)(ii) and Rule 89(5), not with an administrative restriction that adds words to the law.

Rule 89(5) Provides the Working Formula

Section 54(3)(ii) creates the entitlement to refund in cases of inverted duty structure. Rule 89(5) provides the formula for computing the refund of ITC accumulated on account of an inverted duty structure. The formula is important because the law does not simply refund the entire electronic credit ledger balance. It calculates the eligible refund with reference to the turnover of inverted-rated supply, net ITC, adjusted total turnover, and tax payable on such inverted-rated supply.

The High Court held that the formula prescribed under Rule 89(5) must be applied. This is the correct statutory method. Once the claim falls within Section 54(3)(ii), the authority must compute the refund as per the formula. The formula is designed to translate the statutory entitlement into a calculable amount. It also ensures that the refund is not granted arbitrarily or excessively.

The significance of Rule 89(5) is that it avoids subjective debates about which input is principal, which is minor, and how much each contributes to the final product. The formula takes the statutory inputs and applies a uniform method. Therefore, the refund authority should not reject the claim at the threshold merely because different inputs carry different rates or because the principal input is not higher-rated. The formula exists precisely to deal with such situations.

Indian Oil Case Law Clarified That Circulars Cannot Defeat the Statute

The petitioner relied on M/s Indian Oil Corporation Ltd. Versus The Assistant Commissioner Of Central Tax, South Division – 1, Bengaluru - 2025 (5) TMI 538 - KARNATAKA HIGH COURT. In that case, the Karnataka High Court considered Circular No. 135/05/2020-GST and held that the CBIC cannot issue circulars contrary to the statute. The Court observed that Section 54(3) concerns the accumulation of unutilised ITC and does not prescribe an additional principal-input condition.

The underlying principle is simple. A circular may bind departmental officers administratively, but it cannot bind courts against the statute. If the circular restricts refunds in a manner not authorised by Section 54(3), the taxpayer can rely on the Act. The Madras High Court's reliance on this principle strengthens the statutory reading of refund law. It confirms that refund eligibility must be determined by the Act and Rules, not by a restrictive executive gloss.

MK Agrotech Case Law Rejected the Principal-Input Restriction

The petitioner also relied on M/s. MK Agrotech Private Limited Versus Union Of India Through Its Secretary, (Revenue), New Delhi, Additional Commissioner (Appeals) Office Of The Commissioner Of Central Tax (Appeals), Mysuru, Assistant Commissioner Of Central GST And Central Excise Mysuru, Central Board Of Indirect Taxes And Customs New Delhi. - 2025 (7) TMI 914 - KARNATAKA HIGH COURT. Following the earlier Karnataka view, the Court held that the benefit of an inverted duty refund cannot be restricted solely by looking at the principal input. Other inputs contributing to accumulated credit cannot be ignored.

This principle directly supports Vindhya Spinning Mills. Textile manufacturing, food processing, pharma, chemicals, engineering, and many other sectors use multiple inputs at different rates. If refund eligibility were decided solely by the principal input, genuine credit accumulated on higher-rated supporting inputs would remain blocked. The Karnataka view therefore provided a practical and legally sound foundation for the Madras High Court's approach.

Nainar and Eveready Judgments Strengthened the Refund Line

The petitioner further relied on M/s Nahar Industrial Enterprises Limited Versus Union of India, Principal Commissioner of Central Goods and Services Tax, Additional Commissioner (Appeals), Central Goods and Services Tax, Assistant Commissioner, Central Goods and Services Tax, State of Rajasthan - 2023 (11) TMI 209 - RAJASTHAN HIGH COURT. That decision supported a refund entitlement under an inverted duty structure in a similar context. The broader principle is that, where the statutory conditions are satisfied, a refund should not be denied by imposing extra-statutory restrictions.

The Madras High Court also considered its earlier decision in M/s. Eveready Spinning Mills Private Limited, Represented by its Joint Managing Director S. Chandrakumar. Versus The Assistant Commissioner, O/o. the Assistant Commissioner of Central GST & Central Excise, Dindigul - 2024 (7) TMI 1160 - MADRAS HIGH COURT. That case examined decisions of different High Courts and allowed a refund in similar circumstances, noting that the restrictive circular position could not override the statutory scheme. Vindhya Spinning Mills therefore does not stand alone. It continues a judicial line that gives primacy to Section 54(3)(ii) and Rule 89(5).

The Court's Relief Was Direct and Practical

The Madras High Court allowed both writ petitions. The rejection orders dated 17.03.2025 for January 2023 and 15.05.2025 for March 2023 were quashed. The Department was directed to process and sanction refunds of Rs. 10,88,231/- and Rs. 15,50,228/-, respectively, along with interest as per the CGST Act, 2017. The refunds had to be processed in accordance with the formula prescribed under Rule 89(5), after affording an opportunity of personal hearing, within three months.

This relief is important because the Court did not merely remand the matter for open-ended reconsideration. It clarified the legal basis and directed the processing of refunds in accordance with the statutory formula. The opportunity of hearing ensures procedural fairness, while the direction to apply Rule 89(5) ensures statutory computation.

The Practical Message for Refund Authorities

For refund authorities, the ruling provides a clear method. First, determine whether ITC accumulation arises because some inputs attract a higher rate than the output supplies. Secondly, do not confine the examination to the principal input. Thirdly, do not treat the valuation of finished goods or the absorption of input cost as a statutory bar. Fourthly, apply Rule 89(5) to compute the eligible refund. Finally, do not rely on circulars in a manner that narrows the statute.

This approach will reduce avoidable litigation. Many refund disputes arise because officers apply broad administrative assumptions instead of the statutory formula. Vindhya Spinning Mills reminds authorities that refund law is formula-driven once the statutory conditions are met. The Department may verify facts, documents, turnover, ITC and computation, but it should not reject the claim by importing a principal-input test.

The Practical Message for Taxpayers

For taxpayers, the ruling highlights the need to present an inverted duty refund claim as a clear statutory claim, not merely as a hardship claim. The refund file should show the tax rate on output supplies, the tax rates on all relevant inputs, the accumulation of ITC and the computation under Rule 89(5). Where the principal input and output carry the same rate, the taxpayer should specifically demonstrate how higher-rated ancillary inputs caused the accumulation. Proper invoices, credit ledger details and rate-wise workings will make the claim stronger and reduce the scope for rejection on the basis of circulars or valuation objections.

Inversion Is a Rate Question, Not a Principal-Input Question

Vindhya Spinning Mills lays down a clear rule. Inverted duty refund under Section 54(3)(ii) cannot be denied merely because the principal input and output supply carry the same GST rate. If other inputs attract higher GST and cause accumulation of ITC, the claim must be examined under the Rule 89(5) formula.

The judgment restores the statutory focus: compare the tax rate on inputs with that on output supplies, and then apply the prescribed formula. A principal-input filter or valuation-based objection cannot be added where the statute does not provide for it.