Denial of Input Tax Credit to Bona Fide Purchasers: Re-examining Section 16(2)(c) in Light of Section 76

An analysis of the denial of input tax credit to bona fide purchasers under Section 16(2)(c) of the CGST Act, examining supplier defaults, Section 76 as a recovery mechanism, constitutional concerns under Articles 14 and 19(1)(g), and the case for targeted enforcement against fraudulent transactions.

Introduction

One of the major issues in the goods and services tax (GST) regime is the denial of input tax credit (ITC) to bona fide purchasers due to suppliers’ failure to remit the tax to the Government. The core foundation of the GST system was to eliminate the cascading effect and act as a value-added system. Accordingly, the final consumer is supposed to bear the tax burden and not the businesses involved in the supply chain.

A registered individual can avail ITC for the taxes paid on purchases made during the course of business after meeting all the required conditions mentioned under Section 16, Central Goods and Services Tax Act, 2017 (CGST Act). Practically, however, the purchaser can still be denied ITC even after fulfilling all its responsibilities due to supplier’s non-performance, which has also resulted in numerous lawsuits. This denial poses questions on tax neutrality, fairness, obligations, and the overall negative effect on the purchaser due to the supplier’s default.

This dilemma requires more discussion through a comprehensive legal and constitutional lens, especially after the recent judicial development where the Supreme Court stated the reading down approach in cases involving similar provisions under the former value-added tax (VAT) regime.

Section 76: The statutory remedy against defaulting suppliers and its implications for Section 16(2)(c)

One of the crucial provisions that becomes relevant in this discussion is Section 76, CGST Act that specifically deals with defaulting suppliers. It not only defines a proper procedure for recovery but also reflects the intent of the legislature. It begins with a non obstante clause and mandates every individual to remit the collected tax to the Government regardless of whether the supply was taxable or not. This non obstante clause gives this section an overriding effect over any other contrary laws mentioned within the statute. Further, the section provides a detailed procedure for recovery, including show-cause notices, assessment of liability, application of interest, and imposition of penalties.

Section 16, CGST Act, becomes relevant in this discussion as it outlines specific conditions required to claim ITC, including: 1) possession of a valid tax invoice or debit note, 2) receipt of goods or services, 3) filing of prescribed returns, and 4) payment of tax by the supplier to the Government. The first 3 conditions are reasonable and within the control of the purchaser, whereas the fourth condition mentioned under Section 16(2)(c) becomes problematic. The requirement of remitting the tax to the Government by the supplier is completely out of the purchaser’s control and obligations.

In R.K. Transport & Constructions Ltd. v. State of Jharkhand¹, the Court acknowledges that the purchaser should not be punished due to the supplier’s failure. The purchaser’s ITC was denied even after possessing valid invoices, as the supplier did not file GSTR-1 and remit the collected tax. The Court held that Section 76 applies to “every person” who collects taxes and who fails to deposit the same with the Government. Finally, the Court directed the authorities to take action against the supplier under Section 76 instead of denying ITC to the genuine purchaser.

The constitutional protection for bona fide purchasers

A bona fide purchaser can be defined as one who purchased goods genuinely, paid GST, received goods/services, possesses proper invoices, complies with GST requirements, and is not involved in any kind of fraud. However, a default by the supplier can lead to the denial of ITC to a purchaser who has performed all its legal obligations. Section 76 particularly addresses the issue created under Section 16(2)(c).

A strict interpretation of Section 16(2)(c) raises constitutional concerns under Article 14 as it becomes arbitrary and unreasonable for the purchaser to face negative consequences for a circumstance beyond their control and knowledge. The purchaser has no authority or means to guarantee that the supplier remits the tax to the Government. The denial of ITC due to the misconduct of the supplier violates the principle of non-arbitrariness, proportionality, and fairness. In the case of National Plasto Moulding v. State of Assam², the Gauhati High Court overturned the demand orders against the purchaser, stating that the denial of ITC to bona fide purchasers due to the default of the supplier is a violation of Article 14 of the Constitution.

The landmark case that protects bona fide purchasers is the case of Arise India Ltd. v. CTT³. In this case, the Delhi High Court dealt with Section 9(2)(g), Delhi Value Added Tax Act, 2004 (DVAT Act) and held that this denial of ITC due to the supplier’s default was violative of Article 14 and caused undue hardship to the purchaser. The Supreme Court later dismissed the Revenue’s appeal in 2018, thereby solidifying this principle. The Supreme Court again reaffirmed the same principle in CTT v. Shanti Kiran India (P) Ltd.⁴ The court held that the rejection of ITC is only reasonable in the case of fraud, conspiracy, or the purchaser’s deliberate involvement. Otherwise, in all other cases, an action should be taken against the defaulting supplier.

These rulings clarify that an innocent purchaser should not be adversely affected by the action of the supplier that is beyond the purchaser’s control. The Supreme Court’s interpretations in Arise India case and Shanti Kiran case set a constitutional principle that is applicable to the whole indirect tax system, not just the DVAT Act.

The need to read down Section 16(2)(c): Targeted enforcement over blanket ITC denial

These pointers support reading down Section 16(2)(c), where the courts apply a restricted interpretation to prevent any arbitrary or unreasonable outcomes. The strict application of Section 16(2)(c) should only be done in the case of fraud, fake invoices, dishonest acts, and collusion with the supplier. It is important to distinguish between honest and fraudulent claimants.

The denial of ITC is more administratively convenient and protects against tax evasion or false ITC claims. It ensures that the credit is only granted when the tax has reached the Government’s treasury. On the contrary, it can be argued that waiving this strict interpretation of the condition can cause significant revenue leakage and harm the integrity of the GST system. However, practically, this condition requires the purchaser to guarantee something beyond its control and information. The purchaser has no legal means to access the supplier’s tax records, verify compliance, or force the supplier to remit the tax.

Alternative enforcement tools

This complication can be addressed through focused enforcement tools and compliance mechanisms under the GST regime. Mechanisms like data analytics, business intelligence tools, and fraud detection systems can be used to discover suspect transactions and false invoice networks.

Importantly, the legislative framework should also introduce a system that helps the purchaser track the supplier’s compliance. Under the CGST Act, Section 149 proposed a compliance-rating system that would allow recipients to assess the reliability of suppliers, and also Section 159 authorises the publication of tax defaulters’ names. This would help buyers identify risky suppliers, but unfortunately, this system was never fully implemented.

Conclusion

This debate raises a fundamental question of whether a genuine purchaser who has fulfilled all legal obligations should be denied an ITC claim due to the independent default of the supplier. This should be answered through an overall constitutional and legal lens rather than just the strict interpretation of the provisions.

The principle should be straightforward that the criteria for rejection of the ITC should align with the information reasonably available to the purchaser. It is unfair to the purchaser who has paid GST on supplies during the course of business to face consequences and be accountable for the non-compliance by the supplier.

Section 76 already provides a comprehensive procedure to recover tax from the defaulters. Further, a strict application of Section 16(2)(c) infringes Articles 14 and 19(1)(g) by imposing an adverse condition on the purchaser. It is unfair to deny ITC to bona fide purchasers until procedures mentioned under Section 76 are exhausted, and purchasers are given authority with adequate tools to evaluate supplier compliance. Hence, Section 16(2)(c) should only be strictly applied in cases of fraud and tax evasion. This approach would help safeguard the integrity of the GST regime and also the constitutional rights of genuine taxpayers.