Section 16(2)(c) Reaches the Supreme Court: What the Apex Court Must Decide and How

[Daksh is a student at Gujarat National Law University.]

Recently, the Supreme Court of India (SC) has admitted a petition challenging the constitutionality of Section 16(2)(c) of the Central Goods and Services Tax Act 2017 (CGST Act 2017). This challenge comes in the backdrop of several conflicting High Court Judgements. The Tripura, Gauhati, Karnataka and Himachal Pradesh High Courts (HC) have read down the provision exempting bona fide purchasers from its application. At the same time, the Gujarat High Court has refused to do so in the 1 May 2026 judgement in Maruti Enterprise v. Union of India. SC will now have to settle what is perhaps the most consequential structural question in the GST’s 8-year existence: can a bona fide purchaser who has paid tax to a registered supplier, holds a valid invoice, and has filed all returns on time, still be denied input tax credit (ITC) solely because the supplier defaulted on depositing tax with the government?

This article analyses where the Gujarat HC got it right, where it did not go far enough, and what a complete and just SC ruling should look like.

Where Gujarat HC is Correct: GST is not DVAT

The primary precedent adopted by the different HCs in reading down Section 16(2)(c) of the CGST Act 2017 is the Delhi HC's judgment in On Quest Merchandising India (Private) Limited v. Government of NCT of Delhi, which read down the structurally similar Section 9(2)(g) of the Delhi Value Added Tax (DVAT) Act. The same was also upheld by the Supreme Court in Shanti Kiran India (Private) Limited. The Tripura HC in Sahil Enterprises and subsequently the Gauhati, Karnataka and Himachal Pradesh HCs have transplanted the same reasoning in interpreting Section 16(2)(c). 

The primary contribution of the Gujarat HC is its reasoning for why On Quest is inapplicable in the present scenario. It argues that DVAT and GST differ significantly in three crucial areas closely tied to the ITC problem.

First, the proviso to Section 41(2) of the CGST Act 2017 allows the purchaser to re-avail of the credit when the supplier pays the tax. This was absent in the DVAT regime. Both GST and DVAT require the purchasers to reverse ITC; however, only GST allows for re-availment of such credit. Rule 37A of the CGST rules gives effect to this by providing a grace period, giving the recipients until November 30 of the following financial year to reverse credit before any interest liability accrues. This is a structural response to the argument against double taxation, as ITC denial is not permanent but is contingent and reversible.

Second, Section 155 of the CGST Act 2017 places the burden of proof of ITC eligibility on the recipient, unlike the DVAT Act. The Delhi High Court in On Quest did not have the benefit of examining an equivalent provision. The Gujarat High Court correctly points out that when the legislature deliberately chooses to place the burden of proof on the claimant, the courts cannot undo that. 

Third, under Section 53 of the CGST Act 2017, tax collected on inter-state supplies must be transferred to the destination state. Now, as the Gujarat HC pointed out, if a supplier defaults and the recipient is still allowed to claim ITC, the originating state will be obligated to transfer funds to the destination state that it never received. The Kerala High Court in M Trade Links also pointed the aforementioned reasoning. Under the VAT regime, ITC did not cross state borders, and hence such cascading ramifications did not arise. However, such ramifications will affect the very structure of GST. 

The court stressed that the VAT and GST regimes are structurally different. The HCs, which have read down Section 16(2)(c) of the CGST Act by applying the On Quest ratio, did not take the benefit to examine the structural differences between the two regimes in this regard. The Gujarat HC was right in declining to follow them. The doctrine of reading down, as highlighted by the SC in Authorised Officer, CBI v. Shanmugavelu, is a tool for the courts to protect a provision from constitutional invalidity. Still, it cannot be used merely because the provision is harsh. 

Where the Gujarat High Court Falls Short: The Department Cannot Walk Away

Having correctly upheld the provision’s validity, the Gujarat HC then makes an observation that, with respect, is deeply problematic. The court suggests drawing on the European Court of Justice’s formulation in Axel Kittel, which holds that ITC can be denied where the recipient “knew or ought to have known” of fraud, and that bona fide purchasers can protect themselves through contractual indemnity clauses with their suppliers.

Both propositions deserve serious scrutiny, and the Supreme Court must address them head-on.

The Supreme Court cannot accept the Gujarat HC’s suggestion of contract indemnity. The responsibility to pay GST to the government is a statutory obligation under Section 9(1) of the CGST Act 2017 and is not a private contractual obligation. The enforcement of GST is the responsibility of the state, and it has its own machinery for notices, adjudication, recovery certificates, and attachment powers under the CGST Act 2017. In a scenario where the purchaser claims the reversed ITC from the supplier under the indemnity clause, and the state then enforces GST on the supplier, the supplier is subject to double taxation. The enforcement of GST cannot be outsourced to private contracts. 

Moreover, this would disproportionately disadvantage small and medium enterprises. The bargaining power in a market is unequal, and because of this asymmetrical distribution of power, small and medium enterprises cannot realistically negotiate ITC indemnity terms with large or dominant suppliers. The aim of GST was to streamline commerce, not introduce a new source of contractual uncertainty in ITC claims. 

Additionally, the Gujarat HC fails to place a condition for the Department to prove that proceedings have been initiated against the defaulting supplier before ITC can be denied to the purchaser. This is one of the fundamental preconditions that the SC should hold in its judgment. 

From a law-and-economics perspective, permitting the Revenue to deny ITC to purchasers without pursuing the supplier creates no incentive for the Revenue to do so. Naturally, the Department will choose the path with the lowest enforcement cost, which is to proceed against bona fide purchasers, as they are easier to identify and recover from than tracing suppliers who would otherwise have absconded or become judgment-proof. This produces a classic moral hazard problem; once a State recovers revenue from innocent purchasers, its incentive to investigate and prosecute diminishes. 

The SC should thus hold that the Revenue, before confirming the denial of ITC to the purchaser, must mandatorily demonstrate that recovery proceedings have been initiated against the supplier. The SC can also carve out some exceptions that (a) the supplier is missing, cannot be traced, or has no recoverable assets, and (b) there is material evidence of collusion or connivance between the supplier and the purchaser. 

This is not reading down the provision to preserve the constitutionality of Section 16(2)(c); however, it is reading the provision alongside Sections 73, 74 and 78 of the CGST Act 2017. It holds that the extensive powers of the Revenue should be exercised in a more sequenced and purposive manner. 

What the Supreme Court's Ruling Should Contain

Synthesising the above, the Supreme Court's ruling should:

Uphold the constitutionality of Section 16(2)(c) of CGST Act 2017

Considering the proviso to Section 41(2) of the CGST Act 2017 in conjunction with Rule 37A of the CGST rules, it is argued that the provision does not violate Article 14, Article 19(1)(g), Article 265 or 300A of the Constitution. The legislature can lay down the conditions for ITC, and the provision has a rational nexus with tax leakage and tax fraud.

Explain that the Delhi HC decision in On Quest cannot be considered in the context of the GST regime

The principles of GST are very different from those of the DVAT system, especially in terms of the requirements for matching returns, compliance requirements for suppliers and the necessary safeguards.

Hold that before denying ITC to a bona fide purchaser, the Revenue should show reasonable enforcement efforts against the defaulting supplier

Exceptions can be recognised in situations where there has been collusion, fake invoicing, non-existent suppliers or other fraudulent schemes.

Reject contractual indemnity as a sufficient remedy

It is not always feasible to impose the burden on the buyer through private contracts, and such contracts rarely provide adequate safeguards for would-be taxpayers.

Recommend structural reforms

The court should encourage Parliament and GST Council to implement a Split Payment Mechanism as done in Italy, Poland and Azerbaijan and also ensure tax payment visibility at the invoice level on the GSTN portal to minimise tax fraud and to enhance compliance.

Conclusion

As the Gujarat HC correctly holds, Section 16(2)(c) of the CGST Act 2017 is not constitutionally infirm. But a constitutionally valid provision can be applied unjustly. This is where the SC needs to step in. The SC should protect the rights of bona fide purchasers while also taking into account the aim and structure of the CGST Act 2017. The answer is not to read the provision down; rather, it is to hold that the law must be read with the law's intent and enforced against the right people in the right order.