Bona Fide Purchaser's ITC Claim Valid Even If Seller Defaults On Tax Remittance Under KVAT Act: Kerala High Court Full Bench - 2025-10-10

Kerala HC Full Bench Rules Purchaser Can't Be Denied Input Tax Credit for Seller's Default; Overrules 'C.P. Rasheed'

The court affirmed that as long as the purchasing dealer complies with all statutory requirements, their right to ITC is protected, placing the onus on tax authorities to pursue defaulting sellers.

In a landmark decision with significant implications for businesses across the state, a Full Bench of the Kerala High Court has ruled that a purchasing dealer cannot be denied the benefit of Input Tax Credit (ITC) solely because the selling dealer failed to remit the collected tax to the government. The bench, comprising Justice Devan Ramachandran, Justice Gopinath P., and Justice Mohammed Nias C.P., held that the right to claim ITC is established by the purchaser's compliance with statutory norms, such as possessing a valid tax invoice.

The ruling, delivered in a batch of petitions led by S.P. Faizal v. State of Kerala , decisively overrules the previous Division Bench judgment in * C.P. Rasheed v. State of Kerala *, which had linked the purchaser's ITC eligibility to the seller's actual tax remittance.

Case Background

The central legal question referred to the Full Bench was whether the credit of input tax can be availed by a purchasing dealer if the selling dealer, after collecting the tax, defaulted on their payment to the state treasury under the Kerala Value Added Tax Act, 2003 (KVAT Act).

The petitioners, all registered dealers, were denied ITC by tax authorities on the grounds that their suppliers had not deposited the collected tax. They argued that they had fulfilled their obligations by paying the full invoice amount, including tax, to the registered selling dealers and should not be penalized for a third party's default.

Arguments Presented

Petitioners' Stance: The dealers, represented by Senior Counsel Sri. A Kumar among others, argued that the definition of "input tax" under Section 2(xxiii) of the KVAT Act as tax "paid or payable" establishes credit entitlement based on the legal obligation to pay, not the seller's subsequent action of remittance. They contended that denying ITC to a compliant buyer for the seller's fault amounts to double taxation and places an impossible burden on them to monitor their suppliers' tax compliance. They heavily relied on judgments from the Delhi and Madras High Courts, particularly On Quest Merchandising , which held that the revenue department's remedy is to proceed against the defaulting seller, not the bona fide purchaser.

State's Stance: The State, represented by Special Government Pleader (Taxes) Sri. Mohammed Rafiq, argued that ITC is a "statutory concession" contingent upon the actual receipt of tax into the government treasury. Allowing credit without corresponding remittance would create a revenue shortfall. The State maintained that the denial of ITC was a necessary safeguard against revenue leakage and that the matching of returns between sellers and purchasers was a vital part of the VAT system's integrity.

Court's Reasoning and Legal Precedents

The Full Bench, in an order authored by Justice Mohammed Nias C.P., undertook a detailed analysis of the KVAT Act's provisions. The court emphasized the legislative intent behind the phrase "paid or payable" in the definition of input tax.

> "...This definition assumes particular significance in the present context as it employs the disjunctive 'or,' thereby creating two alternative and independent bases for credit entitlement, clarifying that ITC arises from either the actual payment of tax or the legal obligation to pay, irrespective of whether the seller later remits the tax to the government."

The court observed that the statutory conditions for claiming ITC, detailed in Section 11 of the KVAT Act, focus exclusively on the purchasing dealer's documentary compliance, such as possessing a valid tax invoice. There is no provision requiring the purchaser to ensure the seller's tax remittance.

The Bench found the reasoning in the Delhi High Court's On Quest Merchandising decision compelling, noting it protects bona fide commercial transactions and aligns with the VAT system's objective of preventing the cascading effect of taxes. The court highlighted that the State is fully empowered to recover dues from defaulting sellers under Sections 31 and 35 of the Act.

Overruling C.P. Rasheed

In decisively overruling the C.P. Rasheed judgment, the Full Bench stated that the earlier decision had several flaws:

1. It ignored the "paid or payable" definition of input tax.

2. It failed to consider the State's specific recovery powers against defaulting sellers.

3. It created an arbitrary classification between bona fide purchasers based on the actions of their sellers, violating Article 14 of the Constitution.

4. It imposed an impractical and unfair burden on compliant businesses, undermining the core principles of the VAT system.

The court warned that upholding C.P. Rasheed would "encourage defaulters and discourage those who abide by the law," leading to an absurd and unjust outcome.

Final Decision and Implications

The Full Bench answered the reference by holding that:

1. A purchasing dealer can legitimately claim ITC under the KVAT Act even if the selling dealer fails to remit tax, provided the purchaser has complied with all statutory requirements, including having a genuine tax invoice.

2. The responsibility to recover unpaid tax lies with the tax authorities, who must proceed against the defaulting seller.

This judgment provides much-needed clarity and relief to the business community, reinforcing the principle that a taxpayer who has fulfilled all their legal obligations cannot be held responsible for the defaults of another. It strengthens the integrity of the ITC mechanism by placing the burden of enforcement on the state authorities where it rightfully belongs.