Before the introduction of Goods and Services Tax (“GST”), the Centre and the States used to levy various indirect taxes such as Service Tax, Central Sales Tax, Central Excise Duty, State Value Added Tax, Entry Tax, Luxury Tax etc., within their exclusive jurisdiction, based on the subjects assigned to them by the Constitution of India. On July 1, 2017, GST was brought into effect, subsuming most of the indirect taxes levied by the Centre and State into a single tax. This gave rise to a legitimate concern among the States that the implementation of GST could result in a considerable erosion of their revenue base and, hence, an apprehension to give up the exclusive taxing rights was seen amongst various States.
To protect the revenue of the States and to compensate them for the loss of revenue on account of the introduction of GST, the Constitution (One Hundred and First Amendment) Act, 2016 vide Section 18, empowered the parliament to compensate the State for loss of revenue due to implementation of GST upon recommendation of the GST Council for a period of five years. Accordingly, the Goods and Services Tax (Compensation to States) Act, 2017 (“Compensation Act”) was enacted on the recommendations of the GST Council.
The government identified the ‘sin’ goods or ‘luxury’ goods such as pan masala, aerated drinks, tobacco items, coal, and motor vehicles vide Notification No. 01/2017- compensation cess (Rate) dated 28.06.2017 (hereinafter referred to as “Notification dated 28.06.2017”). Further, compensation cess on all goods other than those specified in the Notification was prescribed as ‘Nil’ under Entry 56 of the said Notification. The amount collected as compensation cess was credited to the GST compensation fund made under Section 10 of the Compensation Act from which the compensation is paid to the States.
The projected nominal growth rate was estimated at 14% per annum over the base year revenue (i.e. 2015-2016) of the respective State. If the State’s revenue during a particular year falls short of the projected revenue, the State shall be compensated on the difference between the projected revenue and the actual revenue in terms of Section 7(3)(c) of the Compensation Act.
Initially, the compensation cess was brought in as a temporary measure applicable for a transition period of five years, as per Section 2(r) of the Compensation Act, during which the cess was planned to be levied to create a compensation pool for the states for the potential revenue losses. Due to the pandemic, there was a decline in cess revenue and a stark increase in compensation requirements. The Centre met this gap by borrowing through a special RBI window. To repay these borrowings, the initial transition period was extended until March 31, 2026.
From the FAQs published post 56th GST Council Meeting held on September 3, 2025, it can be inferred that the Council recommended to end the levy of compensation cess and merge the same with GST with effect from September 22, 2025 for all goods except tobacco and related products. The continuation of the cess on a few products was to enable the Centre to discharge the interest and loan obligations undertaken by them to make up for the revenue deficit during the period 2020-21 and 2021-22. The merger of rates meant that the basic GST tax rates were increased to maintain the pre-rationalization level of tax and a special rate of 40% GST was imposed, without there being any amount levied as compensation cess. This special rate of tax has been made applicable only to the sin and luxury goods, most of which attracted compensation cess in addition to GST.
The corresponding notification issued for implementing the proposal, i.e. Notification No. 2/2025-compensation cess (Rate) dated 17.09.2025 (“Notification dated 17.09.2025”) which was issued under Section 8(2) of the Compensation Act amending the Notification dated 28.06.2017, indicated that the revised rates of cess for sin goods including motor vehicles, coal, motor cars etc., with effect from September 22, 2025, except tobacco and related products was ‘NIL’.
Input Tax Credit (“ITC”) is a mechanism introduced under the GST regime to prevent the cascading effect of taxes and to ensure a seamless flow of credit across the supply chain. The tax paid under CGST/SGST/IGST on the inputs/input services is allowed to be set off against the outward tax liability. Similarly, the credit accumulated on account of compensation cess paid on inputs is allowed to be set off against the outward tax liability. But this set-off is limited only to compensation cess, i.e. no cross-utilization of funds is allowed, as available under heads of CGST, SGST and IGST. This restriction has been specifically stated under a proviso to Section 11 of the Compensation Act, which allows such credit to be used solely against compensation cess liability.
With the compensation cess set at ‘Nil’, various industries engaged in the supply of goods that were subjected to cess earlier are facing credit blockage on the goods held in stock, as they were subjected to cess at the time of procurement, but are subjected to a higher rate of GST at the time of clearance without compensation cess. Owing to the nil rate of compensation cess on motor cars, questions persist among the automobile industry concerning the treatment of unutilized compensation cess credit to the extent of ₹2500 crores. A request was made by the Federation of Automobile Dealers Association (“FADA”) to the Finance Minister to transfer the unutilized compensation credit to IGST/CGST credit ledger by 21.09.2025. Further, FADA has moved the Supreme Court seeking relief on the unutilized ITC pertaining to compensation cess post 22.09.2025. They are seeking to either allow an adjustment of the accumulated compensation cess credit against outward liability under CGST/IGST Act or refund of the same, failing which the credit will continue to remain blocked.
As there is no mechanism provided with respect to the utilization/adjustment/transfer/refund of the remaining balance lying the compensation cess credit ledger, the major concern that arises post issuance of Notification dated 17.09.2025 is on future utilisation of the accumulated credit of compensation cess, majorly for businesses with exorbitant amount of unutilized compensation cess credit which cannot be set-off as the outward cess liability turns out to be nil.
In Part 2, we will deliberate on the impact of the Notification dated 17.09.2025 and examine potential mechanisms to utilize the blocked compensation cess credit.
About the authors: Rishab J is an Associate Partner, Shri Gayathri and Princess Preet Kaur are Associates at Shivadass and Shivadass (Law Chambers).
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