Staying indemnified through vendor’s tax defaults

Commercial contracts do not conclude with mere supply and payment. There is yet another key element that warrants attention, namely the taxes, i.e., Goods and Services Tax (‘GST’). One of the facets of an indirect tax system is that the tax paid by a business entity can be used to set off their tax liabilities against the supplies to be made in future, subject to conditions. The recipient, who pays the tax to the vendor at the first instance is enabled this credit of taxes so paid. This credit is referred to as Input Tax Credit (‘ITC’) in GST. It is incumbent on the vendor / supplier to comply with the requirements under the law to enable the recipient to avail the ITC, the absence of which leads to a loss in the hands of the recipient. The vendor is required to report the supplies correctly, file their returns, and make the payment of tax with the government to ensure the recipient is enabled to avail the ITC. When the vendor, however, defaults, it is necessary to contractually fix guardrails to sufficiently insulate against the loss of ITC that may ensue.

ITC is not viewed as a vested right, rather an entitlement subject to conditions prescribed under law. The Central Goods and Services Tax Act, 2017 (‘CGST Act’) vide Section 16 sets out the conditions to avail ITC out of the same. One of the often litigated conditions is Section 16(2)(c) of the CGST Act which provides that credit can be availed by the recipient subject to the condition that tax charged in respect of such supply has been actually paid to the government.

In any commercial transaction, the tax so paid to the vendor is available as ITC in the hands of the recipient provided the vendor ‘reports’, ‘reports correctly’, and also ‘pays the tax.'

Vendor default includes situations where the supplies are not reported correctly, leading to a mismatch in the information and loss of ITC in the hands of the recipient. Further, the vendor may also defer the payment of tax to the government, or may end up not paying the tax to the government, after having collected the same from the recipient. Of the varied vendor defaults, non-payment of tax into the government’s coffers is a situation that does not lie in the realm or control of the recipient. 

Section 16(2)(c) has been subject to constitutional challenge across the country. Courts have drawn an analogy from a similarly placed provision under the Delhi Value Added Tax Act, 2004 (‘DVAT’), to hold that this condition is onerous. Pertinently, in Sahil Enterprises v. Union of India 2026 (105) G.S.T.L. 177 (Tripura), the provision was read down to apply only to fraudulent transactions, on account of the recipient of goods being made to perform the impossible, i.e., push the vendor to pay the tax. Strength was drawn from decisions rendered in the context of DVAT to conclude in Sahil. On a contrast, the decision in Maruti Enterprise v. Union of India 2026 (109) G.S.T.L. 97 (Guj.)], upheld the constitutional validity of the provision distinguishing the DVAT position.

Recently, in Bhandari Scrap Traders v. Union of India and Ors. (SLP (C) 23921 of 2026 vide order dated 24.07.2026), arising on appeal against the batch in Maruti Enterprise, a quietus has been rendered. The Supreme Court has affirmed the decision rendered by the Gujarat High Court in Maruti Enterprises, while taking note of the Gujarat High Court’s reasoning on the difference between DVAT and the GST laws, and the mechanism of re-credit that is available for recipients of supply when tax is ultimately paid by the vendor. The High Court held that when the vendor fails to pay the tax to the government, it is incumbent on the recipient to reverse the credit so availed, and a re-credit can be availed when tax has been subsequently paid by the vendor as per Rule 37A of the Central Goods and Services Tax, Rules, 2017 (‘CGST Rules’). Such a restriction was viewed as necessary to protect the interest of the government.

The immediate commercial impact in the hands of the recipient is the loss of ITC, even if it is temporary. This is coupled with the recipient bringing in cash or other credits to meet their obligation of taxes. In addition, the recipient also suffers the risk of being subject to proceedings for wrongful availment of credit in the hands of the GST department, along with a demand for interest and penalty. This is in addition to a separate commercial dispute that gets staked with the vendor for the loss suffered. It cannot be ruled out that these proceedings are a costly affair, especially when the quantum of ITC is substantial, and is coupled with a demand for interest and penalty.

With the law as it stands today, it is expedient to contractually agree upon guardrails between the parties, in the following manner to minimise the loss for the recipient of supplies:

(a) When the vendor delays payment of tax: The varied loss caused due to delay by the vendor in paying the tax with the government can be insulated by way of warranties and indemnities. The contract should carry a warranty clause that tax will be paid to the government, within a particular time limit. The contract should be structured in a manner that indemnity ensues when there is a breach of the warranty of payment of tax.

Indemnity enforcement may also entail litigations. Therefore, it is ideal to structure the contract where indemnities are ensured to be automatic or with an option to set off against subsequent payments to be made in supplies that are continuous. Automatic indemnities can be brought to “hold harmless” than to “make good."

There may be genuine difficulties for the vendors to pay the tax. Such indemnity clauses should also be structured with a reverse indemnity to pay back the monies, in a situation where the vendor at a future date makes good the payment of tax to the government. Such measures would also ensure the commercial relationship between parties remain unaffected. 

(b) When there is certainty of non-payment: When the vendor’s registration is cancelled, and/ or the business ceases, or a case where the vendor becomes insolvent, it is certain that the ITC is lost permanently. Such situations can be guard railed through a corporate guarantee from a group entity or a parent concern, to make good the loss. The recipient can also obtain tax liability insurance in situations of certainty of loss not being made good.

The law as it thus stands today imposes an added burden to ensure tax paid to the vendor reaches the coffers of the government. While exercising diligence is the key to identifying vendors, it is also necessary to contractually safeguard, to minimise these risks, at the least till the legislature comes up with its own device to protect the interests of the recipient of supplies. Anticipating proceedings, it is ideal to revisit the contracts and firm up indemnity obligations.

About the author: Shwetha Vasudevan is an Advocate practicing before the Madras High Court.

Disclaimer: The opinions expressed in this article are those of the author(s). The opinions presented do not necessarily reflect the views of Bar & Bench.

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