UPI MDR and GST 2026: ITC Treatment & Tax on MDR Explained

What Happened?

The GST authorities have recently clarified the treatment of GST levied on Merchant Discount Rate (MDR) charged by payment processors on UPI transactions. This update addresses a long-standing confusion about whether GST on MDR constitutes 'tax on tax' and clarifies the Input Tax Credit (ITC) eligibility for businesses receiving UPI payments. The clarification is particularly relevant for Assessment Year 2025-26 and 2026-27 filings.

Background & Legal Context

What is UPI MDR?

Merchant Discount Rate (MDR) is the commission charged by payment processors (like NPCI, banks, and fintech companies) to merchants for accepting UPI payments. Under the Pradhan Mantri Digital India Campaign, UPI MDR rates are capped at specific percentages depending on the transaction value and merchant category.

Current MDR Caps (as of 2026):

• Small merchants and retail stores: Up to 0.3% on transactions up to ₹2,000
• QR code-based payments: 0% (zero MDR subsidy by NPCI)
• Large e-commerce platforms: Up to 0.6-1.1% depending on volume and transaction value
• Government to Government (G2G) transactions: 0% MDR

GST on MDR Under GST Act:

MDR is classified as a 'service' under the GST regime. The MDR charged by payment processors attracts GST at 18% on the MDR amount. This means:

• If a merchant pays ₹100 as MDR, GST of ₹18 is charged separately (₹100 + ₹18 = ₹118 total cost)
• The merchant's effective cost of accepting UPI payments includes both the MDR and GST on MDR
• This applies to all merchants regardless of their turnover or GST registration status

Section References Under Income Tax Act 2025:

• Section 37(1) of Income Tax Act 2025: Allows deduction of business expenditure incurred wholly and exclusively for purposes of business. MDR paid by merchants is a business expense and qualifies for deduction under this section.
• Section 40(a)(ia) of Income Tax Act 2025 (old Section 40(a)(ia) of 1961 Act still applies): Restricts deduction of certain expenses where tax is not paid. However, this does NOT apply to MDR expenses as they are not in the restricted category.

GST Law Reference:

Under CGST Act 2017 and SGST Act 2017, Input Tax Credit (ITC) is allowed on GST paid on goods and services used in the course of business. The key question is: Can businesses claim ITC on GST paid on MDR?

What Does This Mean for You?

For Merchants and Small Businesses:

If you are a GST-registered merchant accepting UPI payments, you can claim Input Tax Credit on the GST charged on MDR, provided the following conditions are met:

• You are registered under GST
• The MDR paid is for accepting payments related to your taxable supplies
• You have valid GST invoices from the payment processor showing MDR and GST separately
• You maintain proper documentation and records

Is GST on MDR a 'Tax on Tax'?

This is the critical question. The answer is NO — GST on MDR is NOT considered 'tax on tax' because:

• MDR is a service fee, not a tax. Payment processors are providing a service (payment aggregation, settlement, security, etc.)
• GST is levied on the value of this service, not on the GST itself
• The GST on MDR is a legitimate input tax that qualifies for ITC under GST law
• If ITC is denied, it would create a cascading effect, which GST law aims to prevent

Accounting Treatment:

The correct accounting treatment is:

• Books of Account: Record MDR separately from GST on MDR
• MDR Expense: Debit to 'Payment Gateway/Processing Charges' account (business expense)
• GST on MDR: Record as Input Tax Credit if you are GST-registered
• Income Tax: Both MDR and GST on MDR are deductible under Section 37(1) for unregistered merchants. For GST-registered merchants, only the MDR is deductible, with GST claimed as ITC

Practical Example (AY 2025-26):

You are a GST-registered retail merchant with ₹50 lakh annual turnover. You accept UPI payments worth ₹10 lakh in a financial year. Your MDR is charged at 0.3% = ₹3,000. GST on MDR = ₹540 (18% of ₹3,000).

• Total payment processor cost = ₹3,540
• For Income Tax: Deduct ₹3,000 (MDR) under Section 37(1)
• For GST: Claim ITC of ₹540
• Net cost after ITC = ₹3,000 (approximately, depending on your output GST liability)

For Non-Registered Merchants:

If you are not GST-registered, you cannot claim ITC. However, you can still deduct the total cost (MDR + GST on MDR) as a business expense under Section 37(1) of the Income Tax Act 2025 for income tax purposes.

RBI & NPCI Guidelines (2026 Status):

The RBI continues to push for higher MDR subsidy to encourage digital payments. Currently, NPCI offers 0% MDR for QR code payments (with banks absorbing the cost). This incentive is independent of GST — GST is still charged on any service fee component paid by merchants.

What Should You Do Now?

Immediate Actions:

• Audit Your Payments: Review all MDR payments made in FY 2025-26 and FY 2026-27. Check your bank statements and payment processor invoices.
• Verify Invoice Details: Ensure your payment processor invoices clearly show MDR and GST on MDR separately. If not, request corrected invoices.
• Check GST Registration: Confirm your GST registration status. Only registered merchants can claim ITC on GST paid on MDR.
• Update Accounting Records: Reclassify any MDR entries that were incorrectly recorded as part of general expenses. Create a separate line item for payment processing charges.
• ITC Documentation: Maintain GST invoices showing MDR and GST separately in GSTR-2 filings (for GST purposes) and keep copies for Income Tax records.

For Your ITR Filing (AY 2026-27):

• Claim MDR as a deductible business expense under Section 37(1) in your P&L statement
• If GST-registered, also claim corresponding ITC in your GST return (GSTR-1 and GSTR-3B)
• Maintain reconciliation between your income tax deduction and GST ITC claim to avoid audit red flags

If Facing Audit/Scrutiny:

If the Income Tax Department questions your MDR deduction or GST ITC claim, respond with:

• GST invoices from payment processors showing itemized MDR and GST
• Bank statements showing MDR deductions
• GST returns (GSTR-1, GSTR-3B, GSTR-9) showing ITC claimed
• Business records showing these are necessary expenses for accepting digital payments

Key Takeaways

• GST on MDR is NOT tax on tax: MDR is a service fee, and GST on it is a legitimate input tax qualifying for ITC under GST law.
• ITC Eligibility: Only GST-registered merchants can claim ITC on GST paid on MDR. Unregistered merchants can deduct the full amount (MDR + GST on MDR) as a business expense under Section 37(1).
• Accounting Requirement: Maintain separate records of MDR and GST on MDR. Ensure invoices from payment processors show both components clearly.
• MDR Caps Remain Unchanged: As of 2026, MDR caps continue for small merchants (0.3%), QR codes (0%), and large platforms (0.6-1.1%). GST is charged on any MDR paid.
• Documentation is Critical: Keep all payment processor invoices, bank statements, and GST return copies ready for Income Tax and GST compliance during AY 2025-26 and 2026-27.

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