Supreme Court rejigs priority of tax dues under IBC

The Insolvency & Bankruptcy Code, 2016 (Code) provides a structure for realisation of debts owed to the creditors in the event of liquidation. In this structure, secured creditors are given preference to recover their dues over statutory dues / crown debts owed to the State. However, recently in State Tax Officer v. Rainbow Papers Ltd. (Rainbow Papers Judgement), the Supreme Court has reversed this settled position and has held that by virtue of a ‘security interest’ created in favour of the Government for tax claims arising under Gujarat Value Added Tax Act, 2003 (GVAT Act), the tax authorities i.e., the Government is a ‘secured creditor’ under the Code. The Court held that if a resolution plan excludes statutory dues payable to the Government, it cannot be said to be in conformity to the provisions of the Code and, as such, will be non-binding on the Government.

This decision of the Supreme Court has raised considerable apprehensions, and rightly so, on the aspect of priority of settlement of statutory dues under the Code. In the present article, we analyse the Rainbow Papers Judgement and offer our views, as to how the judgement contrasts with the objectives of the Code, and various precedents on this issue.

Brief facts

In 2016, recovery proceedings were initiated by tax authorities against Rainbow Papers Ltd. (Rainbow Papers) and subsequently its property was attached in October 2018 under the GVAT Act. Meanwhile, corporate insolvency resolution process (CIRP) was initiated against Rainbow Papers and the resolution professional invited claims from all creditors of Rainbow Papers. However, the tax authorities submitted their claims only after the approval of the resolution plan by the Committee of Creditors of Rainbow Papers, and therefore its claims were not considered. Aggrieved by this, the tax authorities filed an application before the National Company Law Tribunal (NCLT) claiming that the resolution plan is not in compliance with the provisions of the Code, as its dues under the GVAT Act have not been considered.

The NCLT passed an order rejecting the application filed by the tax authorities and this order was later upheld by the National Company Law Appellate Tribunal (NCLAT). The NCLAT’s order was challenged before the Supreme Court.

Ruling of the Supreme Court

The issue before the Supreme court was whether the provisions of the Code will prevail over the GVAT Act. The Supreme Court, overturning the orders of NCLT and NCLAT, held that:

(a)   As a statutory charge is created by the GVAT Act in favour of the Government, the claims of the tax authorities will fall within the meaning of ‘security interest’ as defined in the Code and accordingly, the State becomes a ‘secured creditor’;

(b)   A Resolution plan which ignores the statutory demands payable to any Government authority altogether, is invalid and bound to be rejected;

 (c)    GVAT Act is not contrary to or inconsistent with the Code; and

(d)   Financial creditors cannot secure their debts at the expense of the statutory dues which are owed to the Government.

In view of the above, the Supreme Court declared the resolution plan as invalid for ignoring the statutory dues of the tax authorities.

Our analysis

Legal framework of the Code

·        Definition of security interest under the Code

For analysing the observations of the Supreme Court, it is essential to look at the definition of ‘secured creditor’ and ‘security interest’ under the Code. Secured creditor means “a creditor in favour of whom security interest is created.” and security interest means “right, title or interest or a claim in a property, created in favour of, or provided for a secured creditor by a transaction which secures payment or performance of an obligation and includes mortgage, charge, hypothecation, assignment and encumbrance or any other agreement or arrangement securing payment or performance of any obligation of any person.”

Therefore, for a claim in a property to be considered as a ‘security interest’ under the Code, there has to be either a transaction or an agreement / arrangement which secures payment or performance of any obligation. The Code defines a ‘transfer’ to “includes sale, purchase, exchange, mortgage, pledge, gift, loan or any other form of transfer of right, title, possession or lien.” A bare reading of the definitions of ‘security interest’ and ‘transaction’ appears to indicate that the legislative intent of the Code was to limit the ‘security interest’ to consensual arrangement or a transaction between the corporate debtor and another party, and not to include statutory charges created in favour of tax authorities by operation of law.

In our humble view, charge created in favour of tax authorities under GVAT Act is by operation of law and not in the form of a transaction or agreement or an arrangement between the parties and therefore classifying tax authorities as ‘secured creditors’ seems to be inconsistent with the definition of ‘security interest’ and ‘secured creditor’ under the Code.

·        The Code expressly categorises Government dues as distinct from secured creditors

In most jurisdictions, creditors are classified either as secured creditors or unsecured creditors. However, a unique feature of the Code was the distinction between the financial and operational creditors, and their differential treatment with regards to recovery under the Code.

Financial creditors under the Code includes institution like banks and Non-Banking Financial Companies (NBFCs) which forms part of the banking system for providing loans and other lending services in furtherance of economic growth. The BLRC Report[1], which was the foundation of the Code, discusses the reasons for placing government dues below those of financial creditors in detail. Banks and financial institutions form the backbone of a robust economy as these institutions are responsible for availability of credit to businesses. The BLRC was of the view that priority for financial creditors will lead to availability of finance, reduction of cost of capital and economic growth in the long run. The BLRC reasoned that with economic growth, the exchequer would also benefit in terms of higher revenue from taxes and thus, the government was placed lower in the waterfall.

Thus, the view of the legislature is clear that government dues, which would include tax dues, are to be ranked lower than dues to financial creditors. Had the intent of the Code been to treat tax authorities as secured creditors, then there would have been no need of having a separate rank for Government dues in the waterfall mechanism. In our view, by bringing tax claims within the purview of ‘secured debt’, the Rainbow Papers Judgement defeats the purpose of the priority ranking and waterfall mechanism in Section 53 of the Code.

Precedents on the Code prevailing over tax legislations

In the past, there have been several instances where the Supreme Court has upheld the supremacy of the Code over tax legislations and the precedence of secured creditor dues over tax dues. In the very recent case of Sundaresh Bhatt v. Central Board of Indirect Taxes and Customs, the Supreme Court held that the Code has an overriding effect on the Customs Act. Interestingly, the Customs Act, akin to the GVAT Act, also creates a statutory charge in favour of customs authorities over the assets of the corporate debtor. In PCIT v. Monnet Ispat and Energy Ltd., the SC held that income-tax dues, being in the nature of crown debts, do not take precedence over secured creditors, who are private persons. Pertinently, none of these judgments have been considered in the Rainbow Papers Judgment.

Conclusion

In view of the above, this judgement has opened the gates for Government authorities to use the status of ‘secured creditors’ to claim recovery on par with secured financial creditors and workmen dues. The Rainbow Papers Judgement may also have drastic consequences for numerous corporate resolutions where resolution plans have been approved by the NCLT and which may have not regarded Government dues as ‘secured creditors’. It is sincerely recommended that the legislature immediately intervenes and clarifies through due amendments to the Code that the rights of the financial creditors are supreme and should prevail over any government dues to ensure that the key objective of the Code, i.e., rescuing the corporate debtor, continues to the primary aim of the Code.

Authors: Renjith Nair and Altamash Qureshi

The information contained in this document is not legal advice or legal opinion. The contents recorded in the said document are for informational purposes only and should not be used for commercial purposes. Acuity Law LLP disclaims all liability to any person for any loss or damage caused by errors or omissions, whether arising from negligence, accident, or any other cause.

[1] Report of the Bankruptcy Law Reforms Committee, Volume I (2015)