Indian Supreme Court’s Judgment on Priority of Tax Dues in Insolvency—A Setback for the IBC?

Over the past few months, several judgments of the Indian Supreme Court on the Insolvency and Bankruptcy Code, 2016 (IBC) have departed from the scheme and broader purpose of the legislation. Read in isolation and within the narrow confines of the facts in question, these judgments could perhaps appear logical. However, considered in the context of the IBC and the intent of the legislation, the judgments contradict not only specific provisions of the IBC, but also prior judicial pronouncements (including from the Supreme Court itself) on similar questions.

One such judgment is the much talked about case of Vidarbha Industries Power Limited v Axis Bank Limited, which suggested that the National Company Law Tribunal must exercise discretion on whether to admit or reject an insolvency application even in cases where the financial creditor had proved the existence of debt and default as required under the legislation. Interestingly, the Supreme Court has now agreed to review the Vidarbha judgment, and it is hoped that it will close the Pandora’s box that this judgment may have opened. Another decision, which is the subject of this post, is the Supreme Court’s judgment in early September on the priority of dues owed to tax authorities in the corporate insolvency resolution process.

In State Tax Officer v. Rainbow Papers Limited, the Gujarat state tax authorities claimed that the tax authority should be treated as a secured creditor, owing to a provision in the Gujarat Value Added Tax Act (GVAT Act). The state tax authorities cited the GVAT Act to demonstrate that taxes owed by the debtor company were subject to a statutory first ranking charge over its property in favour of the tax authority. The National Company Law Appellate Tribunal (NCLAT) rejected the tax authority’s claim on the grounds that, in view of the non-obstante clause in the IBC, the GVAT Act could not prevail over the priority of payments under Section 53 of the IBC, which clearly treated government dues differently from debt owed to secured creditors. In addition, the NCLAT pointed out that the tax authority had filed its claim with the resolution professional after the prescribed time period and the resolution professional had, thus, rightly rejected its claim.

The Supreme Court overruled the NCLAT’s judgment to hold that the state tax authority is a secured creditor and, as a consequence, these tax dues rank equally with dues owed to other secured creditors. The judgment then goes on to make a broad pronouncement that the adjudicating authority is bound to reject any resolution plan that ‘ignores the statutory demands payable to any State government or a legal authority.’ The Court also dealt with and summarily dismissed the fact that the tax authority had lodged its claim late on the basis that the time period specified under the regulations is a recommendation and not mandatory.

Considered in a vacuum, it may be logical to conclude that the state tax authority is a secured creditor by virtue of the charge created in its favour by operation of law. However, a review of the IBC as well as the legislative intent behind the law as evidenced in reports such as that of the Bankruptcy Law Reform Committee (BLRC) reveals that tax authorities were not intended to be treated on  par with secured financial creditors. The report of the BLRC makes clear the intention to lower the priority accorded to ‘crown debt’ in insolvency, a move that had been taken in other jurisdictions including the United Kingdom with the enactment of the Enterprise Act of 2002. This intent is also set out as one of the objectives in the preamble to the IBC which includes ‘alteration in the order of priority of payment of Government dues…’.

Even keeping legislative intent aside, the text of Section 53 itself specifies how statutory dues are to be treated. While Section 53(1)(b)(ii) refers to ‘debts owed to a secured creditor in the event such secured creditor has relinquished security in the manner set out in section 52’, dues owed to government authorities are dealt with further down in the liquidation waterfall in Section 53(1)(e)(i) which refers to ‘any amount owed to the Central Government and the State Government…’. It is a well-known fact that all tax statutes provide for the creation of a charge in favour of tax authorities for unpaid tax dues. If tax authorities are to be treated as secured creditors owing to the charge created by operation of law, it begs the question of why they are accorded a separate mention in Section 53(1)(e)(i). Similarly, the definition of ‘security interest’ under the IBC refers to a right, title, interest or claim created in favour of a secured creditor ‘by a transaction’ (typically a financing or other consensual transaction among parties where a charge over property is created to secure a payment obligation) rather than a charge created by operation of law.

The Court’s finding that the tax authority’s delayed filing of its claim has no consequence is also a cause for concern. While timelines are to an extent nonbinding, in this case, the tax authority had filed its claim after the resolution plan had been approved by the committee of creditors. If claims could be entertained at this late stage, it would throw a spanner into the resolution process as resolution applicants and other stakeholders would have no certainty on the quantum of claims involved. To date, all creditors, financial and operational, including tax authorities, are required to file their claims with the resolution professional, and courts have, on several occasions, disallowed  claims of tax authorities when filed after the prescribed period.

This judgment will have significant implications on how statutory dues are treated under resolution plans as well as on the role that tax and other governmental authorities will play in the resolution process. The order of priority under Section 53 is important as it determines the liquidation value payable to different classes of creditors. The treatment accorded to different classes of creditors through the liquidation waterfall represents conscious policy choices on the part of the legislature on how to divide the pie when there isn’t enough for everyone. Even if the debtor company does not go into liquidation, liquidation value is still relevant in the context of a resolution plan as operational creditors are required to receive at least liquidation value in a resolution. If tax authorities are to be treated as secured creditors, the liquidation value applicable to them would be much higher than that of other operational creditors. This in turn will dilute the amounts payable to other secured creditors (largely banks and financial institutions) as well as to stakeholders such as workmen and employees. Such a drastic change to the scheme of the IBC is best left to the legislature and it is surprising that the Supreme Court has made a pronouncement that goes against not only the core building blocks of the IBC, but also its own prior decisions on the subject.

Aparna Ravi is a partner at Samvad Partners Advocates and was a member of the Bankruptcy Law Reform Committee. The views expressed are personal.