Muddying the Waters: Supreme Court of India on Tax Dues in Insolvency

The Supreme Court of India (‘SC’) recently held in Rainbow Papers Ltd. that tax dues covered by a statutory first charge ranked equally with secured creditors in insolvency. The author argues that Rainbow Papers is incorrect because it misapplies the Crown’s priority in insolvency, fails to consider the provisions of the Insolvency & Bankruptcy Code, 2016 (the ‘Code’) and past decisions holding the field. It is suggested that a reversal of the position would be in order.

Crown debts and Indian law

The general rule at common law, applicable inter alia in respect of winding-up and bankruptcy, is that Crown debts take precedence over payment of other equal-ranking debts. In case of contractual obligations such as a pledge, the Crown does not take precedence over such ‘special charges’. Statute can nonetheless vary the Crown’s priority.

The general rule has been applied in India since at least 1868. In 1965, the SC observed that this rule of substantive rights had been consistently recognised in India prior to 1950, and would continue in force after adoption of the Indian Constitution.

The deference of Crown debts to special charges has also been accepted since at least 1884. This position was reiterated by the SC, holding that the State did not take precedence over secured creditors.

Priority under statutory charges

Statute can displace or accord more favourable treatment to the Crown. Referring to decisions dating from 1881, the Court of Appeals ('CA’) in Haymarket Publishing held that a statutory charge took priority over an earlier mortgage debt, and was not confined to the owner’s interest when the charge arose. This conformed with legislative intent and prevented abuse. The SC applied Haymarket to hold that a sales tax provision, conferring a first charge on the property in respect of tax dues, assumed priority over an earlier mortgage. Subsequently, the SC observed in Central Bank of India that Parliament’s intention to give priority to secured creditors over a statutory charge needed to be incorporated by specific provisions.

However, it is noteworthy that in context of winding-up, the SC has followed Airedale Garage Co., In re, [1933] 1 Ch. 64 (CA) to hold that statutory restrictions and distributional priority must be respected, and that winding-up provisions restrict a tax officer’s preference.

State dues after the Code

To note the scheme under the extant Code, it is an exhaustive legislation dealing with insolvency resolution. Under s. 238, the Code overrides other laws, and it has been held to supersede other federal and state enactments. S. 53 delineates the manner and priority of distribution in liquidation, which is also applicable to insolvency resolution. It states that ‘[n]otwithstanding anything to the contrary contained in any law enacted by the Parliament or any State Legislature for the time being in force …’, federal and state governments’ dues rank fifth in priority.

With reference to the foregoing analysis, the author contends that the decision in Rainbow Papers is incorrect.

The comprehensive scheme under s. 53 of the Code would override contrary provisions, including statutory charge under provincial laws. It can also be inferred that S. 53 was inserted after considering the observations in Central Bank of India.

In any event, Rainbow Papers fails to appreciate that a statutory charge holder would not take priority in insolvency and become a ‘secured creditor’ under the Code. A ‘secured creditor’ is defined as a holder of a ‘security interest’ created by a ‘transaction’—which is further defined to include an ‘agreement or arrangement in writing for the transfer of assets, or funds, goods or services, from or to the corporate debtor’. By no stretch can this include tax dues.

This interpretation renders the Code redundant and creates a distinct multi-pronged regime contrary to the waterfall under s. 53 and the application of Airedale Garage. This is also in the teeth of s. 31 of the Code, whereby an approved resolution plan (which itself has to satisfy s. 53) is binding on the government, and a previous decision of the SC holding that statutory dues not covered within a resolution plan stand extinguished.

A course correction by the SC in the near future is advisable. The interpretational conflict would recur, since various provincial tax legislations incorporate a statutory first charge, whereas federal tax laws have been appropriately amended.

Rohan Deshpande is an Unregistered Barrister, England & Wales, called by The Honourable Society of the Inner Temple; a Member of the Chartered Institute of Arbitrators and an Indian-qualified Counsel specialising in commercial dispute resolution.