[By Shalin Ghosh]
The author is a student at the Maharashtra National Law University (MNLU), Mumbai.
Introduction
The Insolvency and Bankruptcy Code, 2016 (“IBC”) has been a watershed reform for the Indian economy, being one of the most comprehensive laws governing insolvency and credit recovery matters in the country. The interplay between tax law and IBC has increasingly been gaining traction, throwing up questions that have a great bearing on the future of India’s insolvency regime. A pertinent example is a critical issue that has, over the years, emerged up for consideration before various tribunals and the Supreme Court (“SC”) regarding the classification of tax authorities as secured or unsecured creditors.
A recent decision of the SC in State Tax Officer v. Rainbow Papers Limited (“Rainbow Papers”) has significantly upended the evolved legal position on the issue by declaring tax authorities to be ‘secured creditors’ under the IBC, adding that they have a statutory first charge over the property of the corporate debtor. This article analyses the judgment, pointing out the inconsistencies in the SC’s rationale while discussing the scheme of the relevant provisions and the evolved jurisprudence on the matter.
Facts
The corporate debtor, Rainbow Papers Limited (“respondent”) went insolvent in July 2016 and was burdened with an outstanding tax liability amounting to nearly Rs 47 crore under the Gujarat Value Added Tax Act, 2003 (“GVAT”). Consequently, the State Government’s tax department (“appellant”) filed claims to recover the pending tax dues. However, the concerned Resolution Professional (“RP”) waived off the entire quantum demanded by the appellant contending that the sales tax office is considered to be an ‘operational creditor’ under the IBC and therefore, would not enjoy a first charge over the corporate debtor’s property.
The National Company Law Tribunal (“NCLT”) ruled in the respondent’s favour, validating the contentions of the RP. Upon appeal, the National Company Law Appellate Tribunal (“NCLAT”) reaffirmed the NCLT’s decision, rejecting the appellant’s claims of enjoying a first charge over the respondent’s assets reasoning that Section 48 of the GVAT, which provides for a first charge on an individual’s property with respect to any outstanding claims will not prevail over Section 53 of the IBC. Eventually, as the matter reached the SC, a different conclusion followed, with the Court holding that the appellant’s claim is within the ambit of ‘security interest’, making it a ‘secured creditor’ under the IBC. Resultantly, the Court ruled that the appellants would have a first charge over the respondent’s property, reiterating that Section 48 of the GVAT is not inconsistent with Section 53 of the IBC.
Analysis
Tax dues as secured debt?
The legislative scheme and construct of the IBC seem to imply that any outstanding dues payable to the government should not be classified as secured debt. Section 5(21) defines ‘operational debt’ as “a claim in respect of the provision of goods or services including employment or a debt in respect of the payment of dues arising under any law for the time being in force and payable to the Central Government, any State Government or any local authority.”
The list of items included in the aforementioned definition seems to suggest that outstanding dues like pending tax liabilities fall squarely within the scope of ‘operational debt’. The Court in its landmark Swiss Ribbons judgment clearly enunciated the difference between financial debts and operational debts under the IBC, noting that only the former enjoys a ‘secured’ status as opposed to the latter, which is unsecured.
There is another point that merits comment. In the present case, the SC observed that merely because Section 48 of the GVAT creates a statutory first charge on an individual’s property, the appellant’s claims fall within the scope of ‘security interest’ under Section 3 (31). Therefore, the appellant, by extension, becomes a ‘secured creditor’ as defined under Section 3 (30). The Court, agreeing with the appellant’s argument, ruled that the term ‘secured creditor’ is not narrow or restrictive and can be interpreted expansively to include all types of security interests within its meaning. This observation is erroneous on a few grounds.
Under the IBC, having a ‘security interest’ is a pre-requisite for being a ’secured creditor’. Section 3 (31) defines ‘security interest’ to mean “a title, right, claim or interest to property created as a result of a transaction which secures payment of performance of an obligation.” This clause appears to assume the existence of a contract between two parties, and not a particular legal provision, to give rise to a ‘security interest’. Furthermore, any transaction that leads to the creation of a security interest must be consensual and voluntary and not vitiated by coercion or force, for it to be considered valid. In this light, it is difficult to consider that the non-voluntary and coercive act of tax authorities attaching assets like property leads to the creation of a ‘security interest’ under Section 3 (31) of the IBC.
Deviates from established precedents
Courts across the country have, in the past, adjudicated on the priority of secured creditors, albeit in the context of claims made under the Customs Act, Income Tax Act, and so on. Recently the SC, in Sundaresh Bhatt v. Central Board of Indirect Taxes and Customs, ruled that IBC will prevail over the Customs Act. Incidentally, even the Customs Act contains a provision that gives rise to a statutory first charge to the customs officials over the corporate debtor’s assets.
In another case, PR Commissioner of Income Tax v. Monnet Ispat and Energy Limited, the Court categorically observed that under the scheme of the IBC, income tax dues cannot be accorded a higher priority than secured creditors. A similar conclusion was also reached in a recent decision of the Rajasthan High Court where the court refused to accord a greater priority to government dues over those payable to secured creditors. Incidentally, even in the aforementioned case, the state tax department contended that it enjoys a statutory first charge on the property of the entity undergoing liquidation on the basis of a specific provision (Section 47) of the Rajasthan Value Added Tax, 2003.
Therefore, the established legal position which has been affirmed time and again by Indian courts is that government departments like customs authorities and income tax officials among others, cannot be treated like secured creditors and are consequently ineligible to claim priority during the payment of dues. The ruling in Rainbow Papers completely deviates from these precedents and revives a legal question that was, otherwise, well-settled.
Overlooks Section. 238 and goes against IBC’s intent
Section 238 of the IBC establishes its supremacy over other laws in matters of conflict— a fact that is firmly established and settled. This has also been reaffirmed by the SC in numerous judgments. In the present case, the SC observed that Section 48 of the GVAT is not inconsistent with the provisions of the IBC. A plain reading of the concerned provisions, however, lays bare the evident inconsistency. Section 48 of the GVAT empowers the government to have a first charge over a dealer’s property for any amount which he is liable to pay to the government.
This is in sharp contrast to the scheme of Section 53 of the IBC which denotes the waterfall mechanism governing the payment of dues in case of an entity undergoing liquidation. Under Section 53, statutory dues do not occupy the top rung in the order of priority and are only paid when the outstanding amounts due to several other stakeholders like secured creditors and workmen are settled. Therefore, the provisions of the two laws are conflicting and inconsistent and the IBC should prevail over GVAT due to Section 238.
The primary legislative intent in according lower importance to government dues and placing them after secured creditors, workmen, and other parties is an extension of the ‘business-first’ principle on which the IBC is premised, wherein the government is viewed merely as a facilitator and not as an active participant in an entity’s commercial affairs. The SC, by giving tax authorities the same status as secured creditors, strikes at the heart of this intent, granting more power to government authorities to recover outstanding dues thereby burdening the insolvency process.
Conclusion
In declaring tax authorities to be secured creditors, the SC has overlooked several aspects which could negatively impact the insolvency culture in the country. The higher status accorded to tax authorities will considerably influence the priority and the valuation of statutory dues under Section 53 while an entity undergoes liquidation. The verdict could adversely impact credit recovery and might lead to a massive spike in actions initiated by the government to recover outstanding payments. It is also possible that tax departments may initiate an action in nearly every insolvency resolution process where they have not received a proportionate share of dues. This decision can significantly dent the insolvency framework in the country and warrants an urgent review.