Varied hues of Government dues under IBC
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1. Introduction

The longstanding debate surrounding the prioritization of crown debts vis-à-vis private debts has entered a new chapter with the advent of the Insolvency and Bankruptcy Code, 2016 (“IBC”). Prior to the IBC, the common law principle generally granted crown debts preferential status over unsecured debts. This historical primacy stemmed from the sovereign’s role as the embodiment of the public good, requiring unimpeded revenue collection for the smooth functioning of the State.

IBC introduced a paradigm shift in prioritizing debts of secured creditors over all unsecured debts, including government dues. This recalibration reflected a focus on maximizing recoveries for secured lenders, thereby promoting financial stability, and encouraging credit availability. IBC’s watertight definition of ‘secured creditor’ ensures transparency and predictability in restructuring and liquidation processes.

Even though the trite law over the years recognised that the debts owed to secured creditors would have priority over crown debts due to the lack of a security interest in favour of the government, the Hon’ble Supreme Court’s judgment (“SC”) in the case of State Tax Officer vs Rainbow Papers Limited[1] (“Rainbow Papers”) and the fluctuating position of law since then has prompted us to address the elephant in the room!

2. The colours pre-Rainbow Papers

From times in the pre-independence era wherein the rights of the crown to recover the debt would prevail over the right of a subject, to the judgment of the SC in Union of India vs SICOM Ltd.[2] (“SICOM”), wherein the controversy was addressed by prioritising secured creditors over crown debt but placing the rights of unsecured creditors below it, the question arose time and again.

SC in both SICOM and M/s Connectwell Industries vs Union of India[3], observed that unless there is preference given to the crown debt by a statute, the dues of a secured creditor have preference over crown debts, however, the debts wherein a first charge had been created by virtue a statute would stand at par with the secured debts.

With the advent of IBC and the waterfall mechanism under Section 53 of the IBC, the dues of workmen and secured creditors were prioritised at the second rung once the liquidation and resolution cost were paid in full. Unsecured creditors formed the fourth rung of priority after the employees of the Corporate Debtor (“CD”) were paid their dues, and the government dues were placed much lower in the waterfall, at fifth rank. It is evident that the secured debts have invariably been given preference over almost all kinds of government dues.

These changes were aimed to promote the availability of credit and development of a market for unsecured financing (including the development of bond markets). The object was to increase the availability of finance, reduce the cost of capital, promote entrepreneurship, leading to faster economic growth[4], even if that led to alteration in the order of priority of payment of government dues.

3. Elephant in the Room: Rainbow Papers

The SC affirmed in Rainbow Papers that Tax Authorities are recognized as secured creditors and thereby granting them precedence over the claims of unsecured creditors, however this preference is applicable only in situations where a statutory charge has been created by any Central or State Act. Consequently, any resolution plan that does not meet the criterion laid by Rainbow Papers would be disregarded by the Adjudicating Authority (“AA”), which may eventually lead to the liquidation of the CD.

In Rainbow Papers, the SC was asked to resolve the conflict between Section 48 of the Gujarat Value Added Tax Act, 2003 (“GVAT Act”) and Section 53 of the IBC, as to whether the provisions of the IBC specifically Section 53 overrides provisions of the GVAT Act. Importantly, Section 53 of the IBC starts with a non-obstante clause which states that the proceeds from the sale of the liquidation assets shall be distributed as per the waterfall mechanism, even if there is anything to the contrary contained in any other law. SC opined that Section 48 of GVAT Act is not contrary to Section 53 of IBC, and thus, its applicability is not ousted for the purposes of distribution of liquidated assets. Therefore, SC concluded that the Taxation Authorities in the particular instance would qualify as secured creditors by the virtue of the statutory charge created by Section 48 of GVAT Act. SC further pronounced that any resolution plan that ignored the aforesaid claim is bound to be disregarded by the AA.

The views taken by the SC raised concerns in the minds of unsecured creditors, who would now stand at a lower pedestal than the government authorities having statutory charge in their favour. Therefore, by virtue of the Rainbow Papers dictum, every resolution plan must provide for the dues owed to the government authorities, since they are also classified as secured creditors.[5] It may appear, at the first instance, that the SC has not disturbed the existing priority list under Section 53 of IBC and avoided a conflict between the two Acts. However, by holding government dues as of the ‘secured creditor’, it has, in a way upgraded the priority originally given to the government dues. Therefore, any implied alteration in the defined waterfall mechanism would be tantamount to rewriting the legislature’s wisdom and will culminate in frustrating the very intention of the IBC.

4. Divergent views from Rainbow Papers

There have been a series of judgements/orders by various Courts offering a different interpretation of provisions creating first charge on the property of the taxpayer for the benefit of the government authorities. The following judgements have, fortunately, restricted the scope of the Rainbow Papers judgement to its own peculiar factual matrix and reduced the value of Rainbow Papers as a precedent, by offering differing opinions and by refusing to bind by it.

1. In Paschimanchal Vidyut Vitran Nigam Ltd vs Raman Ispat Pvt Limited (“Raman Ispat”)[6], SC took the view that Rainbow Papers ignored the legislative intent and the waterfall mechanism under section 53 of IBC which places the government dues at a lower pedestal than that of the unsecured creditors. Raman Ispat further concluded by confining Rainbow Papers to the facts of that case alone;
2. The Andhra Pradesh High Court in Southern Power Distribution Company of Andhra Pradesh Limited vs. Samyu Glass Private Limited[7] distinguished from the Rainbow Papers judgement by agreeing with the dictum of Raman Ispat judgement;
3. The Principal Bench of NCLAT in Department of State Tax vs Zicom Saas Pvt Ltd.[8], was confronted with a similar question of law with only distinction being the provision creating a statutory charge, which was Section 37 of the Maharashtra Value Added Tax, 2002 (“MVAT Act”)[9]. The NCLAT observed that due to the difference in the language of Section 48 of GVAT Act and Section 37 of the MVAT Act, the Rainbow Papers judgement is distinguishable. Section 37 of MVAT Act has a distinct nuance, i.e., “but subject to any provision regarding creation of first charge in any Central Act for the time being in force”, which essentially subjects the provision to Section 53 of the IBC, which already provides an order of distribution of proceeds. This view of the NCLAT was reiterated in Department of State Tax vs D.S. Kulkarni Developers Ltd[10] to distinguish Rainbow Papers; and
4. NCLAT Chennai in Assistant Commissioner of Commercial Taxes LGSTO vs. Alok Kailash Saksena and Ors.[11] was dealing with the question of first charge on property with respect to Section 82 of the Karnataka Goods and Services Tax Act, 2017 (“KGST Act”)[12]. Section 82 of the KGST Act also provides an exception to IBC in creation of first charge. The NCLAT concluded that the language of Section 82 of the KGST Act makes it clear that the government authorities in this case cannot claim under the name of ‘secured creditors’ because of the specific overriding exception created in the statute itself in favour of the IBC. Again, the Rainbow Papers judgement was not found applicable or of assistance with regards to the factual matrix of the case.

The primary distinction between Rainbow Papers and the above judicial pronouncements is the difference in language of the section creating a statutory charge. Nonetheless, the Supreme Court was asked to review the erroneous position taken in the Rainbow Papers judgement by way of a review petition filed in 2023.

5. Under the lens of review: Sanjay Kumar Agarwal v. State Tax Officer (“Review Petition”)[13]

The Review Petition was filed before the SC to rectify the erroneous position of law taken by the Rainbow Papers bench. The main argument put forth by the Review Petitioners was basis Raman Ispat judgement, wherein Rainbow Papers was considered to have ignored the waterfall mechanism provided under Section 53 of the IBC.

However, SC outrightly rejected the primary argument, i.e., the reliance on the Raman Ispat judgement since it was delivered by a bench of co-ordinate strength. Thus, the judgement that came afterwards, which is Raman Ispat, cannot lay down the law in ignorance or conflict with the previous judgement, i.e., Rainbow Papers. Further, SC also rejected the argument that the Rainbow Papers ignored the waterfall mechanism.

The SC did not indulge itself with the merits of the case because of the apparent failure on part of the Review Petitioners to flesh out a case for a review. The Review Petition eventually got stuck on grounds of admission of a Review Petition, judicial integrity, and the well-settled principles of law thereof, rather than going into the merits of the case.

6. Impact of the judicial pronouncements on IBC

The IBC has been amended time and again to incorporate changes suggested in judicial pronouncements and to balance the interests of the creditors. Ministry of Corporate Affairs in 2023 invited comments with respect to changes being considered to the IBC (“MCA Paper”)[14] and basis the interpretation of the term ‘secured creditor’ and inclusion of claims of government as a secured creditor in Rainbow Papers.

MCA Paper proposed to clarify the definition of ‘Secured Creditor’ under Section 3 (33) of IBC and that the concept of ‘security interest’ was intended to cover a consensual transaction between parties and not any similar interest created through mere operation of a statute.

Further proposed that all the debts owed to government irrespective of whether they are secured creditors pursuant to a security interest created by a mere operation of statute, shall be treated equally with other unsecured creditors. Only where the security interest is created pursuant to a transaction of the government with CD, the government in question will continue to be treated as a secured creditor in the order of priority.

7. Conclusion

It can be inferred that the SC has created an unintentional yet a very pertinent change in the law, with the dictum of Rainbow Papers and the Review prima facie appearing to be optimally in favour of the Tax Authorities.

Even though, the Review Petition failed to rectify the erroneous position taken by the Rainbow Papers, Raman Ispat has held its ground and distinguished the treatment of dues under liquidation and noted the inapplicability of Rainbow Papers in the same. Thus, diminishing the precedential value of the same without specifically overruling it.

Keeping the above in mind, the position has become as ambiguous as ever. As government dues currently rank lower than the dues of a secured creditor and whether they stand above the dues of unsecured creditors would depend on the facts and circumstances, including the language of the provision creating the charge.

If the current position in law is conceded to perpetrate then it will act as an impairment to the purpose which the IBC is intended to serve. Yet, the proposed amendments by MCA does come as the light at the end of the tunnel for the creditors!

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Juris Corp – Jinal Shah and Ronit Chopra