Supreme Court ruling revives the quandary, holds tax authorities to be secured creditors

Sikha Bansal, Partner, Vinod Kothari & Company

Neha Sinha, Executive, Vinod Kothari & Company

corplaw@vinodkothari.com

Introduction

Lawmakers might have put the best of efforts to frame the law in the clearest possible way, however, there may still be possibilities of diverse readings (and thus, diverse interpretations). Such a scenario is often addressed by the judiciary which, as and when circumstances arise, determines the questions arising out of law. However, there is also a possibility where the judiciary itself would render diverse interpretations on the same subject matter. This would, of course, lead to confusion and chaos.

A similar situation arose in the recent case of State Tax Officer v. Rainbow Papers Limited,^[1] wherein the Hon’ble Supreme Court (‘SC’) dealt with the question as to whether the provisions of the Insolvency and Bankruptcy Code, 2016 (‘IBC’), specially section 53, overrides section 48 of the Gujarat Value Added Tax Act, 2003 (‘GVAT’). Section 48 of GVAT is a non-obstante clause and creates a statutory first charge on the property of the dealer in favour of tax authorities against any amount payable by the dealer on account of tax, interest or penalty for which he is liable to pay to the Government.

SC held that if the resolution plan excludes statutory dues payable to government or a government authority, it cannot be said to be in conformity to the provisions of IBC, and as such, not binding on the government. As such, the same must be rejected by the Adjudicating Authority. Further, section 48 of GVAT is not inconsistent with IBC and hence, it was held that IBC does not override GVAT. The SC went on to rule that by virtue of the ‘security interest’ created in favour of the Government under GVAT, the State is a ‘secured creditor’ as per the definition in  IBC. Hence, as workmen’s dues are treated pari passu with secured creditors’ dues, so should the debts owed to the State be put at the same pedestal  as the debts owed to workmen under the scheme of section 53(1)(b)(ii).

In the most humble view of the authors, the conclusions as above may not in consonance with the well-settled jurisprudence around the subject matter of conflict between IBC and tax statutes and the question of priorities between these, and may also not fit well with the construct of the IBC, the intent of the lawmakers and the Bankruptcy Law Reform Committee (‘BLRC’), as well as several judicial precedents set by SC itself, as discussed below. A plethora of rulings, including by SC itself, go on to hold that crown debts would be subordinate to the dues of secured creditors, and none of these rulings ever equated tax dues to secured dues. The authors thus, analyse the SC ruling in light of the construct of the IBC, intent of the lawmakers and policymakers, and various past precedents and offer their views as to how this ruling has actually reopened a can of worms and how it may impact success of ongoing and future resolution processes.

Authors’ Analysis

Established jurisprudence on priority of secured creditors over tax dues

There have been instances in the past where SC was faced with a similar question in the context of income-tax law, customs law, etc. In all such cases, SC has upheld the precedence of secured creditor dues over tax dues. For instance, in Sundaresh Bhatt v. Central Board of Indirect Taxes and Customs,^[2] the Court had held that IBC has an overriding effect on Customs Act (which too, creates statutory charge in favour of customs authorities). Similarly, in PR Commissioner of Income Tax v. Monnet Ispat and Energy Limited, the SC relied on Dena Bank v. Bhikhabhai Prabhudas Parekh & Co.,^[3] and unequivocally ruled that income-tax dues, being in the nature of Crown debts, do not take precedence even over secured creditors, who are private persons. Notably, in Dena Bank (supra), the SC had held that, “  . .  the common law doctrine of priority of crown debts would not extend to providing preference to crown debts over secured private debts”. It may be noted that none of these past rulings have been referred to in the instant SC ruling. On similar lines, in Leo Edibles and Fats Limited v. the Tax Recovery Officer,^[4] the Andhra Pradesh High Court has clearly ruled that income tax authorities cannot be equated to secured creditors, and thus cannot claim priority.

Further, the mere creation of a first charge in favour of the tax authorities does not accord ‘priority’ to them. In this respect, the Bombay High Court in the recent judgement of  Jalgaon Janta Sahakari v. Joint Commissioner of Sales^[5] held tax dues to be subservient to secured creditors’ dues under RDDB Act and SARFAESI Act and observed that “…there is no magic in the words ‘first charge’. Even a ‘first charge’, by express statutory intendment, can be made subordinate or subservient to a paramount charge.” Hence, by no stretch of imagination can the tax dues be ranked at par with secured creditors’ dues.

Definition of ‘security interest’ to be read with the definition of ‘transaction’

In the instant case, SC ruled that, as because a statutory charge is created in terms of section 48 of the GVAT, the claim of the tax department of the State falls within the meaning of ‘security interest’ as defined in section 3(31)^[6] of IBC and thus, the State becomes a ‘secured creditor’ as defined in section 3(30)^[7] of IBC. The SC accepted the contentions of the State that the definition of ‘secured creditor’ is comprehensive and wide enough to cover all types of security interests. Further, SC stated that the definition of secured creditor in IBC does not exclude any government or governmental authority.

However, in view of the authors, the expressions ‘security interest’ and ‘secured creditors’ have to be read in accordance with the definitions assigned under section 3(31) and section 3(30), respectively. Therefore, in order to be a secured creditor, one has to have a ‘security interest’. The definition of ‘security interest’ reads as to mean a right, title, etc., created by a ‘transaction’ which secures payment or performance of an obligation. ‘Transaction’, as defined in section 3(33) of IBC, includes an agreement or arrangement in writing for the transfer of assets, or funds, goods or services, from or to the corporate debtor. Hence, the concept of security interest, as used in debt recovery laws (like SARFAESI Act) as well as IBC is inextricably linked to consensual arrangement or a transaction between parties. The concept cannot be stretched to include forced or non-consensual acts like attachment of property by tax authorities. As such, while an attachment under tax laws may create a statutory charge in favour of the tax authority (under respective laws); however, that does not impart the status of a ‘secured creditor’ to the tax authority. Therefore, in no way, a charge in favour of the tax authority under the tax laws can be said to be ‘security interest’^[8].

Ranking of claims under section 53: Different treatment to secured creditors and Government dues

The construct of IBC in terms of payment waterfall is quite clear. Section 53 puts secured creditors in second position in order of priority along with workmen’s dues, while dues to the Government are ranked fifth. If the intent of the lawmakers (and thus, the construct of IBC) was to treat the tax authorities at the same pedestal as secured creditors, then the purpose of having a separate rank for Government dues is not clear. And to say that tax dues will not form part of government dues is completely counter-intuitive and defies logic. In this respect, the Andhra Pradesh High Court had rightly observed, “…tax dues, being an input to the Consolidated Fund of India and of the States, clearly come within the ambit of section 53(1)(e) of the Code. If the Legislature, in its wisdom, assigned the fifth position in the order of priority to such dues, it is not for this Court to delve into or belittle the rationale underlying the same.”^[9]

Intent and recommendations of Bankruptcy Law Reforms Committee

The BLRC, in its interim^[10] as well as the final report^[11], has elaborately discussed the prioritisation (or otherwise) of the crown debts. One of the recommendations of BLRC in the interim report^[12] was “there should be a separate declaratory provision that upholds the priority rights of secured creditors on their security interests notwithstanding anything to the contrary contained in any state or central law that imposes a tax or revenue payable to the Government by virtue of a specific statutory provision made as a first charge on the assets of the assessee; provided that such first charge may be allowed for claims that existed on the date when such security interest was created”^[13].

In its final Report too, BLRC had clearly envisaged priority of secured creditors over government dues: “The Committee has recommended to keep the right of the Central and State in the distribution waterfall in liquidation at a priority below the unsecured financial creditors in addition to all kinds of secured creditors for promoting the availability of credit and developing a market for unsecured financing (including the development of bond markets). In the long run, this would increase the availability of finance, reduce the cost of capital, promote entrepreneurship and lead to faster economic growth.”

Overriding provisions of IBC

By virtue of section 238 of IBC, IBC has an overriding effect over any other conflicting law and the same has been held by the Supreme Court in a catena of judgements such as M/S innoventive Industries Ltd. v. ICICI Bank^[14], Rajendra K. Bhutta v. Maharashtra Housing And Area Development Authority^[15] and others.  In this case, the SC held that section 48 of GVAT Act is not inconsistent with IBC.

However, a bare perusal of section 53 of IBC and section 48 of GVAT indicate the conflicting scheme in terms of priority to Government dues. Nonetheless, even if the impugned provision of GVAT has a non-obstante clause, it would not prevail over IBC.  In the Innoventive Industries judgement, the Court had ruled the non-obstante clause of a Parliamentary enactment would prevail over the non-obstante clause of the State enactment. Even otherwise, pursuant to the doctrine of repugnancy, the Central legislation, i.e., IBC, shall prevail over the State legislation, i.e., GVAT.

In fact, there are precedents where the courts asked the tax authorities/other statutory authorities to release the attachments with respect to properties of a corporate debtor under IBC. For instance, in Sundaresh Bhatt v. Central Board of Indirect Taxes and Customs,^[16] the Supreme Court allowed the appeal challenging NCLAT’s order directing the disposal of goods by authorities under Customs Act due to non-payment of customs dues^[17].  In the humble opinion of the authors, the Supreme Court seems to have completely undermined the sweep of IBC in order to reconcile both the legislations and avoid conflicting outcomes.

Closing thoughts

On the basis of grounds as discussed above, SC set aside the resolution plan. It held that such a resolution plan not fulfilling the requirements of section 30(2), would be invalid and not binding on the State/Central Government or any other statutory authority. SC went on to say, “if a company is unable to pay its debts, which should include its statutory dues to the Government and/or other authorities and there is no plan which contemplates dissipation of those debts in a phased manner, uniform proportional reduction, the company would necessarily have to be liquidated and its assets sold and distributed in the manner stipulated in Section 53 of the IBC.” The SC further observed that the CoC, which might include financial institutions and other financial creditors, cannot secure their own dues while ignoring the statutory dues owed to Government authorities.

However, the authors have already discussed how tax dues have always been held to be subservient to dues of secured creditors. Each of the competing creditors is entitled to a share of payments under resolution plan on the basis of liquidation value ascribable to such creditor (which again, is based on the concept of vertical comparison in terms of section 53). This is evident from a reading of section 30(4) of IBC, and an array of rulings like Committee of Creditors of Essar Steel India Limited v. Satish Kumar Gupta,^[18] K. Sashidhar v. Indian Overseas Bank^[19] and India Resurgence Arc Private Limited v. M/S Amit Metaliks Limited & Anr.^[20]

As such, saying that the tax dues must be paid-off under resolution plan without considering liquidation value and section 53 would be counter-intuitive. Consequently, the authors are of the humble view that a resolution plan cannot be rendered invalid, solely because it does not provide for payment of tax dues.

Thus, SC’s stance in the present judgement sounds different to its approach in the past. Ascribing the status of a secured creditor to tax authorities defeats the purpose of the priority ranking and waterfall mechanism in the IBC and strikes at the foundation of IBC. This dictum would result in Government dues being treated pari passu with secured creditors and workmen’s dues which may result in dilution of the rights enjoyed by workmen, as well as secured creditors as a whole. Further, putting secured creditors, tax authorities and workmen in the same pedestal would create a new tussle in the payment of dues on liquidation as well as other resolution processes.

^[1] Civil Appeal No. 1661 of 2020.

^[2] Civil Appeal No. 7667 of 2021.

^[3] 2000 (5) SCC 694.

^[4] Writ Petition 8560 of 2018.

^[5] Writ Petition No. 2935 of 2018. Refer to our detailed article on this ruling.

^[6] IBC, section 3(31)- “security interest” means right, title or interest or a claim to 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: Provided that security interest shall not include a performance guarantee.

^[7] IBC, section 3(30)- “secured creditor” means a creditor in favour of whom security interest is created.

^[8] In Law Relating to Insolvency and Bankruptcy Code 2016, Taxmann (2016), Vinod Kothari and Sikha Bansal observe, “Noticeably, the words “created in favour of, or provided for a secured creditor” are qualified by “by a transaction” which secures payment or performance of an obligation. This implies that there must be a ‘transaction’ which purports to secure payment or performance of an obligation and for this purpose, creates or provides security interest in favour of or for a secured creditor. . .Transaction, as defined under clause (33) of section 3, includes an agreement or arrangement in writing for the transfer of assets, or funds, goods or services, from or to the corporate debtor. It implies that the corporate debtor must be a party to the transaction who concludes such agreement or arrangement. Therefore, the definition seemingly covers only those security interests that are created by acts of parties.”

^[9] Leo Edibles & Fats Limited v. Tax Recovery Officer, Writ Petition No. 8560 of 2018.

^[10] Refer section 5(5.2)(B)(b), p. 96.

^[11] Refer para 5.5.8 and para 6.5.9.

^[12] See p. 97.

^[13] The footnote to such recommendation reads: “For avoidance of doubt, it is clarified that the exception for claims existing on the date of creation of the security interest will not disturb the priority rights of the secured creditors under statutes that recognise such rights of secured creditors without any such exception.”

^[14] (2018) 1 SCC 407.

^[15] Civil Appeal No. 12248 of 2018.

^[16] Civil Appeal No. 7667 of 2021.

^[17] See also,  In the matter of: Clutch Auto Ltd. [CA-1432(PB)/2019 & CA-1433(PB)/2019 in (IB)- 15(PB)/2017] , Om Prakash Agarwal v. Tax Recovery Officer 4 & Anr. [Item No. 301, IA-992/2020 in CP/294/2018], and various other rulings as indicated in IBBI’s Facilitation Paper.

^[18] (2020) 8 SCC 531.

^[19] 2019 SCCOnLine SC 257.

^[20] Civil Appeal No. 1700 of 2021.