Buried Treasure Or Burden? Unmasking Crown Debt In India's IBC Framework

Treatment of Crown Debt under IBC

Section 5 (21) of the IBC defines Operational debt as dues arising under any law for time being in force and payable to the Central Government, any State Government or any local authority.

Section 53 of the IBC provides for the payment of dues to various stakeholders in an event of liquidation under the following priority:

1. Corporate Insolvency Resolution Process costs and the liquidation costs;
2. Workmen's dues for the period of 24 months preceding the liquidation commencement date and debts owed to a secured creditor in the event such secured creditor has relinquished security;
3. Wages and any unpaid dues owed to employees other than workmen for the period of 12 months preceding the liquidation commencement date;
4. Financial debts owed to unsecured creditors;
5. Any amount due to the central government and the state government and debts owed to a secured creditor for any amount unpaid following the enforcement of security interest;
6. Any remaining debts and dues;
7. Preference shareholders; and
8. Equity shareholders or partners.

The aforementioned provisions clearly outline the order of priority for repaying different classes of creditors and classifies statutory dues and government debts as operational debts under the Waterfall mechanism, placing them lower in priority than financial debts.

Judgement of Supreme Court in State Tax Officer v. Rainbow Papers Limited

The legal landscape regarding the positioning of statutory dues within the Waterfall Mechanism was clear and settled until the Judgment of Supreme Court in State Tax Officer v. Rainbow Papers Limited^[2] (hereinafter referred to as “Rainbow Papers”) reopened the debate, creating considerable uncertainty and confusion.

The Supreme Court in Rainbow Papers was dealing with the question as to whether Section 53 of the Code will override the Section 48 of the Gujarat Value Added Tax Act, 2003(hereinafter referred to as “GVAT”). Section 48 of GVAT states that:

“Tax to be first charge on property: “Notwithstanding anything to the contrary contained in any law for the time being in force, any amount payable by a dealer or any other person on account of tax, interest or penalty for which he is liable to pay to the Government shall be a first charge on the property of such dealer, or as the case may be, such person.”

The Apex Court held that:

• The State government is a secured creditor under the GVAT Act. Its security interest arises not through a specific agreement, but "by operation of law." The IBC definition of a secured creditor does not exclude government entities.
• Resolution plans cannot ignore statutory dues. NCLT must reject any plan that fails to address government debts.
• Companies unable to pay debts, including statutory dues, must be liquidated and it assets must be distributed as per the Waterfall mechanism
• The Committee of creditors cannot prioritize their debts over government dues. They cannot secure their own debts by sacrificing statutory dues owed to the government or other creditors.

Pitfall of Rainbow Paper's Ratio

Undermining the Legislative intention

The judgement in Rainbow papers not only did go against the clearly outlined waterfall mechanism in Section 53 but also against the Legislative Intention which can be carved out by the Preamble of the Code which states:

An Act to consolidate and amend the laws relating to reorganisation and insolvency resolution of corporate persons, partnership firms and individuals in a time bound manner for maximisation of value of assets of such persons, to promote entrepreneurship, availability of credit and balance the interests of all the stakeholders including alteration in the order of priority of payment of Government dues and to establish an Insolvency and Bankruptcy Board of India, and for matters connected therewith or incidental thereto.”

The Bankruptcy Law Reform Committee which gave birth to the IBC, in its interim report of 2015, proposed shifting the priority of debt repayment in insolvency cases. Initially, they recommended protecting secured creditors from crown debt, arguing its historical origins in UK Insolvency law and potential conflict with specific tax charges. However, the final report significantly changed course, prioritizing unsecured financial creditors over both secured creditors and the government in the waterfall mechanism. This aimed to boost access to finance, entrepreneurship, and economic growth, with the eventual benefit to the government through increased revenue from a thriving economy.

Even the UNCITRAL's Legislative Guide on Insolvency Law from which Parliament has borrowed the IBC recommends against granting excessive priority to government debts in insolvency proceedings. The guide suggests that prioritizing government debt in insolvency cases could backfire. It might encourage lax tax collection, hurting fairness and enforcement. Plus, it acts like a hidden subsidy for struggling debtors, letting them off the hook while other creditors suffer. This undermines the whole point of insolvency, which is to encourage responsible behaviour.

Wrong interpretation of Security Interest under IBC

The Supreme Court's decision to equate the statutory charge created under Sec 48 of the GVAT Act to a "security interest" under IBC raises concerns. While the definition of "security interest" under Section 3(31) requires a transaction, GVAT creates a charge automatically, not through a contractual agreement. This inconsistency could lead to confusion and potential injustice.

The Court's reasoning, that a "security interest" can arise by operation of law, is also flawed. The combined definitions of "security interest" and "transaction" under Section 3(33) in IBC suggest a contractual basis for such interests. The Court might have overlooked this requirement, potentially leading to an erroneous interpretation that grants the government undue preferential status as a "secured creditor" in insolvency proceedings.

Earlier decisions bind later courts of similar strength on identical or similar legal issues.

In Ghanashyam Mishra & Sons Pvt. Ltd. v.Edelweiss Asset Reconstruction Company Ltd.^[3], the Supreme Court held that the dues owed to any Government of statutory body would be an “operational debt” and the statutory bodies for this purpose would fall under the ambit of an “operational creditor”.

In the landmark judgement of Supreme Court in Swiss Ribbons (P) Ltd. v. Union of India^[4] the constitutional validity of various provisions under IBC including the waterfall mechanism which gave priority to secured debts over statutory dues, was upheld.

In the judgement of the Supreme Court in Dena Bank v Bhikhabahai Prabhudas Parekh^[5] it was held that, the Income-tax dues are Crown debts and they will not have precedence over secured creditors.

Prior to the Rainbow Papers judgment in 2022, a consistent line of aforementioned Supreme Court rulings had classified government debts (crown debts) as operational debts. Importantly, these rulings clarified that crown debts do not rank higher than secured creditors in the repayment hierarchy during insolvency proceedings.

Judgement of Paschim Anchal Vidyut Vitran Nigam Ltd. v. Raman Ispat Pvt.Ltd & Ors

The Supreme Court in another judgement titled PaschimAnchal Vidyut Vitran Nigam Ltd. v. Raman Ispat Pvt.Ltd & Ors^[6] (hereinafter referred to as “Paschim Nigam”) differed with the ratio laid down by the Apex Court in Rainbow Paper. The 2-judge bench in Paschim Nigam observed that:

• The Judgement in Rainbow Papers overlooked the "waterfall mechanism" for prioritizing creditors in Section 53, elevating the Government to "secured creditor" status.

• Section 53 of the Code explicitly includes "government dues" in its repayment order, reflecting Parliament's clear intention to differentiate them from other forms of debt.
• The Judgement in Rainbow Papers must be confined to the facts of the case.

Based on the observations of the Apex Court in Paschim Nigam judgement, the Respondents in Rainbow Papers filed a Review Petition before the Supreme Court.

Judgement of Sanjay Kumar Agarwal v. State Tax Officer & Anr (Rainbow Paper Review)

The Supreme Court in Sanjay Kumar Agarwal v. State Tax Officer & Anr ^[7] dismissed the 5 Review Petitions filed against the Rainbow Paper judgement. The Apex Court held that:

• Observations made by a bench of equal strength in another case cannot be grounds for review of a different judgment.

• The original judgment was carefully deliberated and does not fall under the narrow category of judgments eligible for review.

• Review Petitioners failed to demonstrate any clear mistake or error in the original judgment.

With the Review petition dismissed, the Supreme Court's judgement in Rainbow Papers remains the definitive legal precedent holding the Government as Secured Creditor under IBC. This reinforces the existing legal ambiguity and adds to the conundrum revolving around treatment of Crown Debt under IBC.

The Road Ahead

The treatment of crown debts and their priority is embroiled in a tangle of conflicting legal provisions and Apex Court judgements. This has sown considerable confusion among litigants, lawyers, Resolution Professionals, and lower judicial forums, leaving them unsure of which precedent to follow and how to proceed with claims from various government and statutory bodies. To resolve the ongoing uncertainty surrounding Crown debt under the Indian Insolvency regime, it is recommended that the Apex Court consider referring the matter to a larger bench for definitive adjudication. This would allow for a comprehensive examination of the issue and provide much-needed clarity regarding the position and standing of Crown debt within the insolvency framework.

Views are personal.