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The author is KV Kailash Ramanathan, a student at National University of Advanced Legal Studies (NUALS), Kochi.
Introduction
Collection of taxes is among the most conspicuous exercises that draw its basis from the sovereign position of a State. Any State taxed with the lofty object of redistribution in an iniquitous society heavily relies on taxes to arm its exchequer. In framing such tax legislations a wide range of powers and privileges are conferred on the tax authorities and collection process to actually extract these taxes from reluctant and begrudging payers. One such approach is to proceed against an assessee’s property in lieu of the tax receivable from them in case of default.
Section 281 of the Income Tax Act during the assessment proceedings stage voids any interest created on the assessee’s property in favour of another person to the extent of the arising tax liability if any. This is to prevent a rival claim over the property once an attachment order is passed and prioritize the crown debt to be used for public welfare.
Things appeared clear as it then stood. Matters began to get dicey when a notification (No. 4133) was issued in 2020 operationalizing Section 26E of the Securitization and Reconstruction and Enforcement of Security Interest Act (hereinafter “SARFAESI Act”). The provision provides for priority in payment to secured creditors over government taxes and dues, once a registered interest is created. It acts as a non-obstante clause against revenue legislations, giving secured creditors a priority charge over the debtors’ properties.
This piece seeks to analyze whether there exists room for conflict between the two provisions and if so then which legislation assumes primacy over the other.
General principles of first charge
The doctrine of priority to crown debts is a long-standing common law principle giving the State priority to recoverable dues over private parties. The position of the doctrine in India is not as absolutist. The State has priority in payment over unsecured creditors. Secured creditors on the other hand have a priority over the State unless express statutory provisions to the contrary are provided creating a first charge in favor of the State.
A ruling of the Madras High Court in UTI Bank vs Deputy Commissioner Central Excise while reiterating the aforementioned principles held that the Customs Act and Central Excise Act provide no such first charge and therefore the respective departments are not entitled to priority in recovery. In response, the legislature amended these Acts to insert such first charge provisions in favour of the State, subject to certain exceptions. Similar provisions are available in a number of other legislations such as the Madhya Pradesh General Sales Tax Act, Rajasthan Sales Tax Act, etc. Keeping these principles in mind, the conflict between the SARFAESI Act and Income Tax Act may be analyzed now.
Income Tax Act vs SARFAESI Act
The Income Tax Act has no first charge provision analogous to those in the other legislations discussed above. However, under Section 281, any interest created by the assessee over his properties when proceedings are pending under the Act, would be void as against any claim in respect of payment of tax. This provision seeks to void any other interest created thereby trying to preclude competing secured claims, if the proceeding ends in taxes being levied. In case of unsecured claims, the doctrine of priority to crown debts would apply thereby ensuring the first payment to the income tax department. This whole mechanism has the effect of indirectly providing a first charge in payment of income tax. The Income Tax Act as a whole does not provide an explicit charge. It has provisions facilitating attachment of properties. Some arguments have been advanced contending that an attachment amounts to a charge. Such contentions have been duly dismissed by the Supreme Court in Kerala State Financial Enterprises Ltd vs Official Liquidator where it was held that an attachment in itself does not create a charge.
Whereas under the non-obstante Section 26E of the SARFAESI Act, secured creditors are required to be paid in priority to all other creditors and government debts. It is a statutory recognition of the primacy accorded to security interests created.
It is clear that Section 281 of the Income Tax Act and Section 26E of the SARFAESI Act cannot operate independently without conflict. Application of Section 281 will be subject to the exception under its proviso The proviso excludes only charges created for adequate consideration and without knowledge of the tax proceedings, or ones done with the permission of the assessing officer. This however is not the case in most transactions, which will result in the charge coming under the mischief of Section 281 and thereby being void. Void as per the explanation in State of Kerala vs MK Kunhikannan Nambiar Manjeri Manikoth would mean non-existent from the very beginning and a nullity. Application of Section 26E is predicated on there being a valid charge. If Section 281 obliterates the very foundation of this charge, bankers will be unable to exercise Section 26E and enforce the security interest to the extent that it is in conflict with income tax. The maxim ‘sublato fundamento cadit opus’ (if the foundation is removed the superstructure falls) applies here.
Rule of Purposive Construction: An Interpretative aid
The above conundrum can be resolved by applying the rule laid down in Heydon’s case, also known as the mischief rule or rule of purposive construction. This rule can be applied where there exists ambiguity.
As per this rule, for the true interpretation of a statute, four things have to be considered:
● What was the common law before the making of the Act?
● What was the mischief and defect for which the common law did not provide?
● What remedy had the Parliament resolved and appointed to cure the disease of the Commonwealth?
● The true reason for the remedy.
Under the mischief rule the Court’s role is to suppress the mischief and advance the remedy.
Application of the Rule
In systematically applying the rule the first step is to look at the law prior to the introduction of Section 26E in the SARFAESI Act. Section 35 of the SARFAESI Act provided a non-obstante clause that gave the legislation primacy only in cases of inconsistency with a different law. In Central Bank of India vs State of Kerala and Ors the Supreme Court stated explicitly that Section 35 had no conflict with the taxing legislations like the Bombay Sales Tax Act and Kerala General Sales Tax Act. In such a case the Section proved inadequate to prevent the operation of taxing statutes that render the proceedings under the SARFAESI Act ineffective.
Inadequacy of the non-obstante clause in Section 35 was thus the mischief that the parliament sought to remedy with the introduction of Section 26E. Hence the application of the rule of purposive construction would warrant the prevalence of Section 26E of the SARFAESI Act over Section 281 of the Income tax act. This is the interpretation that would suppress the mischief and advance the remedy which is a priority in recovery to secured creditors over crown debt.
Superior Purpose Doctrine
Alternately, a conflict between two statutes can also be resolved by applying the rule of superior purpose. As per this rule, when there is a conflict, courts must give primacy to the statute that advances a superior purpose. In this case, the Parliament amended and introduced Section 26E of the SARFAESI Act after being fully conscious of the importance that taxes carry to the country. Protecting the interest of secured creditors is the priority that the legislature sought to achieve. Therefore even by the application of this rule, Section 26E prevails over Section 281 of the Income Tax Act even if the latter creates a void interest.
Economic Implications
Applying the aforementioned principles of construction will be beneficial from a policy standpoint. If crown debts are given priority over a contractually created security interest, credit flow will be stifled given the enhanced risks of recovery that secured creditors will face. Ultimately, creditors will be more reluctant to lend. This is bound to have economic ramifications and reduce India’s ease of doing business.
Conclusion
It is plain as day that Section 281 of the Income Tax Act which voids any security interest created when income tax proceedings are pending, is bound to collide with the operation of Section 26E of the SARFAESI Act. In case of such collision, well established rules of interpretation like the doctrine of purposive construction and rule of superior purpose warrant giving primacy to secured creditors. A security interest will otherwise be meaningless and dicey to enforce. The legislature contemplated these very challenges and decided to introduce Section 26E to the SARFAESI Act. Hence it would augur well for courts to follow the interpretation in favour of enforcing a security interest.