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Rainbow Papers: A Forgettable Case For IBC Jurisprudence

The author is Neelabh Niket, a fourth year student at Hidayatullah National Law University.


The Supreme Court of India (‘SC’), has recently in State Tax Officer v Rainbow Papers, held that a resolution plan to revive a corporate debtor from stage of insolvency shall not pass the scrutiny of law if the plan altogether ignores the statutory and government dues and, in such case, the Corporate Debtor is bound to be compulsorily liquidated as per Section 53 of the Insolvency & Bankruptcy Code (‘IBC’). The issue raised in the judgment related to unpaid taxes under the Gujarat Value Added Tax Act of 2003 (‘GVAT’) and its conflict with the waterfall mechanism under Section 53 of the IBC. The waterfall mechanism encapsulated under Section 53 of the IBC is nothing but a legal device enacted to delineate a hierarchy for payment of debts in order of priority, at the time of liquidation of the corporate debtor. In essence, the conflict discussed in the case is between private secured debts and the unpaid claims of the government entities. Thus, it is imperative at this point to revisit the judgment and understand how it impacts the purpose of the IBC.

Background of Statutory Dues Vis-à-vis Private Secured Debt

Before jumping to nuances of IBC, one should have a general idea about the status and preference which has been accorded to statutory dues by the judiciary over the years.

The most significant ruling in this regard came from the Supreme Court came in the case of Dena Bank vs. Bhikhabahai Prabhudas Parekh, wherein it was made clear that Income-tax dues, being in the nature of Crown debts, do not take precedence over secured creditors, who are private persons. The same was discussed and affirmed later in the case of Stock Exchange, Bombay vs V.S. Kandalgaonkar.

The Gujarat High Court, in the case of Bank Of India vs State of Gujarat, while resolving the conflict between Section 31B of the Recovery Of Debts And Bankruptcy Act, 1993 and Section 48 of the GVAT Act held that the rights of a secured creditor to realize its secured debts due and payable by sale of assets over which security interest is created would have priority over all government debts and dues including revenue and taxes due to the State Government.

Thus, it is evident that the secured private debts have invariably been given preference over almost all kinds of government dues. Once this point is appreciated, one shall now delve into grounds on which the instant judgment is being assailed.

A. A Government Entity is Not a Secured Creditor

The Court while arriving at the discussed conclusion, has importantly held that as the State Government having first charge over the property is a ‘secured creditor’ under the Gujarat Value Added Tax, 1974 thus it shall also be classified as a ‘secured creditor’ under Section 53 (1) (b) (ii) of the IBC for the purposes of liquidation.

It is submitted that such interpretation does not align with the purpose of IBC and meaning ordained in one Act cannot be transfused in another separate act. The phrase ‘secured creditor’ under IBC seeks to include and protect entities which took the risk of paying off the debts of the Corporate Debtor in instances of default and was not meant to enable the Government bodies to utilize it as a recovery mechanism. The primary purpose of placing ‘secured creditors’ so high in priority under Section 53 was for the sole protection of creditors upon insolvency of the Corporate Debtor and to provide them with cushion against any cases of cascade or domino insolvencies. In purely finance terms, security attracts capital and also abates the cost of credit. All these aspects are absent in the GVAT Act and the context in which ‘secured’ has been used in the GVAT Act is entirely different under the scheme of IBC. Thus, tax dues may be secured according to a revenue statute, but the same cannot be interpreted to bypass the waterfall mechanism provided for in the IBC.

Further, according to the judgment, a ‘security interest’ can also be created by operation of law and a statute like the GVAT Act, accords the status of a ‘secured creditor’ to the government authorities. It can be argued that such interpretation is erroneous as the Court has, possibly due to an oversight, overlooked the definitions of ‘security interest’ and ‘transaction’ provided under Section 3(31) & 3(33) of the IBC respectively. A combined reading of both these definitions will make it amply clear that a security interest can only be created by a transaction which is contractually agreed upon by two or more parties, based on their commercial considerations.

The definitions ought to be interpreted literally and must keep outside its ambit all those instances triggered and caused by the letter of law. The forceful and non-consensual creation of a statutory charge on a property by the tax authorities cannot possibly be given the colour of a ‘transaction’ under the IBC.

B. Discrimination Meted Out to Other Operational Creditors

The SC relying on Section 30(2) of the IBC, held that the Adjudicating Authority under Section 31 is required to approve a resolution plan only upon the objective satisfaction that the statutory debts in the nature of operational debt are compulsorily paid up.

Admittedly, Section 30(2) of IBC is an enabling provision for the benefit and protection of the operational debtors, but the same does not operate to mean that such debts shall be paid over and above the pending financial and secured debt. It is now trite law that a resolution plan is legal and effective even if nothing is provided to the operational creditors provided that such decision has been taken by the Committee of Creditors to maximize the value of the assets of the Corporate Debtor. It is to be noted that the Court has made such special observation only in respect of the debts held against the Government and not the other operational creditors. There is absolutely no rationale for giving a special status to the Government dues within the general bracket of ‘Operational Creditors’. This biasness of the Court, favoring the Government entities can also be appreciated via another similar argument, discussed below.

Usually, a secured creditor belongs to the class of financial creditors. But there may be cases where even an operational debtor may be classified as a ‘secured creditor’. For example, in the case of Concast Steel & Power Ltd. v MSTC Limited, an operational creditor was classified as a secured creditor by the National Company Law Appellate Tribunal, owing to a pledge agreement signed with the corporate debtor.

Even assuming, without admitting, that the State tax dues are secured debt under IBC, then too there exist foundational flaws with such interpretation. On a careful reading, it is apparent that while ignorance of statutory debts will render a resolution plan void, ignorance of claims from the likes of secured operational creditors shall not be an obstacle in the successful implementation of the plan. Thus, there is a tacit discrimination which is being meted out to the class of secured operational creditors. This discrimination is essentially not fair and equitable between the operational creditors as a class, as a sub-category has been created in the larger bracket of operational creditors, violating the mandate of Section 30(2)(b) of IBC. In short, such differentiation is incorrect at two levels- a) It is inequitable with other secured operational creditors; and b) that such preference to the Government entities has not been envisaged in the scheme of IBC.

C. Altered the Waterfall Mechanism for Liquidation

The Court further added that such statutory dues shall also be given preference while liquidation is underway.

As discussed earlier, the waterfall mechanism enlists the hierarchy which has to be followed while distributing the funds received after liquidating the business of the Corporate Debtor. It may seem at first blush that the Court has not disturbed the existing priority list under Section 53 of IBC, and avoided a conflict between the two Acts, however, it is submitted that by holding government dues as ‘Secured Creditor’, it has in a way upgraded the priority originally given to the Government authorities. It is well-settled that what cannot be done directly, cannot be done indirectly. Thus, any implied modification and alteration in the defined waterfall mechanism will tantamount to rewriting the legislature’s wisdom and will culminate in frustrating the very purpose of the IBC.

It is apposite at this stage to revisit these lines from the Andhra Court in the case of Leo Edibles & Fats Limited v. Tax Recovery Officer,

“It is therefore clear that 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.”


In light of this, it is advisable that the Supreme Court revisits the instant judgement and clarifies law on this point. It is very evident that if the current position in law is allowed to perpetrate then it will act as a detriment to the purpose which the Code is intended to serve. As an aftermath, any prospective resolution applicant is likely to be discouraged with the additional obligation of meeting present or potential government and legislative dues. It may ultimately result in fewer resolution applications, lower values of the assets, and more haircuts for creditors.

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