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Fate Of Unpaid Tax Liability Under The Insolvency And Bankruptcy Code

Tarun Gulati, Senior Advocate & Kumar Sambhav
14 July 2020 7:45 AM GMT
Fate Of Unpaid Tax Liability Under The Insolvency And Bankruptcy Code
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I. Introduction

Taxation disputes and recovery of taxes from companies is one of the most litigated subjects in the country. Often times, outstanding tax liabilities constitute a major portion of the liabilities of a company and can lead to its sickness. The revival and/or liquidation of such a company would depend on how tax liabilities are dealt with in the resolution process. Therefore, a wholesome understanding of the fate of tax liability under the Insolvency and Bankruptcy Code, 2016 ("Code") is essential both for the assessee as well as the tax department.

II. Legal position prior to the introduction of the Code

The common law doctrine of the priority of crown debts envisages precedence of crown debts over other creditors when it comes to recovery of dues. The doctrine, as developed and evolved, provides that the Crown's preferential right to recovery of debts over other creditors is confined to ordinary or unsecured creditors. In other words, it is not entitled to precedence over a prior secured debt.[1] The Supreme Court[2] has summed up the law as under:

"1. There is a consensus of judicial opinion that the arrears of tax due to the State can claim priority over private debts.

2. The common law doctrine about priority of Crown debts which was recognised by Indian High Courts prior to 1950 constitutes "law in force" within the meaning of Article 372(1) and continues to be in force.

3. The basic justification for the claim for priority of State debts is the rule of necessity and the wisdom of conceding to the State the right to claim priority in respect of its tax dues.

4. The doctrine may not apply in respect of debts due to the State if they are contracted by citizens in relation to commercial activities which may be undertaken by the State for achieving socio-economic good."

However, given the limitations of the applicability of the common law principles, most of the Indian taxation statutes have incorporated provisions for preferential recovery of tax dues by treating them as a first charge against the property of the company.[3] Another, step taken to make the recovery of tax dues easier was to allow them to be recovered as arrears of land revenue.[4] The Supreme Court, in relation to Section 46(2) of the Income Tax Act, 1922, which provides for recovery of tax as if it were an arrear of land revenue, has held that the provision does not deal with doctrine of priority of Crown debts at all, and it was impossible to accede to the argument that Section 46 displaces the application of the said doctrine.[5]

Often times, the statutory preference created by taxing statutes in favour of the tax department and the rights of a secured creditor have come in conflict. In Central Bank of India v. State of Kerala,[6] the Supreme Court was confronted with the issue of primacy between State tax legislations containing provisions conferring first charge on the property on one hand as against provisions of the Recovery of Debts Due to Banks and Financial Institutions Act, 1993 ("RDDBFI Act") for recovery of 'debt' and the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 ("SARFAESI Act") for enforcement of 'security interest'. The Supreme Court, after noticing the non-obstante clause contained in Section 34(1) of the RDDBFI Act and Section 35 of the SARFAESI Act, held that "[T]he Court could have given effect to the non obstante clauses contained in Section 34(1) of the DRT Act and Section 35 of the Securitisation Act vis a vis Section 38C of the Bombay Act and Section 26B of the Kerala Act and similar other state legislations only if there was a specific provision in the two enactments creating first charge in favour of the banks, financial institutions and other secured creditors but as the Parliament has not made any such provision in either of the enactments, the first charge created by the State legislations on the property of the dealer or any other person, liable to pay sales tax etc., cannot be destroyed by implication or inference, notwithstanding the fact that banks, etc. fall in the category of secured creditors…"

In relation to first charge on property provided by Section 11-AAAA of the Rajasthan Sales Tax Act, 1954 vis-à-vis an earlier mortgage on the same property, the Supreme Court has held that the former would have priority over the latter.[7] Similarly, the Supreme Court has held that the statutory first charge created under Section 33-C of the M.P. General Sales Tax Act, 1958 would prevail over a charge created in favour of a bank in respect of a loan.[8]

Under the Companies Act, 1956, in relation to payment of debts in winding up, Section 530 provides for the first preference to all revenues, taxes, cesses and rates due from the company to the Central or a State Government payable within twelve months before the relevant date. However, Section 530 is subject to Section 529A of the Act which provides that workmen's dues and dues to secured creditors would be paid in priority to all other debts. Further, the Supreme Court has taken the view that a lien holder, being a secured creditor, would have priority over government dues, i.e., income tax dues therein.[9] Therefore, insofar as winding up proceedings are concerned, tax dues get preference of payment right only after secured creditors and workmen's dues.

Section 178 of the Income Tax Act, 1961 ("IT Act") provides provisions for a 'Company in liquidation'. By virtue of Section 178(6), it overrides anything contrary contained in any other law. Section 178(2) provides that the Assessing Officer shall notify to the liquidator within three months from the date on which he receives notice of the appointment of the liquidator the amount which, in the opinion of the Assessing Officer, would be sufficient to provide for any tax which is then, or is likely thereafter to become, payable by the company. Further, as per Section 178(3), prior to such notification by the Assessing Officer and till the time the Liquidator sets aside an amount equal to the amount notified, the Liquidator shall not part with any of the assets of the company.

The Supreme Court has held that the effect of Section 178(3) is that the amount set aside by the Liquidator is marked off as outside the area of the winding up proceedings and the jurisdiction of the winding up court.[10] Further, under Section 530(1)(a) of the Companies Act, 1956, all taxes which have 'become due and payable' alone are entitled to preferential payment. The amount should have been crystalised into a liability. Under Section 178(2) read with Section 178(3) of the Income-tax Act, provision should be made for any tax which is then or is likely thereafter to become payable. Even the amounts which have not been crystalised into a liability, but which are 'likely to become due thereafter' should be taken note of.[11]

Similar to Section 178 of the IT Act is Section 17 of the Central Sales Tax Act, 1956, and the same interpretation applies to Section 17 Central Sales Tax Act, 1956 as applies to Section 178 of the IT Act.[12]

III. Legal position under the Code

Part II of the Code deals with 'Insolvency Resolution and Liquidation for Corporate Persons'. As the expression suggests, Part II contemplates two steps. First is the Insolvency Resolution wherein a Resolution Applicant proposes a Resolution Plan for insolvency resolution of a Corporate Person as a going concern. The alternative in case of failure of Insolvency Resolution is Liquidation. This section of the article examines (i) the classification of tax liability under the Code, (ii) the effect of moratorium on pending tax proceedings, (iii) the fate of tax liability in case of an approval of a Resolution Plan, (iv) the fate of tax liability in case a Corporate Person suffers liquidation, and (v) the fate of proceedings against the officers of the Corporate Debtor.

i. Classification of tax liability under the Code

Part II of the Code, inter alia, classify creditors as Operational Creditors and Financial Creditors. Operational Creditors are defined as persons to whom an Operational Debt is owed.[13] Operation Debt is defined as "a claim in respect of the provision of goods or services including employment or a debt in respect of the payment of dues arising under any law for the time being in force and payable to the Central Government, any State Government or any local authority."[14] The National Company Law Appellate Tribunal ("NCLAT"), while interpreting the said definition, has held that taxes such as Income Tax, Value Added Tax, etc. come within the meaning of the term Operational Debt. The NCLAT, further, held that the Income Tax Department and the Sales Tax Department(s) are Operational Creditors as defined under the Code.[15]

ii. Effect of moratorium on pending tax proceedings

As soon as an application for initiation of Corporate Insolvency Resolution Process is admitted, a moratorium is imposed in terms of Section 14 of the Code, which is similar to the provisions of Section 22 of the Sick Industrial Companies (Special Provisions) Act, 1985 ("SICA"). Where an application under SICA was admitted, the Courts stayed recoveries or tax proceedings against sick companies on a regular basis under Section 22 of the SICA.[16] Section 14(1)(a) of the Code prohibits the institution of suits or continuation of pending suits or proceedings against the corporate debtor including execution of any judgement, decree or order in any court of law, tribunal, arbitration panel or other authority during the subsistence of the moratorium. Courts have, relying on clause (a), not proceeded with hearing the tax appeals and tax writs, and have disposed them with the liberty to revive subject to the provisions of the Code.[17] Similarly, by virtue of clause (b) to Section 14(1), no payments can be made to any creditors after the imposition of the moratorium. Moreover, Section 14(4) clarifies that the order of moratorium continues to apply till the completion of the corporate insolvency resolution process.

It follows that once an application is admitted, the tax authorities cannot proceed with recovering the tax dues in the ordinary manner. Further, the tax departments will be paid as per the rules and procedures prescribed for payment under the Insolvency Resolution Process.

iii. Fate of tax liability in case of an approval of a Resolution Plan

Insofar as Operational Creditors are concerned, Section 30(2)(b) of the Code provides that the payment made to Operation Creditors under a Resolution Plan shall not be less than (i) the amount to be paid to such creditors in the event of a liquidation of the Corporate Debtor under section 53, or (ii) the amount that would have been paid to such creditors, if the amount to be distributed under the resolution plan had been distributed in accordance with the order of priority in sub-section (1) of section 53, whichever is higher. In other words, the amount paid shall not be less than (i) the liquidation value, or (ii) the amount of disbursement proposed by the resolution plan, whichever is higher, in case the respective amounts are distributed as per the waterfall provided in Section 53.

Section 53 of the Code provides for the order of priority for distribution of liquidation assets in case a Company faces liquidation. In the waterfall provided for in Section 53(1), clause (e) is designated to "any amount due to the Central Government and the State Government including the amount to be received on account of the Consolidated Fund of India and the Consolidated Fund of a State, if any, in respect of the whole or any part of the period of two years preceding the liquidation commencement date".

It is pertinent to mention that under Section 53(1) of the Code, higher priority is provided to insolvency resolution process cost and liquidation cost [clause (a)], workmen's dues and debts owed to secured creditors [clause (b)], wages and employee dues [clause (c)], and financial debts owed to unsecured creditors [clause (d)].

The High Court of Andhra Pradesh[18] was concerned with the issue that whether an order of attachment passed by the Tax Recovery Officer in respect of a property prior to the initiation of liquidation proceedings could be a bar to register the sale of the said property in liquidation proceedings. The High Court, while holding that tax liability being an input to the Consolidated Fund of India and of the States comes within the ambit of clause (e), decided the issue in the negative.

In most cases, the disbursement proposed by the resolution plan as well as the liquidation value gets exhausted before any payments can be made under clause (e). It follows that, for the purpose of Section 30(2)(b) of the Code, there would not be any amount payable to the tax department as the funds available would get exhausted on payments made to other debts which have a preference over government dues. In such a scenario, it is highly unlikely and, in fact, imprudent for a Resolution Professional to propose payment of a significant portion of the outstanding tax liability. This is because the decision to approve a Resolution Plan is primarily taken by the Committee of Creditors which, except for in exceptional cases, constitutes all the Financial Creditors of the Company. Financial Creditors, acting in a commercially prudent manner, would solely be concerned with the proportions of their payments. In fact, in most cases wherein Resolution Plans are approved, the Operational Creditors get little or no payments whatsoever. Therefore, under the provisions of the Code, recovery of outstanding tax payments is extremely difficult and the tax departments cannot claim any preference as they could in the era before the Code.

Further, Section 31(1) of the Code states that "[I]f the Adjudicating Authority is satisfied that the resolution plan as approved by the committee of creditors under sub-section (4) of section 30 meets the requirements as referred to in sub-section (2) of section 30, it shall by order approve the resolution plan which shall be binding on the corporate debtor and its employees, members, creditors, including the Central Government, any State Government or any local authority to whom a debt in respect of the payment of dues arising under any law for the time being in force, such as authorities to whom statutory dues are owed, guarantors and other stakeholders involved in the resolution plan." On a reading of Section 31(1) of the Code, it becomes clear that the Resolution Plan is binding on the creditors including the Central Government and any State Government to whom statutory dues are owed. It follows that the Resolution Plan is binding on the tax departments. Therefore, irrespective of whether the Resolution Plan proposes any payments of tax dues, such payment or non-payment would result in writing off of the entire tax liability qua the Company. In this regard, while interpreting Section 31(1) of the Code, the Hon'ble Supreme Court in Committee of Creditors of Essar Steel India Limited v. Satish Kumar Gupta ("Essar Steel"),[19] has held as follows:

"A successful resolution applicant cannot suddenly be faced with "undecided" claims after the resolution plan submitted by him has been accepted as this would amount to a hydra head popping up which would throw into uncertainty amounts payable by a prospective resolution applicant who successfully take over the business of the corporate debtor. All claims must be submitted to and decided by the resolution professional so that a prospective resolution applicant knows exactly what has to be paid in order that it may then take over and run the business of the corporate debtor. This the successful resolution applicant does on a fresh slate, as has been pointed out by us hereinabove."

Therefore, the fate of tax liability of a Company in case of a successful Insolvency Resolution lies in the explicit provisions of a Resolution Plan on which the tax department has little control.

Once an insolvency petition is admitted against a Corporate Debtor, all its creditors are required to submit their 'claims' to the Insolvency Resolution Professional. As per Section 3(6) of the Code, a claim means (a) a right to payment, whether or not such right is reduced to judgment, fixed, disputed, undisputed, legal, equitable, secured or unsecured, and (b) right to remedy for breach of contract under any law for the time being in force, if such breach gives rise to a right to payment, whether or not such right is reduced to judgment, fixed, matured, unmatured, disputed, undisputed, secured or unsecured. It is submitted that past tax liabilities, including the liabilities on which stay has been obtained, come within the ambit of 'claims'. As stated above, the fate of these claims is decided by the Resolution Plan.

Further, in relation to future tax liabilities where assessments are pending, the Department may either assess the tax liability and submit the claim in which case its fate would be decided by the Resolution Plan. However, in case such claims are not filed, it is submitted that they will lapse by virtue of the clean slate doctrine propounded by the Supreme Court in Essar Steel.

iv. Fate of tax liability in case a Corporate Person suffers liquidation

The rules for distribution of liquidation assets are provided under Section 52 and 53 of the Code. Section 52 applies to a secured creditor who, instead of relinquishing its security interest to the liquidation estate and receive proceeds as per the waterfall provided under Section 53, chooses to realise its security interest in the manner specified therein. The High Court of Andhra Pradesh has held that the Income-tax Department does not enjoy the status of a secured creditor and, as such, it cannot avail the provisions of Section 52 of the Code, and must necessarily take recourse to distribution of the liquidation assets as per Section 53 of the Code.[20] This is true for all other taxes. The legislative intent is also clear from the amendment made by the Code to Section 178 of the IT Act. Section 247 of the Code read with the Third Schedule appended thereto amended Section 178(6) to the IT Act to provide that the provisions of the Code will override anything inconsistent provided to in Section 178. The Apex Court has also held that given Section 238 of the Code, it is obvious that the Code will override anything inconsistent contained in any other enactment, including the Income-Tax Act.[21] Moreover, Section 82 of the Central Goods and Services Tax Act, 2017 ("CGST Act"), which is a later legislation, provides for the tax to be first charge on property. It states that "[N]otwithstanding anything to the contrary contained in any law for the time being in force, save as otherwise provided in the Insolvency and Bankruptcy Code, 2016 (31 of 2016), any amount payable by a taxable person or any other person on account of tax, interest or penalty which he is liable to pay to the Government shall be a first charge on the property of such taxable person or such person." It is clear on a reading of Section 82 of the CGST Act that its provisions will not override anything inconsistent contained in the Code. Therefore, the first charge created by virtue of Section 82 of the CGST Act will not affect the waterfall mechanism provided under Section 53 of the Code.

As such, the outstanding tax liabilities can only be paid as per Section 53 of the Code. As stated above, in most cases, liquidation value gets exhausted before any payments can be made against tax liabilities under clause (e). Therefore, the likelihood of recovery of tax liabilities is bleak.

The doctrine of preference of Crown debts and the priority to secured creditors as existing under the erstwhile regimes are no longer applicable under the Code. This is because the Code provides a clear waterfall mechanism under Section 53 of the Code, and Section 238 of the Code provides for an overriding effect to the Code against any other law which may be inconsistent to the provision of the Code.

v. Fate of pending proceedings against the officers of the Corporate Debtor

Taxing statutes provide for imposition of penalties and criminal liabilities against the officers of a company. As stated above, on the initiation of the Corporate Insolvency Resolution Process, Section 14 of the Code provides for imposition of moratorium. However, the scope of the moratorium is restricted to providing a breathing period to the Corporate Debtor, and it is not applicable to the officers of the Corporate Debtor. In this regard, in the context of liability for dishonour of a cheque under the Negotiable Instruments Act, 1881, the NCLAT has held that neither any criminal proceedings are covered within the ambit of Section 14 nor can the directors take shelter of the said provision.[22] The High Court of Bombay has also taken the view that Section 14 does not cover within its ambit criminal proceedings.[23]

Further, the Code contains no provision for immunity from personal liability of any officer of the Corporate Debtor either under the Insolvency Resolution or Liquidation. In this regard, Section 32A of the Code is relevant. It provides for that the cessation of the liability of a corporate debtor for an offence committed prior to the commencement of the corporate insolvency resolution process. It, further, provides that the corporate debtor shall not be prosecuted for such an offence from the date the resolution plan has been approved, if the resolution plan results in the change in the management or control of the corporate debtor. It is clear, therefore, that it is only the Corporate Debtor that has been granted immunity that too in case the resolution plan contemplates a change in its management.

Therefore, any pending proceeding or prosecution against any officer of the Corporate Debtor will not be affected by the Corporate Insolvency Resolution Process.

IV. Conclusion

Given that the moratorium imposed on the admission of an insolvency application prohibits continuation of any legal proceedings as well as any payment to creditors, the probability of the recovery of the entire tax liability is miniscule. Further, as explained above, the possibility of part recovery is also very less. In any case, the legislative intent is clear, i.e., priority to insolvency resolution, be it by way of approval of Resolution Plan or by way of liquidation, even though it may be at the expense of the exchequer. However, the officers and directors of the corporate debtor who have personal liability under different statutes cannot afford to sleep easy and must be prepared to defend their personal assets against recovery of outstanding tax dues.

Views are personal only.

(The authors are Senior Advocate and Advocate respectively practicing at the Supreme Court of India)



[1] Dena Bank v. Bhikhabhai Prabhudas Parekh, (2000) 5 SCC 694.

[2] Builder Supply Corporation v. Union of India, AIR 1965 SC 1061.

[3] See Section 11E of the Central Excise Act, 1944, Section 142A of the Customs Act, 1962, Section 88 of the Finance Act, 1994, Section 47A of the Delhi Value Added Tax Act, 2004, Section 123 of the Delhi Municipal Corporation Act, 1957.

[4] See Section 11(1) of the Central Excise Act, 1944, Section 142(1) of the Customs Act, 1962, Section 87 of the Finance Act, 1994, Section 43(3) of the Delhi Value Added Tax Act, 2004.

[5] Builder Supply Corporation v. Union of India, AIR 1965 SC 1061.

[6] Central Bank of India v. State of Kerala, (2009) 4 SCC 94.

[7] State Bank of Bikaner and Jaipur v. National Iron and Steel Rolling Corporation, (1995) 2 SCC 19.

[8] State of M.P. v. State Bank of Indore, (2002) 10 SCC 441.

[9] Bombay Stock Exchange v. V.S. Kandalgaonkar, (2015) 2 SCC 1.

[10] Imperial Chit Funds Pvt. Ltd. v. ITO, (1996) 8 SCC 303.

[11] Imperial Chit Funds Pvt. Ltd. v. ITO, (1996) 8 SCC 303.

[12] Imperial Chit Funds Pvt. Ltd. v. ITO, (1996) 8 SCC 303.

[13] See Section 5(20) of the Code.

[14] See Section 5(21) of the Code.

[15] Pr. Director General of Income Tax v. Synergies Dooray Automotive Ltd., [2019] 149 CLA 462 (NCLAT).

[16] Union of India v. Shree Synthetics Ltd., 2002 (142) E.L.T. 529 (M.P.).

[17] See Principal Commissioner of Income Tax v. Monnet Ispat and Energy Ltd., (2018) 304 CTR (Del) 234 upheld in Principal Commissioner of Income Tax v. Monnet Ispat and Energy Ltd., [2018] 147 CLA 300 (SC); CCE v. Monnet Ispat Ltd., 2018 (361) ELT 474 (Chhattisgarh); Oceanic Tropical Fruits Private Limited v. The Assistant Commissioner, MANU/TN/4830/2017; Sujana Towers Ltd. v. CCE, 2020-TIOL-513-CESTAT-HYD.

[18] Leo Edibles & Fats Ltd. v. Tax Recovery Officer, [2018] 146 CLA 192 (Hyd.).

[19] Committee of Creditors of Essar Steel India Limited v. Satish Kumar Gupta, [2019] 153 CLA 275 (SC).

[20] Leo Edibles & Fats Ltd. v. Tax Recovery Officer, [2018] 146 CLA 192 (Hyd.).

[22] Shah Brothers Ispat Pvt. Ltd. v. P. Mohanraj, order dated 31.07.2018 in Company Appeal (AT) (Insolvency) No. 306 of 2018.

[23] Tayal Cotton Pvt. Ltd. v. State of Maharashtra, [2018] 147 CLA 122 (Bom.).

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