Does IBC Impede the Government’s Right of Taxation? -An Analysis

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This article was written by Devina Srivastava, a student of Symbiosis Law School, Pune (guest post).

Introduction

The Insolvency and Bankruptcy Code, 2016 was enacted with a view to consolidate the existing legal framework by creating a single law for insolvency and bankruptcy in India.[1] The Code has given effect to a number of pioneering changes in the insolvency regime in India.

One of the significant reforms relates to a new liquidation waterfall[2] that provides the order of priority for distribution of proceeds from the sale of liquidation assets. This waterfall is a deviation from the earlier regime where Government dues were immediately below the claims of secured creditors and workmen but now rank fifth in the order of priority. This has raised concerns about whether the government’s sovereign right of taxation is impeded by the operation of IBC. The question, though academic in nature, is very significant for comprehending the relationship between taxation law and corporate insolvency law in the country. It is hence worthy of detailed analysis.

Analysis

“Impede” is understood as “to interfere with or to get in the way of progress of”.[3] By definition, anything which “gets in the way of progress of” of right of taxation of the government would be said to impede the sovereign right. There are cogent reasons to support as well as oppose the view that the right of taxation of the government is impeded by the operation of IBC.

Why Government’s Right of Taxation is Impeded by IBC:

  1. Change in order of priority of claims and non-operation of laws other than IBC

Section 53 of IBC prescribes the following order of distribution of sale proceeds of liquidation assets:

  1. IRP costs and liquidation costs
  2. Workmen’s dues and dues of the secured creditors who have relinquished their securities
  • Wages and unpaid dues to employees
  1. Financial debts to unsecured creditors
  2. Government dues and any unpaid amounts remaining for the secured creditors after they have enforced their securities.
  3. Remaining debts
  • Preference shareholders
  • Equity shareholders and partners.

As per this, the waterfall of liabilities under IBC places the government dues on fifth place under order of priority. This is in contrast to the Presidency Town Insolvency Act[4] and Provincial Insolvency Act[5], where all the debts due to the Government or to any local authority were second in priority after cost and expenses of bankruptcy process. Also, under the Companies Act, 2013, the government dues were paid off after the liquidation charges, workmen’s dues and secured creditors[6], and had preference over the claims of unsecured creditors. The IBC has repealed the Presidency Town Insolvency Act and Provincial Insolvency Act[7] and has brought about amendments in the Companies Act 2013[8]. Additionally, Section 53 of the IBC begins with a non-obstante clause “Notwithstanding anything to the contrary contained in any law enacted by the Parliament or any State Legislature for the time being in force[9], which prevents reliance on any other law to the contrary[10]. Therefore, the order of priority laid down in Section 53 of the IBC has to be complied with for distribution of proceeds of the liquidation of any company going through insolvency process and no other law can be resorted to for the same.

  1. Section 178(6) of the Income Tax Act Amended to Limit Power of Liquidator to Satisfy Tax Dues

Section 178(6) of the IT Act initially stated that the provisions of this Section shall have effect notwithstanding anything to the contrary contained in any other law for the time being in force.[11] However, IBC has made an amendment to this Section and has made the application of this Section only those cases where IBC does not apply.[12] Amended Section 178(3) of the IT Act provides that liquidator appointed for any company can part with the assets of the Company or properties in his hand for the purpose of the payment of the tax payable by the company.[13] Hence, in the cases in which liquidation proceedings are conducted under IBC, the liquidator would not be allowed to part with assets and properties of the company for tax payable by the Company.

  1. Government being an Operational Creditor has No Say in Insolvency Resolution Process

Under IBC, the debt owed to the Government is classified as an operational debt[14] which implies the government as well as the Income Tax Department are operational creditors[15]. The IBC treats financial creditors[16] differently from operational or trade creditors. Though this is done to improve the position of unsecured financial creditors vis-à-vis secured financial creditors which have, up until now, been the main focus of law reform efforts in India,[17] it places operational creditors in a disadvantageous situation as they are not a part or committee of creditors[18] and hence, do not have any voting rights under IBC[19]. Consequently, the government does not have any standing in the resolution plan or the power to object or veto a resolution plan that provides for a write-off of outstanding tax demand.

From the above, a reasonable conclusion would be that the right of taxation of the government is impeded by IBC. But, this must not be the final conclusion as several reasons support the argument that the government’s right is not impeded.

Why Government’s Right of Taxation is Not Impeded by IBC:

  1. Tax Claims have only been Lowered in the Priority of Claims and Not Abolished

Although with the operation of IBC, the government dues have been lowered in the order of priority of payments, they have not been abolished. Thus, it cannot be said that the lowering of the government dues in the order of priority of payment gets in the way of progress of government’s right of taxation.

  1. Alternative Options are Available to Recover Tax Dues from Companies in Liquidation

There are alternatives available if the tax dues cannot be recovered from the company during liquidation. In case of private companies, every person who was a director of the company at any time during that year shall be jointly and severally liable for the payment of the tax dues.[20] However, this is subject to the exception that the director is able to prove that the non-recovery cannot be attributed to any gross neglect, misfeasance or breach of duty on his part.[21] In case of public companies, ordinarily the provisions of Section 179(1) cannot be applied. However, the concept of lifting of corporate veil can be resorted to.[22] If it is found that incorporation of a company is only to defraud the government and tax department, the Courts do not hesitate in ignoring the corporate status.[23] In such a case, the Income Tax Department can seek to resort to provisions contained in section 179 of the Act to recover outstanding taxes from the directors of the Company.

  1. Minimum Alternate Tax Provisions are Applicable to Companies Undergoing Insolvency Resolution Process under IBC

Minimum Alternate Tax (MAT) provisions are applicable to the companies undergoing insolvency resolution process under IBC. According to Section 115JB of the IT Act, if in case of a company, for any assessment year, income tax payable on the total income computed according to the normal provisions of the Act works out less than 18.5 percent of the ‘book profits’ of the company, then instead of total income computed as per the provisions of the Act, such book profits are to be considered as the total income for that previous year and income tax on such total income is to be charged at 18.5 percent.[24]  The income tax which is calculated at the rate of 18.5 percent of book profits is MAT. Book profit means net profit as shown in the profit and loss account for the relevant previous year.[25] The IT Act provided that the profits of sick companies, for the year commencing when the company becomes sick until the year in which the net worth was less than the accumulated losses, were exempt from MAT.[26] These Sick Companies are recognized under Sick Industrial Companies Act by the Board of Industrial and Financial Reconstruction.[27] However, with the enforcement of IBC, SICA has been repealed[28] and the status of a company being “sick” no longer exists for any company whose net worth is less than accumulated losses. The clause which excludes sick companies from MAT liability[29] is no longer applicable after the enforcement of IBC. Hence, any company undergoing insolvency proceedings under IBC is liable to pay MAT and the right of taxation of the government is protected.

  1. Common Law Principle of Priority of Government Debts is Subject to Statutory Law

One may argue that the provisions of IBC are in conflict with the principle of priority of government dues that continues to remain in force as per Article 372(1) of the Constitution.[30] However, in the case of UTI Bank v. Deputy Commissioner[31], the Court came to the conclusion that the dues to Government, i.e., tax, duties, etc. get priority over ordinary debts only when there is a specific provision in the statute claiming “first charge” over the property. Therefore, the doctrine will not apply if first charge by way of priority is not claimed under the statute.[32] This is tenable in law as the principle of priority of government is a common law principle and if there is a conflict between the common law and the statute law, one has to give precendence to statutory law.[33] Therefore, the common law principle of priority of government dues must yield to the statutory law of IBC.

Conclusion

In the light of the aforementioned competing arguments, it is strenuous to conclusively determine if the sovereign right of taxation of the government has been impeded by IBC. On the one hand, it can be said that the government has been lowered in the order of priority of claims under IBC but on the other hand, it must also be noted that this has been done only to protect the interests of other stakeholders. Merely lowering of rank in the priority order does not impede the government’s right as it does not extinguish the government’s claim. Especially so, when various alternative provisions exist for the government to enforce the company’s tax liability (under IT Act) or hold persons responsible if they are not satisfied (by lifting of corporate veil). Article 372 of the Constitution gives way to statutory law and similarly, the age-old principle of priority of government dues must also give way to progressive legislation that resolves modern corporate law issues dynamically and holistically. In essence, the relationship between taxation law and corporate insolvency law is a very intricate one and care must be taken that one law does not transgress the interest and object of the other.

[1] Object Clause, Insolvency and Bankruptcy Code of India, 2016.

[2] Section 53, Insolvency and Bankruptcy Code of India, 2016.

[3] Arthur Anderson LLP v. United States, 544 US 696 (2005).

[4] Section 49 of The Presidency Towns Insolvency Act, 1909.

[5] Section 61 of The Provincial Insolvency Act, 1920.

[6] Section 327, The Companies Act, 2013.

[7] Section 243, Insolvency and Bankruptcy Code, 2016.

[8] Section 255, Insolvency and Bankruptcy Code, 2016.

[9] Section 53, Insolvency and Bankruptcy Code, 2016.

[10] Rai Brij Raj Krishna v. S.K. Shaw, AIR 1951 SC 115.

[11] Section 178(6), The Income- tax Act, 1961.

[12] Section 247, Insolvency and Bankruptcy Code, 2016.

[13] Section 178(3), The Income Tax Act, 1961.

[14] Section 5(21), Insolvency and Bankruptcy Code, 2016.

[15] Section 5(20), Insolvency and Bankruptcy Code, 2016.

[16] Section 5(7), Insolvency and Bankruptcy Code, 2016.

[17] The Report of the Bankruptcy Law Reforms Committee Volume I: Rationale and Design, November 2015.

[18] Section 21(2), Insolvency and Bankruptcy Code, 2016.

[19] Section 24(4), Insolvency and Bankruptcy Code, 2016.

[20] Section 179(1), Income Tax Act, 1961.

[21] Ibid.

[22] Pravinbhai M. Khemi v. Assistant Commissioner of Income Tax, (2014) 266 CTR (Guj) 410.

[23] Ajay Surendra Patel v. Deputy Commissioner of Income Tax,(2017) 4 CompLJ 467 (Guj).

[24] Section 115JB(1), Income Tax Act, 1961.

[25] Explanation 1 to Section 115JB(2), Income Tax Act, 1961.

[26] Ibid.

[27] Section 17(1), Sick Industrial Companies Act, 1986.

[28] Sick Industrial Companies Repeal Act, 2003, Gazette of India, Part II, Section 3(ii) (December 25, 2016).

[29] Explanation 1 to Section 115JB(2), Income Tax Act, No. 43 of 1961.

[30] Bank of India v. John Bowman, AIR 1955 Bom 305; Kaka Mohammad Ghouse Sahib v. United Commercial Syndicate, (1963) 49 I.T.R. 25.

[31] UTI Bank Ltd. v. Deputy Commissioner of Central Excise, Chennai, W.P. Nos. 39536 of 2005 (Mad HC).

[32] M. Nagarajan v. The Deputy Commercial Tax Officer, (2009) 25 VST 175 (Mad).

[33] Guljag Industries v.Commercial Taxes Officer, (2007) 7 SCC 269.

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