[Aaditya Gambhir is a fifth-year student at National Law University, Delhi.]
A long-standing issue since the inception of the Insolvency and Bankruptcy Code, 2016 (Code/IBC) is the treatment of statutory dues under the Code. The National Company Law Appellate Tribunal (NCLAT) has finally attempted to resolve the controversy in its judgment, dated March 20, 2019, in Pr. Director General of Income Tax v. M/s Synergies Dooray Automotive (Judgment).[1] This article aims to critically analyse the Judgment and point out certain consequential harms arising therefrom.
The Judgment
The Judgment disposes of a batch of appeals by statutory (tax) authorities from the orders of the National Company Law Tribunal (NCLT) under Section 31 of the IBC, approving the resolution plans for the corporate debtors. In each case, the grievance of the tax authorities was broadly that the resolution plans reduced the tax liability of the corporate debtor drastically, without the tax authorities being heard either before the Committee of Creditors (CoC), formed under Section 21 of the IBC, or before the NCLT, at the stage of approval.
The issues crystallized by the NCLAT in Para 14 of the Judgment were as to whether statutory dues are operational debts, and whether statutory authorities are operational creditors, under the IBC. After summarising the arguments made, the NCLAT’s substantive analysis in Para 23 addresses whether the “or” in Section 5(21) of the IBC (which defines “operational debt”) should be read as an “and”, i.e. as a conjunctive. Section 5(21) reads as follows –
operational debt means a claim in respect of the provision of goods or services including employment or a debt in respect of the repayment 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;
The issue was whether the second part of the definition (“or a debt in respect of the payment of dues”) is conjoined with or disjoined from the first part (“a claim in respect of the provision of goods and services”). The statutory authorities (supported by the Amicus Curiae in the case) argued that the “or” should be read as “and” (conjoined), since the essence of an operational debt is that it arises from the provision of goods or services. In this view, to read the “or” in Section 5(21) as creating two disjunctive parts of the definition (i.e. to create a class of operational debts removed from the provision of goods or services) was obviously outside the intended meaning of “operational debts”.
However, the NCLAT relied on a plain reading of the statute (Para 28), and quoted authorities for the proposition that “or” in a statute should be read as “and” only in extraordinary circumstances. The NCLAT supported its plain reading with the argument (in Para 29) that an operational debt is one arising during the operation of a company, and that statutory liabilities, including tax, arise only when a company is operational, thus establishing a direct nexus with the operation of the company. Thus, the tribunal dismissed all appeals preferred by the tax authorities and upheld the drastic haircuts approved by the NCLT.
However, it is submitted that the NCLAT’s treatment of this argument was not satisfactory. First, the point of departure adopted by the Judgment in Paras 23 and 24 is as follows –
“23. The word ‘or’ has been used at three places in Section 5 (21) namely— a claim in respect of 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.
24. Whether ‘or’ used in three places in Section 5(21) is disjunctive or should be given the meaning ‘and’ is one of the issues?”
This is obviously deficient insofar as the argument of the statutory authorities (and the Amicus) was only regarding the second ‘or’ - the one between ‘employment’ and ‘a debt in respect of…’. It is obvious that the definition does not state “goods and services” such that both must be provided to create an operational debt. While this starting point does not feature very prominently in the conclusion of the Judgment, it still provides an incorrect, or at least unclear, footing for it.
Even otherwise, the tribunal’s conclusions (in Paras 28 and 29) seem unconvincing. Para 28 simply asserts that the plain meaning is clear and unambiguous. Para 29, while appearing to substantiate the point, suffers from a logical malady –
“29. ‘Operational Debt’ in normal course means a debt arising during the operation of the Company (‘Corporate Debtor’). The ‘goods’ and ‘services’ including employment are required to keep the Company (‘Corporate Debtor’) operational as a going concern. If the Company (‘Corporate Debtor’) is operational and remains a going concern, only in such case, the statutory liability, such as payment of Income Tax, Value Added Tax etc., will arise. As the ‘Income Tax’, ‘Value Added Tax’ and other statutory dues arising out of the existing law, arises when the Company is operational, we hold such statutory dues has direct nexus with operation of the Company."
The glaring logical difference in the underlined sentences directly undermines the NCLAT’s attempt to draw a parallel between the provision of goods or services on one hand and the statutory liabilities on the other. While the first sentence acknowledges that ‘goods’ and ‘services’, including employment, are required to keep a company operational, the second sentence does not affirm the same for statutory liabilities. In fact, the second sentence states the converse – it is the operations of the company that are a pre-requisite to the existence of statutory liabilities, and not vice-versa. Thus, even as the language of the Judgment betrays the distinct logical relationship that goods and services bear to a company’s operations, as compared to statutory dues, the flow of the tribunal’s argument seems to conflate the same.
Further, there are situations in which statutory liabilities may also arise where the company has a mere legal existence and is not operational. For example, where a corporate debtor owns a factory building, property tax will be payable to the local municipal authority regardless of whether the corporate debtor is carrying on business or operations at the factory building in question.
Nevertheless, in light of the foregoing justifications, the NCLAT dismissed all appeals on the finding that the statutory authorities are operational creditors simpliciter and that they had been treated equally with similarly situated operational creditors in the impugned resolution plans.
The Consequential Harms
The merits of the NCLAT’s reasoning aside, the outcome of the Judgment also raises substantial questions.
By this Judgment, the statutory/tax authorities have been relegated to an entirely passive role in the IBC process. As an operational creditor, the tax department would have no vote in the CoC and would yet be bound by the resolution plan submitted by a resolution applicant and approved by the NCLT. Thus, a private industrial house may propose to drastically reduce pending tax dues of the corporate debtor (as seen in the present case), and the banks and financial institutions may approve the same, without hearing the tax authority.
It is worth noting that the only guarantee provided by the Code in terms of substantive payout to operational creditors is that they must be paid at least the amount they would have gotten, had the company been liquidated (Section 30(2)(b), IBC) and that this amount must be paid in priority to the financial creditors (Regulation 38, IBBI (Insolvency Resolution Process for Corporate Persons) Regulations, 2016). Considering the low position of the tax department in the liquidation waterfall under Section 53 of the IBC, this liquidation amount may be very low and may even be zero. The earlier respite extended to statutory authorities through taxing statutes providing specifically that the amounts due thereunder would be the first charge on the assessee’s assets has been specifically made subject to the IBC through the non-obstante provision in Section 238 of the IBC (as also the amendments to the Central Excise Act, 1944, the Income Tax Act, 1961, and the Customs Act, 1962, under Sections 246-248 of the IBC.)
Thus, a statutory authority, acting within and by the authority of law, is rendered powerless as regards its own claims. Entirely private entities can now waive these claims unilaterally.
While it is true that the Supreme Court has, in Swiss Ribbons v Union of India,[2] upheld the constitutionality of the distinction between operational and financial creditors (and the absence of operational creditors in the CoC), it still begs the question whether a statutory/tax authority falls within the contours of the intelligible differentia through which the Supreme Court justified this distinction.
There seem to exist important foundational differences between tax claims and trade-related operational debts. As regards the very nature of a tax claim, it arises as a mandatory imposition by a statute (backed by the Constitution), with the aim of securing the fundamental resources needed for the state to function and uphold its end of the social contract. On the other hand, a trade-related operational creditor undertakes a private and voluntary decision to advance funds to the corporate debtor to promote his own business profit. Similarly, even from a moral hazard perspective, a trade-related operational creditor has the choice of whether to lend/advance funds to the corporate debtor. Tax liabilities are, naturally, not a matter of choice or judgment.
These incongruencies can also be sensed in some of the differentiating factors between operational and financial creditors specifically mentioned by the Supreme Court in the Swiss Ribbons case (Paras 39-44), namely - (i) the generally small number of financial creditors v/s large number of operational creditors; (ii) the generally secured financial creditors v/s the generally unsecured operational creditors; (iii) finance as a term loan v/s loans relatable to supply of goods and services in the operation of business; (iv) specificity of payment schedules and defaults; (v) capability of financial creditors to assess feasibility of proposed resolution plans, etc. On most of these counts (apart from existence of security and the capability of assessing resolution plans), a statutory authority has little in common with a trade-related operational creditor. Statutory authorities are likely to be fewer in number, have nothing to do with the supply of goods and services in the operation of the business, and have specifically identifiable schedules and documents of imposition, payment and default.
Finally, an argument may be made by some that the rights of tax authorities will not be infringed unreasonably as the Supreme Court, in the Swiss Ribbons case, has clarified (when the adverse treatment that operational creditors may face as a result of their exclusion was pointed out) that similarly situated creditors would be treated equally under the IBC and that the NCLT would reject a resolution plan that failed to give the operational creditors roughly the same treatment as financial creditors.
However, it is submitted that the reliance on this approach is uncertain at best, and outside the statutory scheme at worst. What is the measure of the equality demanded by the Supreme Court? Does it mean that the CoC must ensure that roughly the same percentage of haircut is being taken by all creditors? That would be commercially unwise and not necessarily justified in many cases. Does it mean that the NCLT will examine other commercial considerations in assessing which sets of creditors are similarly situated? That would lead to great uncertainty and procedural delays before the NCLT, which would defeat the purpose of the Code. This uncertainty may also allow the NCLT to justify the waiver of huge portions of statutory debts in the garb of equal treatment for similarly situated creditors, if all other considerations fall in line, as in the present case.
Crucially, the IBC simply does not state that operational and financial creditors are to be “treated equally” to each other. Once the basic congruency and fairness of resolution plans is ensured, there may very well be situations where the best of the bad resolution options entails more haircuts for operational creditors than for financial creditors (or vice-versa). The IBC's corporate insolvency resolution process seems to create a marketplace of distressed debtors, inviting bids from investors for the most commercially sound resolution plan, which best resolves the unpaid dues of the corporate debtor while ensuring the most efficient use of its assets. That this is intended to be a de-regulated market-oriented process with minimal court/government interference is evidenced by the fact that those directly and commercially invested in the resolution of the debtor, i.e. its financial creditors, are primarily entrusted with the task of judging these plans. Thus, where the commercial requirements in a particular case demand reasonably disparate treatment for operational and financial creditors in the interests of the broader resolution of a stressed asset, the IBC seems to encourage that alternative rather than allowing liquidation because of the lack of a strict equality of outcomes.
The legal sanctity and practical importance of tax authorities demands that they be given a say in that process and not be treated like any other unwise tradesman.
One possible resolution, at least till the operational creditors are given more rights under the IBC, is for the statutory authorities to be made financial creditors by a legislative amendment. In a situation where retail creditors such as debenture-holders and home-buyers can be made financial creditors for certain larger objectives (despite being large in numbers and not having the capability to assess feasibility of resolution plans), there seems no iron clad reason for the tax authorities to be denied that prerogative.
[1]Company Appeal (AT) (Insolvency) No. 205 of 2017 – 20.03.2019.
[2]W.P.(C.) No. 99/2018 – 25.01.2019.