The Hidden Tax Trap in MSME Insolvency: Time to Rethink Haircuts

[Chaitanya and Chandana are students at Gujarat National Law University and Damodaram Sanjivayya National Law University, respectively.]

India’s pre-packaged insolvency resolution process (PPIRP) initiated in 2021 specifically for MSMEs with the goal of saving small businesses from the severe cash flow interruptions and commercial impact caused by COVID-19 by means of rapid, debtor-driven restructuring. MSMEs form the backbone of the Indian economy with a contribution of almost 30% to India’s GDP. In a “pre-pack,” promoters line up a base resolution plan before filing, often involving significant haircuts (partial debt write-downs) for creditors. In theory, haircuts give distressed MSMEs a second chance by slashing their debt burden. Ironically, Indian tax law has treated these write-offs as taxable income in the debtor’s hands. To put it another way, the same relief that insolvency legislation is meant to offer is instead made into a new financial obligation resulting in the "haircut paradox".

This is especially pressing considering that median haircuts have steeply risen from 64% during FY23 to 73% in FY24, and the median time taken for resolution has startlingly risen to 834 days. According to experts, lenders still have concerns about PPIRP and would rather use the more conventional CIRP. Yet, an often-overlooked factor behind PPIRP’s limited adoption is the lack of Indian scholarship examining how taxation policy interacts with insolvency law, a gap that undermines its popularity.

The Haircut Paradox

A “haircut” is simply a write-down of creditor claims to salvage the firm. Lenders help the business "stay alive" by agreeing to accept less than full repayment, preserving jobs, ensuring business continuity, and producing greater value than a complete liquidation. Haircuts are a "sacrifice" that allows the debtor to continue operating with less responsibilities while maintaining the current business.

A strange paradox is created by Indian tax laws, too, in that what is economically a loss for creditors and a gain for the debtor's survival is treated as the debtor's income. In actuality, even though no money really changed hands, the tax code assesses debt repayment as though the business had pocketed cash. As evident, the so-called income out of a haircut is not a result of cash flow at all. It is an accounting fiction created by the Indian Accounting Standards. To tax such a non-cash benefit is to “turn a restructuring solution into a fiscal burden,” penalizing firms for using the very relief meant to rescue them.

This policy conflict is glaring: the Income-tax Act 1961 taxes workouts, but the Insolvency and Bankruptcy Code 2016 (IBC) promotes new beginnings and effective workouts. The outcome contradicts itself. The restructuring mechanism is essentially stifled by this glaring misalignment. As one analysis warned, taxing haircuts “negates the economic benefit of resolution” and quickly “restores insolvency risks” once the plan is implemented.

How an Indian Tax Law Treats Haircuts

Under the Indian tax laws, one or more of these sections will often bring a haircut into the tax net. The key provisions are:

Section 28(iv), Income-tax Act 1961

This clause taxes perquisites “arising from business.” Pre-2023, the Income-tax Act 1961 defined Section 28(iv) so that a benefit had to be other than cash to be taxable. The Supreme Court seized on this in Commissioner v. Mahindra and Mahindra Limited. Where it was held that a loan waiver is a cash receipt, so Section 28(iv) did not apply. In other words, a cash write-off was not “income” under the old law. However, the Finance Act 2023 explicitly amended Section 28(iv) to close this gap as it now clarifies that even cash benefits (including debt waivers) are covered.

Section 41(1), Income-tax Act 1961 

This rule states that if a business liability (e.g. a trading loan) is waived and had been deducted in computing business income earlier, then that amount is treated as taxable income. 

Section 115JB, Income-tax Act 1961 

Even if a waiver slips past Section 28 or 41, it usually shows up in the company’s financial statements as a credit. Indian Accounting Standard IndAS 109 requires reversal of the liability to be charged to profit and loss when a debt is derecognized. That “gain” inflates the book profit, triggering minimum alternate tax (15% of book profit).

In summary, Indian tax law currently offers no blanket exemption for insolvency haircuts. The tax-on-haircut regime is especially harsh for MSMEs as they typically operate on razor-thin margins with limited capital buffers. Practically, this has several chilling effects on MSMEs such as negating the relief of restructuring, undermining access to finance, discouraging early resolution, and slowing down of PPIRP adoption. However Indian courts have shown a clear trend of giving low priority to tax dues in insolvency. In Ghanshyam Mishra v. Edelweiss ARC, the Supreme Court held that once a resolution plan is approved, it binds all stakeholders, including tax authorities, even if no tax payments are provided. Similarly, in Synergies Dooray, the National Company Law Tribunal (NCLT) allowed a 99% waiver on tax dues, treating them like operational creditor claims subject to steep haircuts. This judicial stance favours corporate revival over tax collection.

How Other Countries Handle Debt Waivers

Recognizing this global challenge, many jurisdictions exempt discharged debt from taxable income or provide special relief in insolvency. For example:

United States

The US tax code provides explicitly that in bankruptcy (or insolvency), a company generally does not recognize discharged debt as income. Section 108 of the Internal Revenue Code excludes from gross income any discharge of indebtedness in bankruptcy, or to the extent the debtor is insolvent. 

United Kingdom

Waivers, although accounted for, are not deemed income for taxation purposes. This is based on the understanding that notional gains do not amount to real economic enrichment, particularly when occurring through insolvency procedures.

International recommendations

Bodies like the World Bank, OECD and UNCITRAL emphasize that a distressed company needs a “fresh start,” free from tax drag. The UNCITRAL Legislative Guide on SME Insolvency (2022) and World Bank studies urge that governments avoid taxing routine restructuring adjustments. 

In short, leading jurisdictions decouple insolvency haircuts from taxable income, consistent with the global view that a company restructuring should not be penalized by taxation. By contrast, India’s current approach puts us out of step with these norms.

Policy Recommendation

Addressing the haircut paradox will require targeted legal reform to align tax rules with insolvency goals. Proposed solutions include:

Statutory exemption for PPIRP haircuts

Carving out debt waivers from taxable income under an NCLT-approved scheme is the easiest solution. For instance, experts recommend amending Section 28/41of the Income-tax Act 1961 or inserting a new phrase in Section 10 of the Income-tax Act 1961 to state that “any income arising from a waiver or reduction of liability under a resolution plan approved by the NCLT” is tax-free. 

Binding effect of resolution plans

Reiterating that a plan's contents, including any tax waivers, are binding on all authorities after the NCLT approves it, is another step in the right direction. This has been iterated by the Supreme Court in the Ghanshyam Mishra ruling. Any tax obligations covered by an authorized plan could be declared satisfied by a clarifying amendment. By doing this, a mutually agreeable agreement would not be disturbed by post-resolution tax claims.

MAT and TDS fixes

MAT (Section 115JB of the Income-tax Act 1961) could similarly eliminate write-downs when determining book profit in order to prevent the advantage from eroding. Alternatively, debtors could receive relief under Section 115BAA without losing deductions after completing an IBC process. Similarly, the remaining imbalance would be eliminated by codifying the recent TDS relief (such that lenders give up claims on waived amounts).

Broader incentives for MSME rehab

The government could simultaneously increase PPIRP's appeal through additional means. For instance, tax vacations for earnings made after bankruptcy, quicker reimbursements, or assistance with credit guarantees. The idea that MSMEs genuinely have a new beginning rather than a new set of responsibilities would be strengthened by such actions.

The aforesaid policy changes would bring India’s approach more in line with global practice and establish policy coherence. By harmonizing tax law with IBC objectives, India would reassure creditors and debtors alike that cooperative, PPIRP-based turnarounds are encouraged, not punished.

Conclusion

Theoretically, MSMEs should benefit from haircuts under the PPIRP, which are agreements that keep enterprises afloat and avert bankruptcy. However, under the current tax system in India, a write-off all too frequently turns into a hardship. Although the debtor receives primary relief, they are immediately subject to an equivalent tax claim on that relief. The whole purpose of insolvency legislation, which is to preserve property and encourage regeneration, is compromised by this paradox.

The lesson is evident: the application of the tax legislation to settled obligations is neither required nor consistent with its purpose. Other jurisdictions have demonstrated that tax policy and insolvency laws can be balanced in favour of revival. Only when the legislature resolves the haircut paradox will MSME pre-packs be able to deliver on their promise of helping small businesses grow without incurring an unanticipated tax penalty for the goodwill of their creditors. It is time for tax laws to stop dragging MSMEs back into the quicksand if insolvency is supposed to provide them with a new beginning.