The significance of the insolvency code may be put into question if state governments do not observe the order of priority for creditors over a corporate debtor’s assets, write Arvind Varma and Amita Chohan

“The law must clearly lay out the priority of distributions in bankruptcy to all stakeholders. The priority must be designed so as to incentivize all stakeholders to participate in the cycle of building enterprises with confidence” – Report of the Bankruptcy Law Reforms Committee, November 2015, on Principles driving the design [of the Insolvency and Bankruptcy Code 2016].

State governments in India have more regularly than not directly demanded corporate entities to repay statutory dues such as value added tax (VAT) on the incorrect assumption that such debts take precedence over all other creditors in the insolvency process. This article explores the tensions that arise between the powers of the court in policing the implementation and proper interpretation of the Insolvency and Bankruptcy Code 2016 (code), the limits on the rights of the corporate debtor during the insolvency process, and the powers of the insolvency resolution professional (IRP) in these circumstances. We also place the spotlight on what lessons can be learned from the English legal position on insolvency and taxes.

Pressing claims

Arvind Varma

The code recognizes three types of creditors who are each accorded different types of rights and powers: operational creditors, financial creditors, and other creditors. An operational creditor is one to whom an operational debt is owed. Under section 5(21) of the code, an operational debt is confined to goods, services (including employment) and debts due to the central government, any state government or any local authority. With respect to the order in which the proceeds of sale of a corporate debtor’s assets are distributed under section 53 of the code, the central and state government rank fifth, low in the pecking order.

On 20 March 2019, the National Company Law Appellate Tribunal (NCLAT) clarified that the payment of statutory dues such as VAT fall within the scope of an operational debt, and that any government authority demanding repayment is to be treated as an operational creditor (Director General of Income Tax v Synergies Dooray Automotive Ltd and Ors).

The NCLAT’s decision raises major concerns for government departments and the risk of revenue losses. Until the Supreme Court considers, tests and adjudicates (by way of approval or reversal) the NCLAT’s decision, it remains good law. However, in practice, state governments continue to contest the NCLAT’s position on a case-by-case basis. As things stand, the position in law is that any authority of the Indian government that attempts to foist liability to pay statutory dues upon the corporate debtor has to overcome the NCLAT’s decision in the Synergies Dooray Automotive case.

Side-stepping the code

Amita Chohan

Owing to the lack of case law precedent in this area, we examine the tensions that arise if any state government were to succeed in contesting standing as an operational creditor in respect of tax dues. In our view, the primary tensions are as follows:

The wording of the law. Chapters IV and X of the Insolvency and Bankruptcy Board of India (Insolvency Resolution Process for Corporate Persons) Regulations, 2016 (CIRP regulations), very lucidly lay down the procedure by which the government – be it state or central – may submit a proof of claim and recover debts due to it from a corporate debtor without violating the mandate, letter and spirit of the code. In accordance to the systematic guidelines set out at regulation 7, an operational creditor can submit its claim (with proof) to the Interim Resolution Professional (IRP).

That claim must be backed up with relevant documents and records for facilitating the payment of the relevant dues. Regulation 38(1) envisages that the resolution plan has to be in consonance with the format prescribed in the code. It mandates that the resolution plan will mention the value of the debt due to the operational creditors, and that such amounts shall take precedence/priority in payment over the amounts due to financial creditors. Accordingly, the legislature was fully conscious while drafting the code of: (1) the types of liabilities that are accrued by a corporate debtor; and (2) the potential for non-payment of government dues, which may cause revenue losses to the government. The code, and the CIRP regulations, clearly provide a well-informed standing for state and central governments. That standing within the pecking order should be respected. The state and central governments should not be permitted to even attempt to ride roughshod over the code.

The spirit and policy of the code. The stance that the government takes as a creditor, with higher rights and powers over all other creditors, is arguably contrary to the spirit and economic policy of the code. If such attempts to side-step the code were to succeed (and if such attempts are not properly policed by the courts), the effectiveness of the code (in practice), its reputation and the implementation of it will be thrown into question. In the long term, this may have an impact upon a potential creditor’s appetite for lending, and may risk producing unsatisfactory outcomes for creditors in the resolution plan.

The preamble of the code expressly refers to “balanc[ing] the interests of all the stakeholders including alteration in the order of priority of payment of government dues”.

Further, the distinction between financial debts (which are secured) and operational debts is treated as an important one. In Swiss Ribbons Private Limited and Another v Union of India and Others (2019), the Supreme Court discussed the economic significance of the primacy of secured creditors over operational debts:

  1. “Most importantly, financial creditors are, from the very beginning, involved with assessing the viability of the corporate debtor. They can, and therefore do, engage in restructuring of the loan as well as reorganization of the corporate debtor’s business when there is financial stress […] financial creditors are clearly different from operational creditors and therefore, there is obviously an intelligible differentia between the two, which has a direct relation to the objects sought to be achieved by the Code” (para 51); and
  2. “Repayment of financial debts infuses capital into the economy inasmuch as banks and financial institutions are able, with the money that has been paid back, to further lend such money to other entrepreneurs for their businesses. This rationale creates an intelligible differentia between financial debts and operational debts, which are unsecured, which is directly related to the object sought to be achieved by the Code.” (para 119).

In the landmark judgment of the Supreme Court on 15 November 2019 (Committee of Creditors of Essar Steel India Limited v Satish Kumar Gupta), a number of key principles of the code were clarified, including:

  1. A Bankruptcy Code should not be read so as to imbue creditors with greater rights in a bankruptcy proceeding than they would enjoy under the general law, unless it serves some bankruptcy purpose” (para 61);
  2. “Secured creditors are super-priority creditors on insolvency. Security must stand up on insolvency, which is when it is needed most” (the Supreme Court directly quoted from QC and CBE (Queen’s Counsel and Commander of the British Empire) Philip Wood’s book, Principles of International Insolvency) (para 67); and
  3. “It can be seen that the code and the regulations, read as a whole […] all lead to the conclusion that the equality principle cannot be stretched to treating unequals equally, as that will destroy the very objective of the code – to resolve stressed assets. Equitable treatment is to be accorded to each creditor depending upon the class to which it belongs: secured or unsecured, financial or operational” (para 72).

Self-invitation to criminal liability. Corporate debtors and IRPs are bound by the restrictions placed on them under the code. Under section 74(1) of the code, where a corporate debtor (or any of its officers) “knowingly or wilfully committed or authorised or permitted” a breach of section 14 of the code, any such officer may face imprisonment or a fine. Further, section 70(2) penalizes an IRP if he or she deliberately contravenes that part of the code.

The core duties of an IRP include balancing the interests of all stakeholders. An IRP “shall make every endeavour to protect and preserve the value of the property of the corporate debtor […]”. Any position taken by a state or the central government as to the alleged supremacy of its rights and powers over other classes of creditors clearly places the corporate debtor and IRP at risk of committing a violation of the code. At the very least, this risks compromising the position of the corporate debtor and the IRP.

English legal stance

The English insolvency regime is governed by the Insolvency Act, 1986. When a company enters insolvency and is liquidated, the order of priority in which creditors are paid is as follows: (1) secured creditors with a fixed charge, e.g., asset-based lenders with a security in the form of a mortgage; (2) the fees and expenses of the liquidator and administrator – liquidator fees are subject to restrictions placed on certain types of expenses that have not been authorized by preferential creditors, the court or floating charge holders; (3) preferential creditors, including employees who are owed wages; (4) secured creditors holding a floating charge, e.g., charges held over stock or raw materials; (5) unsecured creditors; (6) interest incurred on all unsecured debts post the liquidation; and (7) shareholders in accordance with their respective rights under the shares.

In the UK, Her Majesty’s Revenue and Customs (HMRC) is the government department responsible for the collection and administration of taxes including VAT. While currently ranked as an unsecured creditor, HMRC will regain its previous status as a preferential creditor in April 2020. This reform will relate to taxes held by corporate debtors on behalf of other taxpayers such as VAT. In its policy paper on “Changes to protect tax in insolvency cases” (July 2019), HMRC explains that: “This change will enable more of those taxes paid in good faith [to] go to fund public services as intended.”

Further, the reforms are rooted in the UK government’s concerns that around £1.9 billion (US$2.5bn) fails to reach government every year due to the current hierarchy of creditors.


Of course, one can only speculate the future treatment of an Indian state government’s direct calls for repayment of tax from a corporate debtor, and the higher rights that it seeks to enforce. For now, we take the view that Indian courts should interpret sections 5(21) and 53 of the code literally.

This approach would remain consistent with the preamble of the code, the economic need to encourage lending (especially since the code is still in its infancy) and the need for a body of precedent, which accords with the objectives of the code as set out by the Bankruptcy Law Reforms Committee.

Until any reforms are suggested and debated by parliament and state legislatures, any deference provided to state governments during the insolvency process will undoubtedly throw the purpose and implementation of the code into incredibly uncertain territory.

Arvind Varma is a senior advocate in the Supreme Court and Delhi High Court, and Amita Chohan is an English barrister based in the London office of Locke Lord, where she concentrates her practice in dispute resolution and insolvency.