A crucial fault line in India’s insolvency system, the tension between the rights of secured creditors and governmental claims for unpaid taxes has been highlighted by the controversy surrounding the Rainbow Papers ruling[i]. The Supreme Court upset the priority hierarchy under the Code and deviated from long-standing business expectations when it ruled that government dues are ‘secured’ under the IBC. This has caused a great deal of concern among lenders and resolution experts, raising questions about the insolvency process’s efficacy and predictability.
The ruling threatens to weaken the importance of business acumen in decision-making in addition to contesting the accepted understanding of the waterfall mechanism under Section 53. In light of this, the conflict between market efficiency and national interests has intensified, necessitating immediate legislative or judicial clarification to restore the Code to its original meaning.
The Rainbow Papers Verdict: A Jurisprudential Shift
The conflict between state-level tax laws and the insolvency framework is at the core of the controversy. Under the Gujarat Value Added Tax Act, 2003 (GVAT), the State of Gujarat asserted unpaid Value Added Tax (VAT) obligations against Rainbow Papers Ltd. Tax arrears are listed as a ‘first charge’ on the dealer’s property under Section 48 of the GVAT. However, in the fifth layer of the Section 53 distribution waterfall, the IBC placed government responsibilities directly below secured creditors, insolvency specialists, and employee claims.
The Supreme Court decided that because of Section 48 GVAT, the tax department’s claim was eligible as a secured obligation under the IBC. Depending on the factual matrix, this interpretation essentially raised the State’s claim above other unsecured operational creditors and possibly even above secured creditors. The Court’s reasoning revolved around its broad interpretation of ‘secured creditor’ under Section 3(30) of the IBC, holding that it could encompass statutory charges established by operation of law. This represented a substantial shift from earlier court rulings that supported the IBC’s meticulously drafted priorities.
This ruling drew immediate criticism for its potential to destabilise the credit ecosystem in addition to its interpretation that deviated from the legislative intent and text of the Code. Statutory dues arise unilaterally and without registration, in contrast to traditional secured creditors who acquire a security interest through contractual agreement and registration (such as mortgages or pledges). According to Section 3(31) of the IBC, a ‘security interest’ includes rights resulting from transactions, assuming some degree of formal creation and mutuality. The Court made it more difficult to distinguish between unilateral state claims and voluntary business agreements by expanding this definition to include statutory first charges.
The judgment in the Rainbow Papers case contrasts sharply with a number of previous decisions that upheld the dominance of the IBC. In the case of Swiss Ribbons Pvt Ltd v Union of India[ii], the Supreme Court upheld the constitutionality of the Code’s provisions, particularly emphasizing that government debts would take precedence below that of financial creditors. In a similar vein, the Supreme Court in Ghanashyam Mishra & Sons Pvt Ltd v Edelweiss Asset Reconstruction Co Ltd [iii]determined that once a resolution plan receives approval, all claims not incorporated in the plan, including statutory debts, are extinguished. These rulings aligned with the suggestions made by the Bankruptcy Law Reform Committee (BLRC), [iv]which explicitly recommended placing government dues in a subordinate position to facilitate effective market-driven resolutions.
The rationale behind the Rainbow Papers ruling seems to contradict international best practices. The UNCITRAL Legislative Guide on Insolvency Law[v] cautions against prioritizing sovereign claims, as it disrupts market discipline and obstructs lenders’ ability to evaluate risk effectively. By implicitly favoring tax authorities, the Indian judiciary may be reintroducing the legal ambiguity that the IBC aimed to resolve.
Paschimanchal Nigam: A Measured Recalibration
In Paschimanchal Vidyut Vitran Nigam Ltd v. Raman Ispat Pvt Ltd [vi](2023), the Supreme Court attempted to limit the consequences in an effort to restore doctrinal unity. A state distribution corporation claimed electrical dues in the case, which the court classified as operational obligations rather than secured debts. In his writing for the court, Justice Ravindra Bhat pointed out that a statutory charge cannot take precedence over Section 53’s waterfall process unless it is backed by registration or a recognised security interest. More importantly, the Court upheld Section 238 of the IBC’s overriding effect, which guarantees that the Code takes precedence over contradictory provisions in other laws.
The Paschimanchal Nigam ruling did not overturn Rainbow Papers, albeit providing some clarification. Rather, it identified it as a fact-specific instance that only applies in cases when a first charge is expressly created by statutory provisions. Although doctrinally sound, this subtle distinction hasn’t been able to dispel doubt.
The Dismissal of Review Petitions: Rainbow as Settled Law
This ambiguity was further cemented by the Court’s subsequent decision in Sanjay Kumar Agarwal v. State Tax Officer (2023)[vii], which denied review petitions against Rainbow Papers. The Court ruled that Rainbow Papers and Paschimanchal Nigam were resolved by benches of equal strength, therefore neither could overrule the other, and that a review was not the appropriate forum for contesting a decision on substantive grounds.
The insolvency ecosystem in India is significantly impacted by this jurisprudential dilemma. To find possible statutory charges, resolution professionals must now perform intricate due diligence across several state statutes. The possibility that government agencies may make exaggerated claims could jeopardise authorised resolution plans for lenders, especially banks and financial institutions. The finality doctrine, which is so important for establishing trust in the settlement process, has been undermined. Furthermore, venue shopping and protracted litigation are made possible by the potential for disparate National Company Law Tribunals (NCLTs) to interpret the same case differently.
The Rainbow Papers precedent poses a systemic risk of cooling lending markets. If secured interests are no longer given priority, financial institutions could be reluctant to lend. This might undermine one of the main goals of the IBC by increasing the cost of capital and discouraging investment in distressed assets.
The judiciary has subtly confirmed that Rainbow Papers is currently the law of the land, notwithstanding this legal ambiguity. Even if the precedent’s logical consistency is still debatable, its standing is cemented by the dismissal of the review petition in Sanjay Kumar Agarwal. Despite being legally enforceable, this stance does not address the fundamental conflict between tax claims and business recovery.
The Way Forward: Judicial and Legislative Remedies
A comprehensive approach is required to resolve this dilemma. First and foremost, Parliament must act through legislation. To clearly subordinate all statutory dues to secured creditors and other priority stakeholders, Section 53 of the IBC must be revised. To make it clear that only registered security interests will be considered ‘secured debts’ under the Code, a proviso could also be added. Creditor confidence would be restored and a common standard would be established.
The second option is for the Supreme Court to think about sending the case to a Constitution Bench. A larger bench is better suited to settle the jurisprudential difference because of the conflicting rulings by co-equal courts and the fundamental significance of the matter. For all parties involved, a final decision would bring much-needed clarity.
Third, there should be a centralised registration of statutory charges. The strain on resolution professionals is currently increased by the obscurity surrounding tax liens and state dues. Transparency, due diligence, and post-resolution litigation would all be improved by a national platform that requires the registration of such charges.
Last but not least, regulators and legislators need to communicate with state governments, tax authorities, and insolvency specialists more broadly. It is crucial to have a coordinated strategy that strikes a balance between the IBC’s commercial goals and the state’s financial obligations. Piecemeal judicial interventions will continue to cause conflict and uncertainty in the absence of such coordination.
In summary, the Rainbow Papers conundrum illustrates a more profound struggle in Indian insolvency law: the balancing of private contractual rights with state claims. Prioritising tax obligations over secured creditors runs the risk of reversing the gains obtained under the IBC, even if the state has a legitimate interest in recovering public monies. The insolvency framework’s goal of prompt, predictable, and equitable resolutions will be undermined unless judicial or legislative certainty is established. Now, it is up to Parliament and the Supreme Court to restore the statute to its original intent, which states that the destiny of struggling businesses is determined by business judgement rather than financial expediency.
[i] State Tax Officer v. Rainbow Papers Ltd., (2022) SCC OnLine SC 1162.
[ii] Swiss Ribbons Pvt. Ltd. v. Union of India, (2019) 4 SCC 17.
[iii] Ghanashyam Mishra & Sons Pvt. Ltd. v. Edelweiss Asset Reconstruction Co. Ltd., (2021) SCC OnLine SC 313.
[iv] Bankruptcy Law Reform Committee Report, 2015.
[v] UNCITRAL Legislative Guide on Insolvency Law, United Nations Commission on International Trade Law.
[vi] Paschimanchal Vidyut Vitran Nigam Ltd. v. Raman Ispat Pvt. Ltd., (2023) SCC OnLine SC 1245.
[vii] Sanjay Kumar Agarwal v. State Tax Officer.,2023 INSC 963
Author: Eesh Jauhari
Juris Centre 