Introduction
One of the most consequential and jurisprudentially contentious questions in Indian insolvency law concerns the treatment of government dues, primarily tax claims under income tax, GST, customs, and state VAT laws, in the waterfall mechanism established by Section 53 of the Insolvency and Bankruptcy Code. This question goes to the heart of the IBC’s foundational design choice: to override the patchwork of statutory first-charge and priority provisions that had long given various government bodies a privileged position in the recovery of dues from insolvent debtors, and to replace them with a rational, predictable hierarchy that prioritises the continued operation of insolvency resolution processes and the repayment of secured financial creditors.
The government, both Central and State, has never been fully at peace with this subordination. Revenue authorities are institutionally accustomed to claiming priority over all other creditors, and the IBC’s relegation of government dues to a position behind secured financial creditors, unsecured financial creditors, and even workmen’s dues represents a profound cultural and institutional disruption. The tension has expressed itself in several forms: disputed tax claims filed in CIRP proceedings at inflated amounts, PMLA proceedings attaching assets subject to IBC moratoriums, GST Council lobbying for statutory first-charge protection, and most significantly, the Supreme Court’s controversial decision in State Tax Officer v. Rainbow Papers Ltd (2022).
Rainbow Papers has generated a legal controversy of the first magnitude. A Supreme Court bench of two judges held that the state’s first charge under Gujarat VAT Act created a “security interest” within the meaning of the IBC, entitling the state to be treated as a secured creditor for the purposes of Section 53 distribution. If this interpretation were to hold, government tax dues across a vast range of statutory frameworks would effectively jump the queue in insolvency distributions, reversing the IBC’s waterfall mechanism and fundamentally altering the economics of corporate insolvency resolution. The commercial consequences would extend well beyond the specific facts of any individual case.
Legal Framework
Section 53 of the IBC establishes the order of priority for the distribution of assets in liquidation. The order, from highest to lowest priority, is: insolvency resolution process costs and liquidation process costs; workmen’s dues for the 24 months preceding the liquidation commencement date; wages and any unpaid dues owed to employees (other than workmen) for the 12 months preceding liquidation commencement; financial debts owed to secured creditors (to the extent not recovered through enforcement of security); unsecured financial debts; any remaining debts and dues owed to Central Government, State Government, and local authorities; operational creditor claims; and, finally, preferences payable to preference shareholders, followed by equity shareholders.
This waterfall is a deliberate hierarchy that places government tax dues below both secured and unsecured financial creditors. The hierarchy is reinforced by Section 238 of the IBC, which provides that the IBC shall override any other law for the time being in force to the extent of any inconsistency. Section 178 of the Income Tax Act, 1961, which required assessing officers to be notified in liquidation and gave the tax authority a priority over the liquidator in certain circumstances, was specifically amended in 2018 to bring it into conformity with the IBC’s waterfall mechanism.
The concept of “security interest” is defined in Section 3(31) of the IBC to mean “a right, title or interest or a claim to property, created in favour of, or provided for a secured creditor by a transaction or operation of law and includes mortgage, charge, hypothecation, assignment and encumbrance or any other agreement or arrangement securing payment or performance of any obligation of any person.” The phrase “by a transaction or operation of law” is significant: it suggests that a security interest need not arise from a contractual agreement, but may be created by statute.
Under Section 53 read with Section 3(30), a “secured creditor” is a creditor in favour of whom security interest is created. If the state’s statutory first charge under a tax law constitutes a security interest within this definition, the state would be a secured creditor for Section 53 purposes, entitled to priority equivalent to other secured creditors.
Judicial Developments
The Supreme Court in State Tax Officer v. Rainbow Papers Ltd (2022) held, in a judgment that has been extensively criticised by the insolvency bar, that the first charge created in favour of the state under the Gujarat Value Added Tax Act, 2003 constituted a “security interest” within the meaning of Section 3(31) of the IBC. On this basis, the state was entitled to be treated as a secured creditor and to receive priority treatment under Section 53. The Court also held that the IBC did not override the state’s statutory first charge, rejecting the argument that Section 238’s non-obstante clause took the IBC’s waterfall mechanism to override pre-existing statutory priorities.
This judgment was immediately controversial. The Insolvency Law Committee, the IBBI, and a large section of the insolvency profession objected to it on the grounds that it fundamentally misread the IBC’s design and would, if followed, make corporate resolution economically unviable. If state tax authorities had secured creditor status for all statutory first charges, the assets available to genuine financial creditors (the banks and institutions whose capital was at risk in the lending relationship) would be dramatically reduced, making insolvency resolution unattractive to financial creditors and significantly impairing credit markets.
The Union of India, through the Ministry of Finance and IBBI, filed a curative petition before the Supreme Court challenging Rainbow Papers. This petition argued that the judgment was per incuriam (decided without consideration of binding prior decisions on the relationship between IBC and statutory priorities) and that its application would cause widespread disruption to the insolvency ecosystem. The Supreme Court has referred the issue to a larger Constitutional Bench for authoritative resolution, and the matter remains pending.
In the interim, NCLT and NCLAT have taken divergent positions on the applicability of Rainbow Papers. Some benches have followed it as binding Supreme Court authority and applied it to give state tax authorities secured creditor priority in individual proceedings. Other benches have distinguished Rainbow Papers on its specific facts or have stayed its application pending the Constitution Bench’s decision. This divergence has created precisely the uncertainty that the IBC was designed to eliminate.
The Ruchi Soya resolution, one of the largest and most closely watched insolvencies under the IBC, involved contested tax dues running to several thousand crores of rupees from income tax, GST, and state authorities. The resolution plan for Ruchi Soya, approved by the NCLT, provided for a specific treatment of tax dues that the tax authorities contested as insufficient. Subsequent litigation on the tax dues in Ruchi Soya has generated NCLT and NCLAT decisions that illustrate the practical complexity of settling government dues in large insolvency resolutions.
Contemporary Issues and Analysis
The Rainbow Papers controversy illuminates a deeper conflict between two legitimate policy objectives that the IBC’s drafters attempted to resolve but that have not been definitively settled. The first objective is the maximisation of creditor recovery through a rational, predictable hierarchy that rewards those who have committed capital to productive enterprise (the financial creditors) ahead of those who have incurred claims through the compulsory operation of law (the tax authorities). The second objective is the protection of public revenue, which funds government services, and the fairness principle that businesses should not be able to evade tax obligations by entering insolvency.
The IBC’s resolution of this tension through the Section 53 waterfall was a deliberate policy choice, informed by comparative international experience showing that jurisdictions which gave government a first-priority claim on insolvent estates systematically reduced the availability of credit at reasonable cost. If banks and other financial institutions know that their security interest competes with, rather than takes priority over, the state’s statutory first charge, they will either decline to lend or demand a higher risk premium to compensate for the uncertainty.
The GST Council’s concerns about IBC overriding GST first-charge provisions reflect a legitimate revenue protection interest. The Central GST Act and State GST Acts both contain provisions creating first charges on the assets of tax defaulters for unpaid GST dues. These provisions are analogous to the provisions considered in Rainbow Papers, and the GST authorities have argued that the Rainbow Papers logic should apply to make them secured creditors in IBC proceedings.
This argument, if accepted, would significantly expand the scope of the Rainbow Papers holding. GST is now a major source of government revenue, and the aggregate GST dues in large corporate insolvencies are substantial. If GST authorities rank as secured creditors, the practical effect on financial creditor recovery in large insolvencies would be severe, potentially rendering many otherwise viable resolution plans commercially unviable.
The Finance Ministry and IBBI are reportedly in dialogue about a legislative response to Rainbow Papers that would clarify the legislative intent behind Section 53 and Section 238, specifically providing that statutory first charges created by tax laws do not constitute security interests for IBC purposes. Whether this legislative response will be forthcoming before the Constitution Bench delivers its judgment, and whether the Constitution Bench’s judgment will make such legislation redundant or necessary, remains to be seen.
Comparative and International Perspective
The treatment of Crown priority in tax claims has evolved significantly in international insolvency law over the past two decades. The United Kingdom’s Enterprise Act, 2002 abolished Crown preference in insolvency, removing the previously privileged status of HMRC in distributing the insolvent estate. Under the post-2002 UK framework, HMRC ranks as an unsecured creditor, not as a preferential or secured creditor, for tax dues. This reform was motivated by the same economic logic that underlies India’s IBC waterfall: that giving government tax dues priority over other unsecured creditors distorts credit markets and reduces recovery for trade creditors and other ordinary creditors.
However, the UK retained Crown preference for certain categories of tax (specifically, PAYE deductions and VAT collected from third parties but not remitted to HMRC), on the theory that these are “collected” funds that the company holds in trust for HMRC rather than debts owed to HMRC. This “trust” theory, if applied to Indian GST collected from customers but not remitted to the GST authorities, might provide a more nuanced treatment of certain government claims than the binary secured-versus-unsecured classification of Rainbow Papers.
The United States Chapter 11 framework provides for the priority treatment of certain tax claims as administrative expenses (if the tax claim arose after the bankruptcy petition) or as priority unsecured claims (for pre-petition tax claims meeting certain requirements). US tax priority is a statutory priority within the unsecured claims framework, not a security interest, and it ranks below secured creditor claims. The US approach carefully delineates the scope of government tax priority and provides a clear hierarchy that does not disrupt secured creditors’ expectations.
Australia’s insolvency framework similarly places secured creditors ahead of priority unsecured claims (which include certain employee entitlements and government dues), without treating statutory first charges as creating security interests equivalent to contractual mortgage or charge security.
Practical and Policy Implications
The practical implications of the Rainbow Papers uncertainty are felt in every large CIRP where there are outstanding state tax dues. Resolution professionals must now navigate the uncertainty about whether state tax authorities should be treated as secured or unsecured creditors in developing resolution plans for CoC consideration. Bidders for distressed assets must price in the risk that tax claims will rank more highly than the current IBC framework suggests, reducing their willingness to pay and thereby reducing financial creditor recovery.
The chilling effect on resolution applicants is particularly significant because it affects the negotiation dynamics within the CoC. Financial creditors who were previously confident about their secured priority now face the possibility that the proceeds of their security interests will be shared with state tax authorities, reducing their effective security coverage. This reduced confidence in security interests affects the banks’ own willingness to provide resolution funding or to accept lower haircuts in resolution plans.
For the government, the Rainbow Papers controversy is not straightforwardly advantageous. While individual state revenue authorities may benefit from elevated priority in specific cases, the systemic effect of government tax claims crowding out financial creditors would be to reduce the availability of bank credit to the corporate sector generally, slowing economic growth and investment. A government that is also concerned with economic growth has an interest in a functional credit market that the Rainbow Papers logic undermines.
Suggestions and Reforms
The most urgent reform needed is legislative clarification that statutory first charges created by tax legislation do not constitute “security interests” for the purposes of Section 3(31) of the IBC. This clarification should be achieved through an amendment to the IBC itself, rather than relying on the Constitution Bench’s judgment, which will take time to arrive. The amendment should specify, in clear terms, that a security interest for IBC purposes must arise from a consensual transaction between the corporate debtor and the creditor, and that statutory charges created by operation of law to secure tax and other government dues do not qualify.
Separately, Parliament should engage in a genuine policy deliberation about the appropriate level of government priority in insolvency. The current Section 53 treatment, which places government dues below all secured and unsecured financial creditors but above operational creditors and equity, is a reasonable resolution of the competing interests. However, there may be a case for a limited elevated priority for certain categories of government claims, specifically for taxes collected from third parties (GST collected from customers, PAYE deductions from employees) that the company holds in a fiduciary capacity, analogous to the UK’s retained preference for collected taxes.
IBBI should also develop standardised procedures for the resolution of disputed tax claims in CIRP proceedings, including mechanisms for the tax authorities to file their claims promptly, for the RP to assess and admit or reject claims on a principled basis, and for disputed claims to be referred to a fast-track adjudication mechanism that does not delay the overall resolution process.
Finally, the Central Government should develop a coordinated insolvency policy across the Central Board of Direct Taxes, the GST Council, and IBBI, to ensure that tax recovery objectives and insolvency resolution objectives are pursued in a complementary rather than conflicting manner. Currently, the tax authorities’ pursuit of maximum recovery in individual cases, while individually rational, conflicts with the systemic goal of maintaining a functioning insolvency resolution mechanism that serves the broader economy.
Conclusion
The relationship between the IBC and government tax claims is one of the most practically significant and legally contested areas of Indian insolvency law. The Rainbow Papers decision, by treating statutory tax first charges as security interests, has introduced profound uncertainty into the IBC’s carefully designed waterfall mechanism, uncertainty that is impeding resolution in ongoing cases and that will, if the decision is not corrected, ultimately impair the IBC’s core promise to financial creditors.
The Constitution Bench reference offers the possibility of authoritative resolution, but legislative clarification should not wait for the outcome. The IBC’s Section 238 non-obstante clause and Section 53 waterfall mechanism represent a clear parliamentary intent to override pre-existing statutory priorities in the interests of a rational insolvency regime. That intent should be reinforced, not subverted, by the legislature’s response to Rainbow Papers. The lessons of international experience, from the UK’s post-Enterprise Act reform to the US’s carefully calibrated treatment of government claims in Chapter 11, point consistently in the same direction: a secure and predictable financial creditor priority is the foundation of a functional insolvency system, and statutory government claims should be accommodated within that system rather than allowed to distort it.
