The Heterogeneity Of Statutory Dues: Why Direct Taxes Must Be Excluded From the Liquidation Estate Under Section 36(4) IBC?

The author is Mohit Kumar, a Third Year Student from National Law School of India University, Bengaluru.

Abstract

Section 53 of the Insolvency and Bankruptcy Code embodies a carefully calibrated waterfall designed to ensure predictability in credit markets by subordinating government dues to private claims. The Supreme Court’s decision in State Tax Officer v. Rainbow Papers Ltd. unsettled this framework by elevating statutory charges to secured creditor status, prompting legislative correction through the Insolvency and Bankruptcy Code (Amendment) Bill, 2025. While the Amendment restores the intended priority structure, this paper argues that it introduces a distinct error by uniformly subordinating all government dues. It fails to distinguish between taxes owed by the corporate debtor and taxes collected by it in a fiduciary capacity, such as GST and TDS. Drawing on trust law principles, comparative insolvency regimes, and Section 36(4)(a)(i) of the Code, the paper contends that unremitted fiduciary taxes never form part of the debtor’s estate and must be excluded from the waterfall altogether.

I. Introduction

The waterfall mechanism enshrined in Section 53 of the Insolvency and Bankruptcy Code forms the backbone of India's insolvency regime. It determines the order of return of dues when a company fails. This hierarchy was thoughtfully designed to build enterprise confidence by providing ex ante certainty and stability to lenders’ credit risks. Since the Code's incorporation, this hierarchy has delivered predictability for creditors, discipline for debtors, and efficiency for capital markets.

However, in 2022, the Supreme Court's decision in State Tax Officer v. Rainbow Papers Ltd disrupted this settled position. By elevating government dues to the secured creditor status, the Court allowed government dues to leapfrog the carefully constructed waterfall. The Insolvency and Bankruptcy Code (Amendment) Bill, 2025, has responded to the judgment by restoring government dues to fifth priority. It conflates two fundamentally different entities: (i) the corporate debtor that owes income tax liability (government dues) arising from the corporate debtor’s own taxable events, and (ii) the entity that collects TDS and GST (amounts collected or deducted by the corporate debtor on behalf of the State- statutory dues) liabilities pursuant to statutory withholding obligations. The authority over the latter belongs to the debtor (state). In this background, this piece argues that the Amendment's blanket subordination of all government dues, including statutory dues, is doctrinally unsound and economically harmful. 

II. The Rainbow Papers Anomaly & The 2025 Amendment

The waterfall mechanism under the IBC subordinates’ government dues to the fifth priority. The Bankruptcy Law Reforms Committee Report (2015) expressly recommended reducing the priority of statutory debts to incentivise private investment and maximise creditor recovery. The report mentioned that, unlike financial creditors who voluntarily extend credit based on commercial assessments of risk, the State never consented to become a creditor of the corporate debtor. Based on this rationale, the waterfall mechanism ensures that voluntary creditors are not prejudiced by the claims of an involuntary one, reflecting a deliberate legislative choice.

Rainbow Papers held that a statutory first charge created under Section 48 of the Gujarat Value Added Tax Act constituted a "security interest" within the meaning of Section 3(31) of the IBC, interpreting the State qualified as a "secured creditor" entitled to priority under Section 53(1)(b)(ii), rather than a governmental claimant relegated to Section 53(1)(e). This interpretation suffers from doctrinal infirmities by failing to engage with the waterfall mechanism's deliberate distinction between "secured creditors" and "government dues". Parliament has employed the two expressions in the same provision, which, by elementary principles of statutory construction, cannot be considered identical. Subsequent decisions like Paschimanchal Vidyut v Raman Ispat attempted to quarantine Rainbow Papers to its facts but failed to overrule it, resulting in coordinate benches reaching irreconcilable conclusions that materially impaired regulatory predictability. The resulting doctrinal uncertainty materially impaired the predictability upon which insolvency proceedings depend.

The Amendment represents Parliament's intervention to resolve this confusion. The Bill inserts an explanation to Section 3(31) clarifying that a security interest arises only where a right, title, or interest in property is created. A corresponding Explanation to Section 53(1)(e) confirms that the Central or State Government shall not be classified as a secured creditor absent a security interest created through an actual transaction with the corporate debtor. Thus, it legislatively overrules Rainbow Papers and restores government dues to their designated fifth priority.

This, however, addresses only part of the problem. In correcting the conflation of statutory charges with contractual security interests, it perpetuates a distinct conflation: between taxes owed by the corporate debtor (government dues) and taxes collected by the corporate debtor on behalf of the State due to withholding obligations (statutory dues). Corporate income tax is a liability arising from a debtor's own profits, payable from its taxable income. Meanwhile, dues like GST liability represent money the debtor collected from its customers as an agent for the government, held in statutory trust pending remittance. The debtor never acquires ownership of these funds. If not remitted, debt is not incurred; it rather becomes a misappropriation of money belonging to the State.

The drafters, focused on reversing the Rainbow Papers, failed to recognise this distinction, resulting in a regime that correctly resolves the priority question but incorrectly resolves the anterior ownership question. It determines where government claims should rank within the waterfall without first determining whether certain government claims belong to the debtor at all.

III. Economic Hazards & Comparative Perspectives

The first consequence of blanket subordination is strategic misappropriation. When a company collects GST or deducts TDS, it does not incur a tax liability in its capacity as an assessee. Rather, it holds amounts belonging to the State pursuant to a statutory obligation of collection and remittance, functioning as a custodial intermediary rather than a debtor. Under the Amendment, these funds rank fifth in the waterfall. A company in distress thus faces a rational calculation: retain unremitted taxes to fund operations; if the business recovers, remit the arrears; if it fails, the government receives nothing. The Amendment transforms trust property into an interest-free loan from the exchequer, a loan the government never consented to provide.

The Select Committee on the IBC (Amendment) Bill, 2025, expressly acknowledged this concern, observing that TDS represent "tax of third party retained on behalf of the Government by the corporate debtor" and that the "corporate debtor has unjustly enriched himself by keeping government money as his own." It noted the downstream consequence: the deductee seeks credit from the government for amounts already deducted, creating an obligation on the government towards the deductee. This way, the Government exchequer faces a double-edged loss. It recommended that treatment of non-deposited amounts be addressed through regulations, an implicit acknowledgement that blanket subordination is inadequate. [1]

The second hazard operates through credit markets. If banks anticipate recovering from accumulated fiduciary taxes, they will prefer companies collecting substantial GST over manufacturers generating less indirect tax. Capital flows not to its most efficient use, but to businesses sitting on government money that banks can access upon default. Credit risk becomes systematically mispriced. Enterprise value is destroyed as lenders adopt "extend and pretend" approaches, hoping companies accumulate more trust funds before failing.

Mature regimes avoid this error. The UK’s Finance Act 2020 accords preferential status to taxes collected as agents (VAT, PAYE), reasoning that subordination would transfer taxpayer funds to commercial creditors. Similarly, the US Internal Revenue Code imposes personal liability for non-remittance of trust fund taxes, treating it as misconduct rather than a distributional issue. 

The Amendment's blanket subordination thus departs from established practice in jurisdictions with sophisticated insolvency frameworks. The IBC already contains the doctrinal apparatus for implementing this distinction: Section 36(4)(a)(i) mandates that assets held in trust for any third party shall not form part of the liquidation estate. Part IV proposes a framework operationalising this provision.

IV. Operationalising The Fiduciary Distinction

This Part proposes a framework for operationalising this distinction through two interpretive axes and addresses potential objections to such an approach.

The first axis concerns the nature of the obligation. Taxes may be classified according to the corporate debtor’s status as the taxpayer or merely the collection agent. Corporate income tax, property tax, and customs duty on imports for own use represent obligations where the company itself is the assessee. The economic burden falls on the company, and the liability arises from its own transactions or ownership. GST collected on outward supplies, TDS deducted from employee salaries or vendor payments, and TCS collected on specified transactions occupy a fundamentally different position. Here, the economic incidence falls on third parties, namely customers, employees, and vendors, respectively. The corporate debtor's role is fiduciary. It holds amounts belonging to others for transmission to the State. 

This distinction finds explicit recognition in the Select Committee Report, which acknowledged that TDS and TCS amounts represent "tax of third party retained on behalf of the Government" rather than the debtor's own obligation.

The second axis concerns the trust's statutory character. Fiduciary taxes are not ordinary debts where the government happens to be the creditor. The CGST Act, 2017, mandates the deposit of collected tax within prescribed timelines and imposes interest and penalties for delayed remittance. The Income Tax Act, 1961, creates a statutory obligation to deduct and deposit, with Section 276B imposing criminal liability for failure to remit TDS. These provisions establish that unremitted Union taxes are not merely "dues" owed to the government, but amounts held in a statutory trust, the breach of which attracts criminal sanction. The Amendment's placement of such amounts in the fifth priority category alongside ordinary government dues ignores this statutory architecture.

Section 36(4)(a)(i) of the IBC is a property provision, not a priority one; trust assets are excluded from the estate because they never belonged to the corporate debtor, recognising pre-existing property rights rather than elevating government claims. The Insolvency Law Committee Report explained that Section 36(4) recognises that "certain assets in possession of the corporate debtor are not its own assets" and therefore "cannot be used for repayment to creditors." Unremitted GST collected from customers and TDS deducted from employees fall squarely within this principle. The corporate debtor holds these amounts as trustee, and beneficial ownership vests in the government as representative of the ultimate taxpayers. Excluding such amounts from the estate is not a matter of according priority to government claims but of recognising pre-existing property rights.

The proposed framework would operate as follows. Upon commencement of insolvency proceedings, the resolution professional would identify amounts representing unremitted fiduciary taxes through examination of GST returns, TDS statements, and related records. These amounts would be excluded from the liquidation estate under Section 36(4)(a)(i) and remitted to the appropriate government authority. Taxes owed directly by the corporate debtor, such as corporate income tax and property tax, would continue to be governed by Section 53(1)(e) and rank in the fifth priority. This approach requires no legislative amendment. It merely applies the existing statutory framework according to established trust law principles.

Two principal objections may be raised against this framework. The first concerns traceability. Money being fungible, opponents might argue that once collected taxes are deposited into the corporate debtor's general accounts, they lose their character as trust property and become indistinguishable from other funds. This objection misconceives the nature of the trust. The obligation to hold amounts in trust does not depend on physical segregation. Previously, the Supreme Court in Morvi Mercantile Bank Ltd v Union of India has held that statutory dues deducted but not deposited retain their character as government money notwithstanding deposit into general accounts. The trust is over a sum of money, not specific currency notes. The resolution professional can quantify unremitted fiduciary taxes from statutory returns without tracing specific funds.

The second objection is practical. Excluding Union tax dues would reduce amounts available for distribution, thereby diminishing recoveries for all creditors and potentially undermining the viability of resolution plans. This objection, if accepted, would justify including any third-party property in the debtor's estate merely because doing so increases the pool for distribution. Section 36(4) exists precisely to prevent such outcomes. The objection also ignores the countervailing benefit of accurate pricing of credit risk. If lenders cannot rely on accumulated fiduciary taxes to enhance recoveries, they will price credit according to the debtor's actual assets and cash flows. This promotes efficient capital allocation rather than subsidised lending premised on appropriation of government funds.

V. Conclusion

While the 2025 Amendment resolves the Rainbow Papers anomaly, its uniform treatment of government dues creates moral hazards by conflating debts with trust assets. Taxes owed by the debtor represent debts subject to the waterfall; taxes collected on behalf of the State represent trust property excluded from the estate. The IBC already contains the apparatus for differential treatment in Section 36(4)(a)(i), which excludes trust property from the liquidation estate. The framework proposed in this paper requires no legislative amendment. It requires only that courts and resolution professionals apply existing provisions according to their plain meaning.

References

[1] Select Committee on the Insolvency and Bankruptcy Code (Amendment) Bill 2025, Report of the Select Committee on the Insolvency and Bankruptcy Code (Amendment) Bill, 2025 (17 December 2025)