Do tax dues have supremacy over lien of creditors?

It is believed that the biggest fiscal problem for Greece isn't debt, but unpaid taxes. According to the Organisation for Economic Co-operation and Development (OECD), the tax debts of Greece is equal to 90 per cent of its annual tax revenue: this translates to a whopping $86 billion at the end of 2014. People have gone bankrupt having no money to pay tax.

In India however, there seems to be sufficient protection for the government to claim supremacy in collection of its tax dues, even diluting the interests of secured creditors by making overriding provision for tax collection under certain tax laws. This clearly mandates that creditors in India should be meticulous in their due-diligence before financing, and take appropriate legal precautions to secure recovery of their debts.

The common law doctrine that 'Government debts have priority' is recognised within the meaning of Article 372(1) of the Constitution of India. However, in the normal course, government's preferential right of recovery of debts over other creditors is confined only to ordinary unsecured creditors as held by the Supreme Court in Builder Supply Corporation vs. Union of India (AIR 1965 SC 1061). In a subsequent case of Dena Bank Vs. Bhikkmbhai Prabhudas Parekh & Co and others (2000 AIR SCW 4237), the Supreme Court held that the statutory dues will have priority over the dues of a secured creditor if there is a specific provision in that particular statute. To overcome the impact of this SC judgement, most of the major tax laws (not all) have now been amended to provide for a first charge for recovery of tax dues.

In the past, courts have also distinguished public revenue from land revenue and in the case of Indian Bank Vs. State of AP & others (1993 STC Page 548), held that sales tax arrears cannot be treated as land revenue and hence, it is not a sovereign debt. Taking cue from this case, most of the VAT Acts now contain a specific provision categorising the tax dues as Land Revenue for recovery. Thus, the government has also overcome this difficulty.

Supremacy over secured creditors:

Let us now analyse the present provisions of important tax acts like Central Excise, Custom Duty, Service Tax, VAT and Income Tax from the point of view of their supremacy even over the secured creditors for recovery of dues. Section 11 of Central Excise Act, Section 142 of The Custom Act 1961 and Section 83 of Service Tax provides that pending dues shall be recovered from the said person the amount specified therein as if it were an arrear of land revenue. Further, Section 11E, Section 142 and Section 88 of the above Acts respectively provides that liability under these Acts to be the first charge except as provided in section 529A of the Companies Act 1956, the Recovery Debts Due to Banks and Financial Institution Act, 1993 and Securitisation and Reconstruction of Financial Assets and the Enforcement of Security Interest Act, 2002.

Section 32 of the Maharashtra VAT Act provides that any unpaid tax, penalty, interest, fine or sum forfeited shall be recoverable as arrears of land revenue. Sec 37 creates a first charge for any amount of tax, penalty, and interest etc. subject to any provisions in any Central Act. In this context it is pertinent to note that Section 33 of the Madhya Pradesh VAT Act goes a step further and has non-obstante clause to create first charge for recovery of tax dues over any other Acts.

Section 226 & 227 of the Income Tax Act, read with Rule 93 of the Second Schedule, creates first charge upon any asset for recovery of unpaid tax. Further, Section 281 goes to the extent of declaring transfer of assets as void if done during pendency of a proceeding under some circumstances.

To conclude, lenders should evaluate tax litigations under different tax laws thoroughly as unpaid tax dues in most of the cases have the first charge on assets of a company. The first major decision of the SC on this point was in the case of Central Bank of India v. State of Kerala (C.A. No. 95/2005) dated 27thFebruary 2009, which upheld the priority of state dues on the basis of the existence of statutory first charge in a particular tax Act. However DRT Act (Sec 34) &SARFAESI Act (Sec 13(9)) seems to be giving protection to the lenders under its schemes at least against tax dues under most of the central taxes.

Nihal Kothari is Executive Director & Narendra Pati is Principal Associate. Khaitan & Co.