[Subham Mangla and Dirshi Shah are 4th Year B.A. LL.B (Hons.) and B.B.A LL.B (Hons.) students, respectively, at Gujarat National Law University, Gandhinagar]
The order of priority for the distribution of assets during liquidation, colloquially known as the “waterfall mechanism,” is the bedrock of any modern insolvency regime. In India, this critical function is enshrined under section 53 of the Insolvency and Bankruptcy Code, 2016 (“the Code”). This waterfall mechanism was unsettled by judicial interventions, creating significant uncertainty and necessitating legislative clarification.
The Insolvency and Bankruptcy Code (Amendment) Bill, 2025 (“2025 Bill”) represents a strong legislative response to this jurisprudential turmoil. The 2025 Bill’s proposed amendments seek to restore the original intent of the Code, reduce delays, and enhance the effectiveness of the insolvency process.
This post highlights how the amendments fall short of resolving the legal issues created by judicial interpretations and argues for further reforms under the Code.
The Judicial Hurdle: How Rainbow Papers Upset the Hierarchy
The stability of the IBC’s waterfall mechanism was disturbed by the Apex Court in State Tax Officer v. Rainbow Papers Ltd. (“Rainbow Papers”) in 2022. The Court disrupted the Code’s priority system by holding that a statutory first charge under the Gujarat VAT Act qualified as a security interest. This elevated government tax dues from their intended low priority under section 53(1)(e) of the Code to the same rank as secured creditors under section 53(1)(b), putting them on par with financial lenders and workmen’s dues. Rainbow Papers blurred the line between statutory charges which are involuntary in nature, as these taxes are to be paid mandatorily by the company to the state, with no scope of negotiation on the terms of the payment for this amount, and transactional securities, which are credit facilities that the company incurs on consensual basis with the creditor, based on negotiation between the parties.
As a corrective measure, the Apex Court, in PVVNL v. Raman Ispat, sought to contain this fallout. It reaffirmed the Parliament’s design that government dues stand lower in priority than secured creditors and clarified that Rainbow Papers should not be read broadly. However, it stopped short of overruling it, leaving alive the core idea that statutory dues could be treated as secured debt. This limited correction led to ongoing uncertainty, making legislative intervention necessary to restore clarity and stability.
Legislative Intervention: The 2025 Bill’s Two-Pronged Solution
In response to the judicial uncertainty, the 2025 Bill proposes a direct, two-pronged legislative solution aimed at restoring the original intention of the waterfall mechanism. The amendments surgically target the specific interpretations that arose from Rainbow Papers and the concurrent confusion surrounding inter-creditor agreements.
Settling the Government Dues Debate
The 2025 Bill’s primary objective is to legislatively overrule the central premise of Rainbow Papers. The insertion of explanations to section 53(1)(e)(i) & section 3(31) of the Code clarifies that all the government dues, regardless of any statutory charge, that purport to secure them, must be paid out at the fifth level of the waterfall. The definition of security interest under section 3(31) of the Code shall now not include interest created merely by operation of the law.
Upholding Inter-Creditor Arrangements
The second prong of the 2025 Bill’s solution addresses a parallel area of ambiguity, the validity of inter-creditor agreements within the liquidation waterfall. While the IBC was largely silent on this aspect, judicial attempts to resolve the issue failed due to conflicting views of the NCLTs. The judiciary disregarded inter-creditor arrangements by holding that all secured creditors who relinquish their security must be treated equally, thereby disregarding inter-creditor arrangements that established a priority. This stance was contrary to the Insolvency Law Committee’s (ILC) recommendation that the liquidator should respect valid inter-creditor agreements.
An attempt to resolve this dispute is made by the insertion of an illustration after section 53(2), which provides a scenario where two secured creditors, ‘X’ and ‘Y’, have a contractual arrangement that the debt owed to ‘X’ shall be cleared before ‘Y’. The 2025 Bill clarifies that “Such a contractual arrangement shall not be disregarded.”
This is a clear legislative signal that inter-creditor agreements establishing inter-se priority among creditors within the same class are valid and must be honoured by the liquidator.
Why the Amendments Are Not Enough?
Firstly, the 2025 Bill’s categorical subordination of all government dues, while effective in nullifying Rainbow Papers, fails to differentiate between distinct types of governmental claims. This monolithic approach overlooks a critical distinction recognized in more mature insolvency jurisdictions, such as the UK, where the jurisdiction differentiates between taxes a company owes on its own income and taxes it collects on behalf of the state from others.
Under the Enterprise Act 2002, the UK had, like India, relegated all claims of its tax authority to the status of unsecured debts. However, this position was revised in 2020. The UK now grants secondary preferential creditor status to certain tax debts, specifically Value Added Tax (VAT) & Pay as You Earn (PAYE) income tax. These claims now rank ahead of floating charge holders and general unsecured creditors, although they still fall behind fixed charge holders and employee wage claims. The rationale for this change is compelling, as these are trust taxes. They are not debts of the company itself but rather funds collected by the business in a de facto trust for the government. Allowing these funds to be distributed to other creditors in an insolvency was seen as fundamentally inequitable, as it meant that money paid in good faith by taxpayers and employees was being used to satisfy the claims of financial institutions.
The 2025 Bill should have adopted a similar, more sophisticated distinction. Taxes like the Goods and Services Tax (GST) and Tax Deducted at Source (TDS) are directly analogous to the UK’s VAT and PAYE. They are funds collected by the corporate debtor on behalf of the government. By treating these trust-based taxes with a degree of preference, perhaps by placing them higher than unsecured financial creditors but still below secured creditors, the legislature could have struck a more equitable balance. Such an approach would protect public revenue derived from third parties without unduly disrupting the credit market.
The 2025 Bill’s current blanket subordination, while pro-credit, creates a potential moral hazard where businesses under financial stress may be tempted to use collected GST and TDS as working capital, knowing that the government’s claim in a subsequent insolvency will be of low priority.
Secondly, although the 2025 Bill validates inter-creditor agreements through an illustration, it is a positive but fragile solution. Beyond this jurisprudential weakness, the amendment fails to address critical operational deadlocks that arise from the existence of multiple secured creditors.
The real problem remains unresolved, which is the conflicting enforcement preferences among secured creditors over the same asset. A first-charge holder may wish to enforce its security outside liquidation under section 52 of the Code, while a second-charge holder may prefer to relinquish it and participate in the waterfall under section 53 of the Code. There is no mechanism to resolve this deadlock, which forces the parties to pursue litigation, thereby defeating the IBC’s central objective of timeliness and efficiency.
A more effective reform would have mirrored section 13(9) of the SARFAESI Act, 2002, by allowing a majority of secured creditors, by value, to decide the enforcement route for a commonly held asset. Until a bolder amendment is made, the Bill risks being a cosmetic change, offering recognition in theory but little certainty in practice.
Conclusion: A Step Forward
The 2025 Bill is an essential legislative intervention decisively restoring clarity and predictability to the section 53 waterfall, which had been rendered uncertain by the judiciary. By explicitly subordinating government dues irrespective of statutory charges and by validating inter-creditor agreements, the 2025 Bill reaffirms the foundational economic principles of the IBC and provides much-needed comfort to the credit market.
However, this analysis concludes that the 2025 Bill, while necessary, is ultimately insufficient. It is a reactive fix to an immediate problem, a legislative patch that plugs the most significant leaks but fails to reinforce the entire structure. Further reforms are a must to develop a more creditor friendly environment in respect to insolvency with the priorities being: (i) Government dues should be differentiated by granting preferential status to trust fund taxes like GST and TDS, while keeping direct taxes lower in priority; (ii) Inter-creditor agreements must be substantively protected through a statutory amendment to section 53 of the Code, rather than relying on fragile illustrations; (iii) Deadlock resolution mechanisms are required to resolve disputes among secured creditors over asset enforcement, preventing delays and value erosion.
– Subham Mangla and Dirshi Shah