Treatment of Capital Gains during Liquidation and the Interplay of the Income Tax Act the IBC; Decisions so far
–Navaneeth Krishnan, B.Com, LL.B,
(The author is a lawyer currently pursuing the Graduate Insolvency Programme at the Indian Institute of Corporate Affairs)
The Insolvency Bankruptcy Code, 2016 (“The Code”) has had quite a few teething problems in its fledgling years. The Code now nearing its fifth year of existence, has had several judicial interferences to clear the cloud on several issues. Having said that, several such aspects still exist, that could use some clarity and consistency from the courts of law.
The treatment of capital gains tax during the liquidation of a company and the resulting question of the inconsistency between the Income Tax Act 1961 (“The IT Act”) and the Code is one area where the jurisprudence has been fairly consistent. Liquidators have time and again knocked on the doors of the Adjudicating Authority seeking directions on whether or not capital gains tax must be deposited with the tax authorities during the process of liquidation.
Recently, in the matter of Om Prakash Agrawal Liquidator-S. Kumars Nationwide Limited Vs. Chief Commissioner of Income Tax (TDS) and Anr (2021) ibclaw.in 54 NCLAT., the Hon’ble National Company Law Appellate Tribunal further crystallised the judicial stance on the overriding provisions of the Code over the Income Tax Act 1961 with respect to the treatment of capital gains tax during the liquidation process. This article attempts to summarise few of the major decisions that have emanated from the corridors of justice with regards to the taxmen’s position while sale proceeds from liquidation are distributed.
Status of capital gains during liquidation of the company
As per Section 2(14) of the Act, a ‘Capital Asset’ is defined as property of any kind held by an assessee whether or not it is in connection with his business or profession. Any profit or gain arising from a transfer of such a capital asset can be termed as a ‘Capital Gain’.
The charging provision of Section 45 of Income Tax Act, 1961 states that any profits or gains arising from the transfer of a capital asset effected in the previous year will be chargeable to income-tax under the head of ‘Capital Gains’. Such capital gains will be deemed to be the income of the previous year in which the transfer took place. Section 46 of the Act meanwhile states that notwithstanding anything contained in Section 45, where the assets of a company are distributed to its shareholders on its liquidation, such distribution shall not be regarded as a transfer by the company for the purposes of section 45.
Section 53 of the Code talks about the priority of distribution of sale proceeds from liquidation. As per the waterfall mechanism envisaged therein, dues to Central and State Government stands fifth in the order of priority. Clause (1)(e) of the Section 53, states that they rank in pari passu basis with debts owed to a secured creditor for any amount unpaid following the enforcement of security interest.
Pr. Director General of Income Tax &Anr. Vs. M/s Synergies Dooray Automotive Ltd. & Ors. (2019) ibclaw.in 443 NCLAT holds that all statutory dues, including Income Tax, Value Added Tax etc. come within the meaning of operational debt. Consequently, Income Tax Department of the Central Government and the Sales Tax Department(s) of the State Government and ‘local authority’, who are entitled to dues arising out of the existing laws, are all accorded the status of operation creditors.
It is also certain that the Income Tax Department does not enjoy the status of a secured creditor, on par with a secured creditor covered by a mortgage or other security interest, who can avail the provisions of Section 52 of the Code to realise their security interest. Hence, the dues towards government, whether in the form of income tax or on sale of properties, would qualify as operational debt and must be dealt with accordingly.
In Dena Bank vs. Bhikhabhai Prabhudas Parekh and Co. & Ors (2000) 5 SCC 694. it was made clear that income-tax dues, being in the nature of Crown debts, do not take precedence even over secured creditors, who are private persons.
Should capital gain tax form a part of liquidation costs?
The Hon’ble Supreme Court in Commissioner Of Income-Tax V. KTC Tyres (India) 185CompCas17(SC) rejected the view that that the capital gains tax which was payable by the company to the Union of India must be treated as liquidation expenses and, therefore, must be paid first, even before the dues of the workmen and secured creditors are discharged. The Apex Court in this judgment points out how the Act, does not treat the revenue taxes as liquidation expenses.
Section 178 of the Act mandates that the liquidator cannot part with any of the assets of the company or the properties in his hands till he has been notified by the Assessing Officer and the liquidator shall set aside an amount, equal to the amount notified. As per Leo Edibles & Fats Limited Vs. Tax Recovery Officer (Central)  ibclaw.in 12 HC, the Hon’ble Andhra Pradesh High Court states that in the event an assessee company is in liquidation under the Code, the Income-tax Department can no longer claim a priority in respect of clearance of tax dues of the said company, as provided under Sections 178(2) and (3) of the Act of 1961. In the context of liquidation of an assessee company under the provisions of the Code, the Income-tax Department, not being a secured creditor, must necessarily take recourse to distribution of the liquidation assets as per Section 53 of the Code.
Overriding effect of the provisions of IBC
The Hon’ble Supreme Court on 10.08.2018, in Principal Commissioner of Income Tax v. Monnet Ispat and Energy Ltd.  ibclaw.in 30 SC, held that given the non-obstante clause in Section 238 of the Code, it is obvious that the Code will override anything inconsistent contained in any other enactment, including the Income Tax Act.
Section 194 IA of the Act of 61, dictates that the transferee shall deduct an amount equal to one per cent of such sum payable to the transferor of an Immovable property as income-tax. On 22.10.19 in the order of M/s Shree Ram Lime Products Pvt Ltd vs Gee Ispat Pvt. Ltd.  ibclaw.in 02 NCLT, it was held that Section 178 or 194A of the IT Act will not have an overriding effect over the waterfall mechanism prescribed under the Code. It is noteworthy to mention here that Section 178 of the Act in itself has a non obstante clause, similar to the Code, thereby causing an apparent conflict. However the amendment brought in to sub-section 6 of the Section 178 as per the Section 247 read with the Third Schedule of the Code, makes it clear that when it comes to liquidation under the Code, the Act will not be applicable. It was also noted in the order that if the Government dues viz. the Income Tax dues were paid before the secured creditors as laid out under the Code. In other words, it would create an anomalous situation in so far as the secured creditor getting lesser remittance that what they would have realised had they not released the security into the common corpus.
More recently, on 31.08. 2020, In the matter of LML Limited  ibclaw.in 86 NCLT, the National Company Law Tribunal, Ahmedabad, held that a tax liability arising out of the sale of assets by the liquidator shall be distributed in accordance with Section 53 of the Code and shall not be treated as liquidation cost. It was also observed that by virtue of Section 238 of the Code, Section 53 (1) (e) of the Code shall have overriding effect on the provisions of the Section 194 IA of the IT Act.
The question of TDS and the liquidator filing Income Tax Returns
In S. Kumars Nationwide (supra), the National Company Law Appellate Tribunal (“NCLAT”) set aside an order of the Adjudicating Authority that had held that the deduction of TDS does not tantamount to payment of Government dues in priority to other creditors because it is not a Tax demand for realization of Tax dues and that it is the duty of the purchaser to credit TDS to the Income Tax Department. The NCLAT was of the view that TDS under Section 194 IA, is an advance capital gain tax, recovered through transferee on priority with other creditors of the company and hence is inconsistent with Section 53 (1) (e) of the Code.
The order touches upon the fact that if the liquidator of a Company in liquidation under the Code is not required to file Income Tax Return, then there is no question of claiming refund of TDS deducted under Section 194 IA of the IT, and also that by virtue of Section 238 of the Code, it shall have override Section 194 IA of the IT Act. It was further opined that it is a cumbersome process to take refund from Income Tax Department and hence Code and IBBI (Liquidator Process) Regulation 2016 is silent on the subject of filing of Income Tax Return as Code provides for a time bound period for completion and maximization of value of assets and ease of doing business.
If statutory dues were treated with priority, i.e. in contradiction with Section 53 of the Code, it would topple the whole repayment hierarchy and cause grave injustice to secured financial creditors whose preferential treatment is the cornerstone of the Code. Hence, the decisions discussed above on the treatment of capital gain tax are well and truly in line with the objective of the Code. They clarify various questions that have propped up in due course such as the liquidator’s role in the treatment of TDS by the transferee during liquidation, conflict between the IBC and the Income Tax Act amongst others. Such consistency in decisions is much desired as it caters to the Code’s primary spirit of time bound resolution.