No More Rainbows: How IBC 2026 Fixes the Waterfall
Introduction
Few questions in the contemporary insolvency jurisprudence have sustained as major controversy under the Insolvency and Bankruptcy Code, 2016 (IBC), one of them being as to whether Government creditors with a statutory first charge under a statute qualify as a ‘secured creditor’ or not. Such recognition elevates the tax claim of a government to go up the waterfall of liquidation to a new status, one that is pari passu with the claim of the private secured lenders, which in effect redraws the entire priority architecture that the Parliament had built down. This is exactly what the Supreme Court held in State Tax Officer (1) vs. Rainbow Papers Ltd. (2022), which triggered various conflicting judicial responses.
Parliament finally gave a conclusive response on 6 April 2026, with the Insolvency and Bankruptcy Code (Amendment) Act, 2026, which, in addition to many other reforms, legislatively repeals Rainbow Papers and restores fidelity to the original design of Section 53. This article follows the route from that controversial decision to the correction of the statute.
Section 53 and the Waterfall Mechanism
Section 53, introduced by a non obstante clause, prescribes an eight-tier hierarchy for the distribution of a liquidating debtor’s estate. The second tier is occupied by the secured creditors who have relinquished their security, along with workmen dues. The Corporate Debtor’s (CD) dues owed to the Central and State Governments are ranked at the fifth place in precedence even below the unsecured creditors. This was not an inadvertence. In 2015, the Bankruptcy Law Reforms Committee (BLRC) proposed to subordinate government dues to those of private secured and unsecured financial creditors. Lower government ranking leaves more of the recovery pool for private lenders during liquidation, which gives them the confidence to extend credit more cheaply. Cheaper credit keeps distressed companies alive through restructuring, and surviving companies keep paying taxes, so revenue rises even as government claims sit lower in the repayment order.
Even before introduction of the IBC, the settled law maintained that private secured creditors shall have priority over the crown debts, and the dual non-obstante nature of the code in Section 53 and Section 238 reinforced the idea as a matter of positive law. The pre-IBC era of ‘crown debt’ primacy was consciously dismantled, which Rainbow Papers briefly put back.
Rainbow Papers: The Pivot and its Fault Lines
The dispute was brought about by the insolvency of Rainbow Papers Ltd., which was indebted to the State Tax Officer to the tune of ₹53.71 crore under the Gujarat Value Added Tax Act, 2003. Section 48 of that Act stated that tax dues would constitute a “first charge” on the dealer’s property, notwithstanding any other law. The Resolution Professional rejected the claim as belated and both the NCLT and NCLAT upheld that rejection. The Supreme Court (Banerjee and Bopanna JJ.) however took an opposite stance, holding that the statutory first charge constituted a “security interest” under Section 3(31) of the IBC, which expressly encompasses interests ‘arising by operation of law.’ Accordingly, the State now ranked pari passu with the workmen at Tier 2 and was considered a “secured creditor” under Section 3(30). Resolution plans not taking these debts into account were liable to be set aside. This is in direct conflict with the ‘Clean Slate Doctrine’ established in Ghanshyam Mishra and Sons Pvt Ltd v Edelweiss Asset Reconstruction Co Ltd., under which all claims revealed after the Adjudicating Authority’s approval of the Resolution Plan are to be extinguished.
This ruling was immediately questioned on certain grounds. Firstly, it equated an ex lege fiscal imposition coercively levied on a defaulting taxpayer with a consensual mortgage or pledge; the paradigmatic security interests that the Code was designed to protect. Secondly, and most importantly, the Bench failed to take cognizance of Section 53, which clearly places Government dues below secured creditors, which is directly contrary to the equality established above. Thirdly, the decision deviated from the existing case law, according to which debts of the Crown would not have equal footing with private secured creditors. This provided sufficient leeway to the tax authorities of different states to file recovery claims in pending insolvency cases, demanding Tier 2 treatment.
The Judicial After effects
In another recent case, Paschimanchal Vidyut Vitran Nigam Ltd v Raman Ispat Pvt Ltd, a coordinate bench of two judges of the same division clearly held that Rainbow Papers “did not notice the waterfall mechanism under Section 53” and extended the holding to the facts of that case. This was a relief for the credit markets but created an interesting conflict situation where two benches of equal strength had arrived at different conclusions on the same statutory question. Furthermore, NCLAT, in the insolvency proceeding involving Jet Airways, limited the applicability of Rainbow Papers yet again by holding that the reasoning in that decision could not be applied in the context of the Maharashtra GST Act, 2017, because the IBC itself falls outside the scope of Section 82 of the Maharashtra GST Act, consequently making Rainbow Papers’ holding of a statute-specific nature rather than general. Moreover, in February 2024, the Supreme Court in Greater Noida Industrial Development Authority v Prabhjit Singh Soni followed the reasoning in Rainbow Papers for remanding the plan for real estate insolvency. Conclusively, in October 2023, in Sanjay Kumar Agarwal v State Tax Officer, a three-judge bench dismissed all five petitions for review by simply observing that it was “unideal” to be deviating from coordinate authority decision in Rainbow Papers.
The IBC (Amendment) Act, 2026: Closing the Rainbow
When the impasse over the interpretation of the law was developing, the MCA had circulated a Discussion Paper on 18 January 2023 suggesting that the definition of “security interest” in Section 3(31) would refer only to agreements of a consensual nature, while the dues of the Government ought to be included in the list of unsecured creditors in Section 53. This could have been, in essence, the reform that the legislature adopted into law three years later.
The Insolvency and Bankruptcy Code (Amendment) Act of 2026, may very well be the most extensive legislative update of the IBC since its creation, covering aspects such as insolvency resolution, liquidation, and the revision of timelines. However, the critical change that matters in this particular case is the amending (legislative overruling) of Rainbow Papers through two interrelated provisions.
Clause 5 of the IBC (Amendment) Act of 2026 adds an Explanation to Section 3(31) stating that a “security interest” does not include “any interest, lien or charge created purely by reason of any operation of law, including a statutory charge or any interest created in pursuance of any statute.” In other words, the statutory tax lien is explicitly taken out of the category of “security interest”. Therefore, any government authority whose claim is founded solely on the basis of such a statutory charge cannot claim the status of a “secured creditor” under Section 3(30) and can only claim Tier 5 of Section 53. This is confirmed by the changes made by Clauses 31 and 32 to Sections 52 and 53 regulating the settlement of government dues and limiting the priority rights of the secured creditor.
From the standpoint of legislation, this is a targeted solution rather than a sweeping change. It means that even though the Amendment rules out the possibility of a government entity being a secured creditor in relation to a statutory lien, it will still be able to exercise the role of a secured creditor in relation to those interests in the property which it gains as a result of a consensual relationship (pledge, mortgage, hypothecation). The Amendment, therefore, eliminates the ‘fiction of priority’ between the tax lien and the voluntary security of the lender. As noted by Finance Minister Nirmala Sitharaman in her remarks during the discussion of the bill, the IBC was meant to help rescue a business in trouble, not collect debts.
Conclusion
The journey from Rainbow Papers (2022) to the IBC (Amendment) Act, 2026, marks a critical issue in insolvency law, namely, the conflict between the State’s interest in realizing its revenue and the requirements of the credit market for an order of priorities. What Parliament did through its amendment in Clauses 5, 52, and 53, far from minimizing the State’s claim, was to firmly reassert the principle that separates the coercive power of fiscal exaction by the state from private lending secured by credit. Consenting State agencies will continue unaffected, whereas agencies that operate merely on statutory tax liens have been rightly placed back in their proper hierarchy under the liquidation waterfall. Thus, the rainbow that had temporarily distorted the priorities of the IBC to create an anomaly has finally been shut down. And with it, the core ideal of the BLRC of an insolvency code that is fundamentally credit-enabling has been revived.
*The author is a Second year B.A. LL.B. (Hons.) student at National University of Study and Research in Law, Ranchi.
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