Initiation of Corporate Insolvency Resolution Process for Arrears in Lease Transactions

[Tejpal Singh Rathore is a 4th-year B.B.A. LL.B. (Hons.), student at Gujarat National Law University in Gandhinagar]

Corporate Insolvency Resolution Process (“CIRP”) can be invoked by a financial creditor, an operational creditor and a corporate debtor itself. An application can be filed by a financial creditor under section 7 of Insolvency and Bankruptcy Code, 2016 (“Code”) if there is any default in respect of a “financial debt”. Similarly, an operational creditor can file an application for any default with respect to an “operational debt” under section 9 of the Code.

A lease is an agreement whereby the lessor conveys to the lessee the right to use an asset for an agreed period of time in return for a payment or series of payment. For the purposes of Code, two types of leases may be relevant, viz. (i) finance lease and (ii) operating lease.

Insolvency Proceedings in a Finance Lease

Section 5(8)(d) of the Code defines “financial debt”. The said definition, to the extent relevant, is extracted as under: 

“Financial Debt means debt, along with interest, if any, which is disbursed against the consideration for the time value of money and includes:

…

(d) the amount of any liability in respect of any lease or hire purchase contract which is deemed as a finance or capital lease under the Indian Accounting Standards or such other accounting standards as may be prescribed.”

The Indian Accounting Standards (“Ind AS 17”) defines a finance lease as a lease which transfers substantially “all the risks and rewards” incidental to ownership of an asset. Title may or may not eventually be transferred. Disputes with respect to finance lease arise when there are two possible interpretations as to whether all the risks and rewards have been transferred. In Association of Leasing and Financial Services Company v. Union of India, the Supreme Court observed that in case of a finance lease the lessee could use the asset for its entire economic life and, thereby, acquires the risks and rewards incidental to the ownership of such assets. Further, in Asea Brown Boveri Ltd v. Industrial Finance Corporation, the Supreme Court, while distinguishing a finance lease and an operating lease, held:

“A finance lease is one where the lessee uses the asset for substantially the whole of its useful life and the lease payments are calculated to cover the full cost together with interest charges. It is thus disguised way of purchasing the asset with the help of a loan.”

Therefore, the terms of the lease agreement become paramount in determining whether the lease can be categorized as a finance lease for initiation of insolvency proceedings. In other words, the extent of control by the lessor over the assets would determine the character of a lease. 

Insolvency Proceedings in an Operating Lease

The definition of an operational creditor within the meaning of section 5(20) of the Code is reproduced as under: 

“Operational Creditor means a person to whom an operational debt is owed and include any person to whom such debt has been legally assigned or transferred.”

From a perusal of the above, it is clear that the term “operational creditor” has been defined in relation to an “operational debt”. The term “operational debt” under section 5(21) of the Code is defined as under:

“Operational Debt means a claim in respect of the provision of goods or services including employment or a debt in respect of the repayment of dues arising under any law for the time being in force and payable to the Central Government, any State Government or any Local Authority”.

The above definition of operational debt has four elements namely: (i) goods; (ii) services; (iii) employment; and (iv) government dues. Now the question that assumes significance here is whether the lease of immovable property amounts to provision of goods or services. The issue whether arrears of such lease amount to an operational debt has recently gained judicial scrutiny. The Delhi Bench of the National Company Law Tribunal (“NCLT”), in Parmod Yadav and Ors. v. Divine Infracon Pvt. Ltd., has held that the lease of an immovable property cannot be considered as a supply of goods or rendering of any services and, thus, cannot fall within the definition of “operational debt”. While referring to the term “goods or services” used in the definition of operational debt, the bench observed that it must relate to direct input to the output produced or supplied of the corporate debtor. The tribunal also held that any debt arising without nexus to the direct input to the output produced or supplied cannot, in the context of the Code, be considered as an operational debt. Even though it can be a claim amounting to a debt, it cannot be categorized as an operational debt.

Furthermore, it is pertinent to note that the National Company Law Appellate Tribunal (“NCLAT”) upheld the judgment of the NCLT in Jindal Steel and Power Ltd. v. DCM International Ltd., which further substantiates the position mentioned above. The tribunal rejected the argument that a transaction of lease of immovable property will fall within the term of “service” under section 5(21) of the Code. It also clarified matters pertaining to the Gujarat High Court Judgment in Cinemax India Ltd. v. Union of India, relied upon by the operational creditor, wherein the High Court had held that the lease transaction in relation to immovable property, namely renting of immovable property in furtherance of business or commerce of service recipient, amounts to rendering service and would fall within the meaning of definition of service tax.

However, the tribunal did not accept the High Court’s reasoning, citing that the question before the court was with respect to service tax and that such interpretation cannot be imputed in to the Code, as both legislation operate on a completely different footing and have been enacted with different objects and purposes. This position clearly establishes that arrears of lease rent cannot be considered as an operational debt and, hence, CIRP for the default of the same cannot be initiated under section 9 of the Code.

Conflicting Judgments

On the other hand, there have been judgments wherein the tribunals have considered a contrary position. In Mahesh Madhavan v. M/s Black N Green Mobile Solutions Pvt. Ltd., the Chennai bench of the NCLT has allowed an application filed under section 9 to initiate a CIRP. The contention inter alia of the operational creditor was the default in payment of dues out of a leased commercial complex.

On the same footing, the Kolkata bench of the NCLT has also in Sarla Tantia v. Nadia Health Care (P) Ltd., while relying upon the judgment of Supreme Court in Mobilox Innovations Pvt. Ltd. v. Kirusa Software Pvt. Ltd., has held that receiving any consideration by way of rent, lease from time to time and license fee for letting out the premises would fall under the purview of providing services and the consideration that is receivable becomes an operational debt. This judgment has been the latest in a series carrying the debate. It has observed and relied upon the report of Bankruptcy Law Reform Committee which considers a lessor as an operational creditor. The tribunal also relied upon the provisions of section 2(a) of the Central Goods and Services Tax Act, 2017 which states that any lease to occupy is a supply of service and hence recovery of arrears of rent is operational debt within the meaning of section 5(21) of the Code, contrary to the position taken in Jindal Steel (discussed above).

Conclusion

On a perusal of the positions mentioned above, in my view, it is pertinent that the judgment in Jindal Steel gets the precedence owing to the higher authority of the NCLAT over the judgment of the NCLT in Sarla Tantia, despite the latter being the last precedent on the contentious issue. The stance taken in Jindal Steel is the correct position in the absence of any opinion by the Supreme Court. Moreover, imputing definition of service provided in a fiscal statute to the Code for a transaction of lease of an immovable property is akin to setting a wrong precedent, as both have completely different purposes; with the former the legislature has cast a wide net and latter needs to be strictly interpreted. As of now Sarla Tantia has not been challenged before any higher forum. Therefore, the position taken in Jindal Steel, i.e. arrears of lease rent not being an operational debt would be binding unless the position in Sarla Tantia is upheld by the NCLAT or the Supreme Court.   

– Tejpal Singh Rathore