Reassessing Taxation on Haircuts: A Case for MSME Recovery under India’s Pre-Packaged Insolvency Framework

India’s vibrant insolvency regime has been in the limelight for its responsiveness to sectoral concerns, best illustrated by the introduction of Pre-Packaged Insolvency Resolution Process (“PPIRP”) in 2021, particularly for Micro, Small, and Medium Enterprises (“MSMEs”), to ensure their efficient and feasible revival from the drastic cash flow disruptions and business impacts they faced due to COVID-19. While the policy framework under the Insolvency and Bankruptcy Code, 2016 (“IBC”), addresses the growing need for swift and effective revival of insolvent MSMEs, there is a long way to go to ensure its effective implementation and achieve the legislative intentions behind these reforms.

One area that warrants reappraisal is the taxation of haircuts granted to MSME debtors in a restructuring process. Taxing forgiven debt increases the financial burden on an already liquidity-constrained entity, aggravating post-resolution liquidity crises. It also contracts the total pool of recoverable assets, disincentivising creditors from providing significant haircuts. This is especially pressing, given that median haircuts have risen sharply from 64% in FY23 to 73% in FY24, and the median time to resolution has skyrocketed to 834 days. This prolonged resolution process, combined with deep haircuts and additional tax charges, undermines the PPIRP’s main aim, eroding the MSME recovery environment.

The paper’s primary purpose is to address an important lacuna in the Indian insolvency regime by placing the interaction between taxation policy and insolvency law at the centre stage. It advocates a strategic fiscal policy intervention to ensure that taxation does not undermine the PPIRP’s revival goals (and, in turn, the IBC’s). In the process, it brings a new and persuasive voice to the MSME rehabilitation and insolvency reform debate in India, which is economically realistic and legally sophisticated.

The paper addresses this concern in a fourfold manner. It begins by outlining the rationale for introducing the PPIRP and recognising MSMEs’ specific financial vulnerabilities. Secondly, it conducts a critical examination of existing tax governance regarding haircuts under Indian law and discusses its implications for business viability upon resolution. Thirdly, it provides a comparative policy analysis, drawing on legal frameworks that provide preferential tax schemes for distressed debt resolution. Lastly, it proposes policy recommendations, including an initiative to provide preferential tax treatment for haircuts for MSMEs undergoing PPIRP.