The Return of Crown Preference in Insolvency

UPDATE 1 DECEMBER 2020

HMRC has issued a policy paper explaining how taxes paid by employees and taxpayers will be protected in insolvency procedures commencing after 1 December 2020.

Last Autumn the government proposed that they would reinstate Crown Preference for some tax debts owed by companies and individuals in Insolvency, which would mean that they take preference ahead of unsecured creditors when assets are realised and payments are made to creditors. 

This is likely to have knock-on consequences which companies – both strong and weak – need to consider. 

In insolvency law there is a strict hierarchy for the repayment of creditors.

Until 2003, the Crown had preferential status in corporate insolvencies for all tax debts, limited to those debts that arose in the 12 months preceding the date of insolvency.

In 2003 it gave up that right of preference, citing the benefits to the wider pool of other unsecured creditors of standing alongside them as an unsecured creditor. HMRC is now in most cases the largest unsecured creditor when a company fails. 

At the same time, the government created the Prescribed Part fund, which ensured that a proportion of realisations from assets secured by debentures were ring-fenced for the benefit of unsecured creditors as a whole. 

The government is now proposing to take a preference for VAT, employees' NIC and PAYE in all insolvencies.

It argues that these are not general liabilities of the company, but that the cash is really an asset held on some sort of “trust” for the benefit of the state by the company. Furthermore, if the legislation is enacted, the proposal will apply retrospectively to all relevant taxes that are outstanding, regardless of how old the debt is. 

Why does this matter?

We think that the “law of unintended consequences” could have a big effect. 

Firstly, most businesses regard these taxes as a legitimate source of working capital. There is a modest lag between the liability being finalised and the taxes being paid over and almost every business (and their lenders) will see this as a normal part of cashflow.

The proposal will put HMRC ahead of floating charge debenture holders, although not fixed charge lenders, so whilst it might not directly affect a lender offering, say, debt-factoring (fixed charge lending) or a mortgage over property, a lender offering an overdraft or other floating charge lending will find that their security has been reduced by the average amount of VAT, PAYE and employees NIC that is outstanding at the end of an average month. 

In a future insolvency, those taxes would be payable before the floating charge debenture holder, and it is inevitable that funds offered by those lenders, will reduce to mitigate the increased risk of non-payment.

Previously, secure businesses might find that, come facility renewal date, they are being offered less funds and have a cashflow squeeze. 

Growing businesses, taking on more staff, might become a less attractive banking option, and any business employing a lot of staff with labour representing a large proportion of their cost base will be particularly vulnerable. 

One of the supposed benefits of HMRC giving up its Crown Preference was that it could bring influence on behalf of unsecured creditors. We see this with Time-to-Pay plans for businesses in early stages of distress. You have to wonder if HMRC will be as willing to support struggling businesses when, by moving straight to an insolvency process, it can recover a significant amount of its debt because of this proposed preference. 

The government has been consulting on this. We have contributed to representations to this process, pointing out the significant flaws in the proposal. This consultation closed on 27th May and we are now waiting for the government response.

If the proposal does go ahead, we can expect to see a more difficult borrowing environment for many businesses.