Very few people would be surprised to hear that the unpaid taxes of an insolvent company would remain the subject of the attention of a tax authority.  Where a company collects taxes, such as value added tax (VAT) and employee taxes (being “pay as you earn” income taxes, or PAYE, in the UK) on behalf of the UK’s taxing authority, HM Revenue & Customs (HMRC), it is reasonable to expect those taxes to be paid over to HMRC in the insolvency process. 

However, the question of exactly where the payment priority of HMRC ranks against other creditors, whether secured or unsecured, has historically been a vexed question in the UK.  While the question of “Crown Preference” – the priority position HMRC has in collecting tax from an insolvent company – was seemingly settled in 2002, a recent statement in the UK Budget of October 2018 has resurrected the debate all over again.

The UK Government’s announcement about Crown Preference

The Chancellor of the Exchequer announced in the October 2018 Budget that HMRC will become a secondary preferential creditor for certain taxes “paid in good faith by [a business’] employees and customers but held in trust by the business” from 6 April 2020.  These taxes are not taxes on income or gains, but rather are “taxes paid … by employees and customers but held in trust by the business”, and will include VAT, PAYE, employee National Insurance contributions and Construction Industry Scheme deductions.

If this proposal is enacted in the Finance Bill 2019, HMRC will leapfrog floating charge holders and unsecured creditors in the insolvency order of priority of a UK company.  Under the new measures, HMRC, as a secondary preferential creditor, will still rank below the fixed charge holders (importantly, banks and other lenders to companies which routinely protect their investment with a fixed security charge), insolvency practitioners (in relation to their fees for administering the distribution of assets to creditors) and other primary preferential creditors.  Nonetheless, HMRC’s priority "leapfrogging" has caused considerable controversy in the UK’s business recovery sector.

Why is this change of priorities, as a result of Crown Preference being reinstated, so problematic?

Crown Preference was removed in the Enterprise Act 2002 as part of a wide reform to the UK insolvency regime.  Under the Enterprise Act 2002, HMRC was left at the level of an unsecured creditor in any corporate insolvency.  While this potentially reduced the amount of tax to be recovered in corporate insolvencies by HMRC, it had the very significant advantage of securing higher insolvency recoveries for trade creditors, encouraged HMRC to take a longer-term view of forcing companies into insolvency (by depriving HMRC of the ability to quickly resort to a winding up petition under UK law when facing a company in financial trouble), and helped salvage floundering businesses. 

Furthermore, so the arguments went in 2002, the Treasury was more capable of absorbing a loss for unrecovered VAT and PAYE than unsecured creditors, which were often small trading enterprises which were susceptible to becoming insolvent themselves upon a bad debt being realised. Over the intervening years, the UK Government’s approach was seen to be in tandem with is an international trend to minimise categories of priority claims in insolvency, recommended by both UNCITRAL’s Legislative Guide on Insolvency Law (in 2004) and the World Bank’s Principles for Effective Insolvency and Creditor/Debtor Regimes (in 2015).  

Finally, the abolition of Crown Preference in 2002, which gave an improved priority position to floating charge holders, was itself a quid pro quo for the introduction in the Insolvency Act 1986 of the “prescribed part” of an insolvency. The “prescribed part” of an insolvency created a partial exception to the insolvency order of priority in favour of unsecured creditors (at the expense of floating charge holders), being the portion of the amount realised from the sale of floating charge assets to be set aside to fund a distribution to the unsecured creditors, rather than the floating charge holders. The “prescribed part” is calculated as a percentage of the value of the floating charge assets, subject to a cap (which is currently £600,000).  Arguably, reinstating Crown Preference, without untangling other elements of the corporate insolvency regime which accompanied Crown Preference’s removal in 2002, risks unbalancing the regime.

So why reinstate Crown Preference now?

The Chancellor’s announcement concerning the proposed reinstatement of Crown Preference was accompanied by statements that the Government simply wanted to collect taxes due and payable from insolvent companies.  Various commentators have pointed to the desire of the current Government to fill the black hole of funding UK public services, as well as the imperative of building a "war chest" for Brexit-related funding needs.

More neutrally, the Chancellor gave a not-too-satisfying assurance that unsecured creditors will be mostly unaffected by the proposed change because they currently recover only 4 percent of debts owed on average from insolvent companies. However, it is difficult for small businesses to be as optimistic as the Chancellor given their cash-flow constraints and exposure to bad debts from suppliers and counterparties.

What does the reinstatement of Crown preference mean for financing transactions?

Assuming the proposals are enacted without material amendment, financial institutions and other lenders will need to take extra measures to ensure that sufficient security is obtained by way of fixed charges owing to floating charges being pushed down the order to priority in corporate insolvency. 

Additional complications also arise in the context of lending to group finance companies that might be vulnerable to VAT group secondary tax liabilities. The reinstatement of Crown Preference makes it additionally important for lenders to ensure that security packages are crafted in such a way that fixed charges can be obtained for lending facilities in such a way to protect financing from being vulnerable to unpaid group VAT being sought by HMRC in an insolvency situation.  This can add time and complications to group financing transactions, particularly where group finance companies are being presented to lenders as being commercially remote from other group activities.

Borrowers may also be adversely affected by the proposal as financial institutions may become more aggressive in obtaining fixed charges and less willing to lend (or more inclined to lend at a higher cost of borrowing).  Of particular concern for borrowers is that overdraft and working capital facilities – not infrequently protected with only a floating charge – would be subordinated to HMRC’s recovery of certain taxes, such as VAT and PAYE, in an insolvency.  Such a situation is likely to make overdraft and working capital financing harder to arrange for a number of businesses. 

Finance Bill 2019 and the Government’s proposal

At the date of this article, the Government has not published draft legislation for the reintroduction of Crown Preference.  While the devil is often in the detail, the reception to the Government’s proposal has been unfavourable so far, not least because of concerns that the move could reverse successive governments’ attempts to encourage a culture of business rescue since 2002 and undermine the Government’s recent work to improve and strengthen the UK’s insolvency framework.  

The adverse impact of the reintroduction of Crown Preference on floating charge holders will be compounded by the Government’s proposal announced in August 2018 that the cap on the “prescribed part” will be raised from £600,000 to £800,000 in line with inflation. While not directly connected with the reinstatement of Crown Preference, the increase in the “prescribed part”, which favours unsecured creditors at the expense of floating charge holders, is an additional disadvantage floating charge holders will face on top of confronting any new Crown Preference rules.

However, given the current political environment and fiscal pressure, it remains to be seen to what extent substantial changes will, if any, be made to the proposal before it arrives in Parliament as part of the Finance Bill 2019.