Crown preference – an unwelcome return

  • April 2, 2019
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In last October’s Budget speech, the Chancellor announced, out of the blue, that the Government was planning to reintroduce Crown preference for certain taxes in insolvencies. At R3, the insolvency and restructuring trade body, we think this proposal has potential to cause long-term damage to the UK economy and to our business rescue culture, and will end up costing the public purse more in lost income and higher expenses than it will supposedly “save” in extra taxes returned after corporate insolvencies.

What’s it all about?

In insolvency procedures, creditors are repaid according to a strict, statutory hierarchy. The lower down the hierarchy they are, the less money a creditor is likely to see back. The Government’s plan is to move some HMRC debts ‘up’ the hierarchy. Affected tax debts include PAYE, employee NICs, and VAT. Other tax debts, such as corporation tax or employer NICs, will remain an unsecured debt.

The new proposal is a return to the situation that existed pre-2003, but with some key differences. Up until 2003, HMRC had preferential status in corporate insolvencies for all types of tax debts. This was changed by the 2002 Enterprise Act, which was designed to foster a culture of business rescue and turnaround, and to improve the survival prospects for UK businesses. Under the new Crown preference proposals, tax debts will qualify for preferential status regardless of when they arose, whereas before 2003, only tax debts arising in the 12 months prior to insolvency had preferential status. The proposal is ‘retrospective’, too: while it will apply to insolvencies starting after 6 April 2020, any tax debts and penalties from before this date will have preferential status.

We think that overturning a system that has functioned well for 16 years, with very little warning and no proper scrutiny to date of the myriad potential impacts, is reckless and ill-judged.

Impact on other creditors

The creditors most affected by the changes are those leapfrogged by HMRC: ‘floating charge’ creditors (who lend against a changing asset, such as stock) and unsecured creditors such as the company pension scheme, some employee claims, and the company’s suppliers or customers – including small businesses and consumers.

The extra money HMRC gets as part of the proposed reform will be coming from what would otherwise be repaid to these other creditors. The lack of a time ‘cap’ for the new ‘Crown Preference’ means unsecured and floating charge creditors could get even less back in insolvencies than they did before the Enterprise Act 2002.

Floating charge lending, such as asset-based lending or invoice discounting, is a very common form of business finance. If the proposal is brought in, floating charge lending will essentially become as risky as unsecured lending for the finance provider, as its balance sheet will have to register a zero value for the loan in case of insolvency, with no prospect of any kind of meaningful return through the insolvency process. Finance companies will be less willing to lend, particularly to those companies already in financial distress (but who may be in a position to turn themselves around with fresh funding).

Lenders will have to respond, either by taking out insurance on floating charge loans, the cost of which will be passed on to the borrower, and/or by carrying out due diligence on every floating charge borrower on their books for unpaid tax and penalties going back decades in order to determine the risk to their capital. UK businesses need reliable access to finance in order to operate, while sectors such as retail use floating charge lending to finance their stock levels. Small and medium sized enterprises (SMEs) are more likely to rely on floating charge lending than their larger counterparts, and will therefore take a bigger hit from a lesser availability of floating charge lending.

The time taken to resolve insolvencies and distribute final payouts may rise, too, as insolvency practitioners wait for the final approval of tax debts owed from HMRC. The Government would see greater benefits if HMRC were to engage more fully in insolvency procedures, rather than trying to jump the queue.

Next steps

The Government’s consultation is open until 27 May. R3 will continue to make the case against the proposals, as we believe they are a step backwards which will prevent the rescue of potentially viable businesses, and which will harm floating charge holders and unsecured creditors to an unreasonable degree. The returns that HMRC expects from the partial restoration of its preferential status – £185 million by 2022/23 – are far outweighed by the damage that could be caused to the UK economy. An urgent rethink is required.

The order of priority for repayment in corporate insolvencies

  1. ‘Fixed charge’ creditors– creditors whose lending to a company is secured against a definable object (e.g. a mortgage on a building/warehouse)
  2. Costs of the insolvency process– this could include staff wages or rent due during the process, or the fees of the office holder
  3. Preferential creditors– this currently covers some payments due to employees, and money owed as part of the Financial Services Compensation Scheme. Until 2003, HMRC was classed as a preferential creditor (this was changed by the 2002 Enterprise Act)
  4. ‘Floating charge’ creditors– creditors whose lending is secured against a class of asset (e.g. ‘stock’ in a warehouse, but not specific items of stock). Asset-based lending is a common type of floating charge lending
  5. Unsecured creditors– almost all other creditors, including pension schemes, customers and trade creditors. HMRC is currently an unsecured creditor
  6. Shareholders.

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Crown preference – an unwelcome return

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