The return of Crown preference

06 December 2018

At the recent Budget, the Chancellor announced that HMRC will become a secondary preferential creditor in the event of a corporate insolvency. As such, from April 2020, HMRC will be able to claim tax paid by third parties which is being held temporarily “in trust” by companies in an insolvency procedure. The move will partly reverse the 2002 Enterprise Act, which removed HMRC’s status as a preferential creditor in corporate insolvencies (known as ‘Crown preference’). This post will look at what has led to the partial restoration of Crown preference, and the implications of the change.

Background

Prior to the 2002 Enterprise Act, HMRC was a preferential creditor in insolvencies, which gave it priority over floating charge and unsecured creditors in receiving any payments following a company’s insolvency. The Act then removed HMRC’s privileged position, making it rank alongside other unsecured creditors, such as suppliers. The measure was part of a number of reforms introduced by the then-Labour Government to encourage business rescue, and to make the insolvency process fairer on unsecured creditors (including trade creditors and company pension schemes, among others). It was thought that removing HMRC’s status as a preferential creditor would provide it with an incentive to support business restructuring proposals, and tackle the perception that HMRC was winding up distressed but ultimately viable companies in order to increase the ‘tax take’.

Circumstances have changed considerably since 2002. Theresa May’s drive to ‘end austerity’ is likely a significant factor behind the partial restoration of HMRC’s preferential status, as the Government seeks to increase its tax revenue to cover some of the costs of ending austerity, while at the same time continuing to bring down the deficit. In its Budget briefing on the proposal, the Government has suggested that the change could see an extra £185 million being raised every year; however, the basis on which this estimate has been reached is not yet clear. In response to written parliamentary questions tabled by the Liberal Democrat Peer Baroness Burt (here, here and here), the Government simply referred back to the figures provided in the Budget briefing – giving no further information as to how its estimates had been reached.

The proposal

If introduced, the Budget changes will see some HMRC debts bumped back up to priority repayment status. The taxes affected will be those which companies pay to HMRC on behalf of others: PAYE and employee NICs deducted from pay packets, VAT payments, and similar taxes. Unaffected, and remaining an unsecured debt, will be those taxes owed by a company itself, such as corporation tax debts. This is slightly different to the situation before 2002 when all tax debts enjoyed preferential status

What this means

The move will have a significant impact on creditors and, by extension, business rescue and funding.

The creditor groups most affected by the changes will be those leapfrogged by HMRC: ‘floating charge’ creditors (those who lend against a changing asset, such as stock) and unsecured creditors (as above, things like the company pension scheme, or the company’s suppliers or customers – often small or medium-sized enterprises or consumers). The extra money HMRC gets as part of the proposed reform will be coming from what could be repaid to these other creditors.

This squeeze on ‘floating charge’ lenders could have a big impact on business rescue and funding. With these lenders facing the possibility of not seeing any of their money back if a company becomes insolvent, they will be less willing to lend, particularly to those companies already in financial distress (but who might be able to turn themselves around with some extra cash). This isn’t good news for the UK’s small businesses, which need reliable access to finance to operate.

The changes may force lenders to switch to less flexible ‘secured lending’ (where money is lent against a fixed asset, like a building). Secured lenders trump all other creditors when it comes to post-insolvency repayments, so more secured lending means less money back for everyone else, too.

One other problem is that it is not clear how HMRC will differentiate between tax money temporarily “held in trust” by a company, and funds owed to others: it is not a requirement for companies in the UK to have separate trust accounts for collected but unpaid taxes. This means all the cash a company has in its bank account might be used to pay secured creditors and taxes owed to HMRC – leaving nothing for other creditors, and no money to pay for any legal action which might be required to track down any of the company’s other assets which could be used to repay others.

It’s also worth bearing in mind that this proposal has appeared at the same time as the Insolvency Service has proposed increasing the ‘prescribed part’ – money which would otherwise be paid to floating charge holders but which is ring-fenced for unsecured creditors – from a maximum of £600,000 to £800,000. Coordinated or not, floating charge holders will feel squeezed.

R3 strongly recommends that the Government rethink its position, as the move could reverse successive governments’ attempts to encourage a culture of business rescue since 2002, and undermine its recent work to improve and strengthen the UK’s insolvency framework. HMRC would see greater benefits from engaging with the insolvency process than jumping the queue. R3 looks forward to engaging with the Government in due course.