Guides & Advice

The return of Crown Preference

Published: 30th November 2020
Area: Litigation & Dispute Resolution

Earlier this year, the Insolvency Act 1986 (HMRC Debts: Priority on Insolvency) Regulations 2020 (SI 2020/983) (the “Regulations”) were published coming into force on 1 December 2020. The regulations will restore the Crown Preference in insolvency proceedings, despite arguments that it’s a step backwards preventing potentially viable businesses being rescued and negatively impacting floating charge holders and unsecured creditors.

Why was Crown Preference abolished?

Crown Preference was an established principle in insolvency proceedings for many years, until 2003. Its abolition was designed to improve the survival prospects for companies by increasing the use of business rescue procedures. Its preferential status meant HMRC was regularly petitioning to wind up companies to reclaim the monies owed to them; companies that could often have been rescued if another insolvency procedure had been used. Removal of Crown Preference was aimed at levelling the field of play and bringing it in line with other creditors.

Why is Crown Preference being reintroduced?

The main purpose of the reinstatement of HMRC as a preferential creditor is to ensure that a larger proportion of the taxes paid by employees and customers can be recovered to fund public services, rather than be distributed to other creditors, such as banks.

The effect of the changes

From 1 December 2020, HMRC will become a secondary preferential creditor in insolvency procedures meaning it will rank above floating charge holders and unsecured creditors; further reducing the typically already small pot left for such creditors.

The following will be included in HMRC’s preference:

  • Pay As You Earn Tax (PAYE);
  • Value Added Tax (VAT);
  • Construction Industry Scheme deductions (CIS);
  • Employee National Insurance contributions (NIC); and
  • Student loan repayments.

HMRC will remain an unsecured creditor for direct taxes such as Corporation Tax and Employer NICs.

The order of priority in insolvency proceedings will remain the same but rather than preferential creditors only being employees entitled to arrears of wages up to a maximum of £800, holiday pay and pension contributions arising in the four months prior to insolvency, it will now also include HMRC to an uncapped amount.

  1. Fixed charge (secured) creditors
  2. Costs of the insolvency process
  3. Preferential creditors
  4. Floating charge creditors
  5. Unsecured creditors
  6. Shareholders

There is however a significant change to the remit of HMRC in these proceeding.  Previously, HMRC was only entitled to preferential status for tax debts less than 12 months old. Under the new regulations, any tax debt will now have preferential status, regardless of how old it is. This open ended timescale has the potential to vastly increase the amount HMRC could recover in a liquidation of a business which will in turn, further reduce the returns for unsecured and floating charge creditors.

How will this impact businesses?

HMRC is usually one of an insolvent company’s biggest unsecured creditor, typically due to directors prioritising payments to critical creditors, such as trade suppliers, over tax payments. From December, with its preferential status likely to act as an incentive to wind up companies rather than enter into lengthy negotiations with a company in an attempt to agree a repayment plan, directors are now more likely to have HMRC at the forefront of their minds. If a troubled company tries to continue meetings its obligations to HMRC and all of its other creditors, it's unlikely to continue trading for long without some form of rescue process, such as a CVA or administration being implemented.

If a company is experiencing any financial difficulties, directors are urged to seek professional advice sooner rather than later, and before HMRC arrears spiral out of control.

As floating charge holders are likely to have their returns significantly impacted, finance providers may become more risk averse and hesitate to lend large sums of money with only a floating charge for security. Banks and other financial institutions will likely seek additional security in the form of personal guarantees from directors. As this would result in a personal liability, directors are again more likely to prioritise paying HMRC as and when their payments fall due.

The change, however, may have a bigger impact on smaller businesses as they are less likely to have substantial assets for a lender to take fixed security over. As lenders will be more cautious when providing finance for a floating charge, smaller companies may find themselves unable to obtain the necessary funding. This would be a blow to companies in normal times but with so many businesses suffering due to COVID-19, and cash being more important than ever, the reintroduction of Crown Preference is likely to hinder the recovery of businesses that would otherwise have been viable.

Whilst HMRC expects to receive millions by its return to preferential status, which would then go into the public purse, it is unlikely that the benefit of this will outweigh the harm to companies, floating charge holders, unsecured creditors and the economy as a whole.

For further information, guidance and support on how these changes may impact you as a creditor in a potential liquidation, do not hesitate to contact a member of our corporate, insolvency and restructuring team.

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