Reintroduction of UK Crown Preference from 1 December 2020

Updated 24 November 2020

Since the Enterprise Act 2002 abolished what was known as Crown Preference in the UK, tax claims have ranked as ordinary unsecured debts on insolvency.

In the October 2018 budget it was announced that certain tax debts would be moved back up the insolvency hierarchy to rank as secondary preferential debts. These debts would rank after employees' preferential claims but, importantly, before claims of floating charge holders.

In the March 2020 budget it was announced that these changes, which were originally scheduled to commence from 6 April 2020, would instead take effect from 1 December 2020. Legislation to effect the changes was then included in the Finance Act 2020, and subsequent supporting regulations.

The impact of these changes on domestic and foreign lenders from 1 December 2020 onwards could be dramatic, especially as the change will come into effect at a time of damaged balance sheets and reduced liquidity as a result of the Covid-19 pandemic, and where significant tax arrears are likely to have built up as a result of the various payment deferrals granted by the government to help alleviate financial distress.

What is the current position?

Since 2003, HMRC (the UK tax authority) has been an unsecured creditor in respect of all taxes owed to it on any basis, unless it has separately taken security in individual cases, which is quite rare.

The quid pro quo when tax debts lost their preferential status in 2003 was that the windfall to floating charge holders would be offset by the introduction of the prescribed part. The prescribed part is, simply put, a percentage of floating charge realisations (currently up to a maximum of GBP800,000 in respect of floating charges granted on or after 6 April 2020 or GBP600,000 in respect of those granted earlier) that is set aside and made available to unsecured creditors in priority to floating charge holders.

As a result, other than HMRC’s entitlement to a share in the prescribed part, the holder of any class of charge (whether fixed or floating) currently ranks in priority to HMRC in respect of their pre-existing claims against an insolvent company.

What is changing?

For insolvencies commencing on or after 1 December 2020 secondary preferential status will be granted to any money owed to HMRC relating to certain types of tax which a company has collected on behalf of others. The relevant types are currently VAT, PAYE, employee national insurance contributions, construction industry scheme deductions and student loan repayments. Others can be added by regulation. HMRC’s claim for these taxes will rank in priority to floating charge holders and unsecured creditors but not to ordinary preferential creditors, which include employees in respect of accrued unpaid wages (up to a cap) and holiday pay. Other tax debts which a company owes to HMRC on its own account, such as corporation tax, will still rank as ordinary unsecured claims.

Importantly, the application of the legislation depends on the date on which the insolvency proceeding commences. Neither the date the tax debts were accrued nor the date of the floating charge are taken into account. There is provision for regulations to be made limiting the amounts which will be given preferential status to those referable to a particular period, but no such regulations have yet been made. This means that existing tax debts going back a number of years would be elevated to preferential status, regardless of whether there is a floating charge which pre-dates the debts and/or was entered into before the legislative changes took effect or were even announced. The potential floating charge realisations from existing lending may therefore be affected.

The changes were originally proposed to apply to insolvencies in England, Wales and Scotland only, but at the 2020 budget it was announced that they would also extend to Northern Ireland.

Lenders will also need to be mindful of a parallel legislative change, initially announced in the government’s response to its consultation on Insolvency and Corporate Governance, published on 26 August 2018 and subsequently taking effect on 6 April 2020, whereby the cap on the prescribed part was increased from GBP600,000 to GBP800,000 in respect of floating charges granted on or after 6 April 2020, further reducing recoveries under the floating charge and therefore the value of this security.

Why?

HMRC has stated that the change is intended to protect public funds and, based on its analysis, ensure that there is an estimated GBP185 million increase in taxes reaching the government. However, the proposals have been subject to criticism since they were put forward in the 2018 budget. Notwithstanding such objections, the government has moved forwards with the original proposal.

Who will be affected?

Floating charge holders and unsecured creditors will essentially foot the bill for these taxes, because the prior ranking of HMRC's claim will dilute the realisations available to pay their claims. However, HMRC's claim will still rank behind lenders in respect of their fixed charge realisations and expenses of the administration/liquidation, which will include the fees of the insolvency office holder.

How can lenders protect themselves?

This change to give HMRC priority ahead of floating charge holders should be taken as a reminder to all lenders to revisit origination and credit procedures aimed at ensuring that as much security value as possible falls subject to an assignment, fixed charge or trust arrangement, so as to elevate the lender above HMRC in the statutory order of priority wherever possible (or, for assignment, take the lender outside of the statutory order altogether).

When structuring financing arrangements, the lender should consider structures specifically designed to mitigate Crown Preference. For example, where a significant amount of lender collateral consists of stock or other types of assets usually only subject to a floating charge, the lender could consider asking the borrower group to ring-fence that whole asset class or classes in a group SPV which collects no VAT and has no employees. Obviously borrowers may not wish to reorganize their asset holding structures to suit lenders' requirements. However, for some deals, it may be appropriate to explore this.

The change also increases the importance of exercising sufficient control over assets purportedly subject to a fixed charge to mitigate the risk of such security being re-characterized as floating security and therefore diluted by the Crown Preference.

Lenders should consider on-going diligence to ensure their borrowers are complying with their tax obligations, perhaps adding such matters to their standard facility terms. For example: i) a representation that the borrower’s tax is paid up to date; ii) an obligation to regularly report the paid/unpaid tax position; and iii) monitoring information requests.

When companies suffer financial distress, it is commonplace for them to stretch creditors and in practice HMRC is often one of the first creditors to suffer as a result of this (whether informally through missed payments or formally through agreed “time to pay” arrangements). The stretching of certain HMRC arrears will result in a dilution of lenders’ security once the legislation is implemented. Lenders could consider holding reserves of tax and/or making it compulsory for borrowers to hold tax reserves if, for example, the borrower’s business has an irregular tax profile in general. As noted, this issue is particularly acute in present circumstances, given the combination of widespread financial distress together with significant tax arrears which are likely to have built up as a result of the various payment deferrals granted by the government.

Upon learning of any financial distress affecting a borrower, lenders should consider whether they can take measures to improve their position. These might include:

• perfecting, supplementing or retaking fixed charge security; and/or
• exploring whether existing working capital facilities consisting of overdrafts, cashflow loans or revolving credit facilities, which are wholly or partially secured by floating charge security, can be refinanced through the provision of invoice discounting facilities which shift floating charge assets from being charged in favour of the lender to being owned by the lender.

Any changes to a lender’s practices need to be considered carefully in terms of the potential inconvenience and cost to both the lender and their borrowers in implementing these structures and any associated risk that a lender will be perceived as uncompetitive in the market.

In making an assessment, lenders should consider the potential worst case leakage of value to HMRC upon an insolvency, based on the maximum amount of unpaid VAT, PAYE and NICs a company might be holding at any given time in its cash flow cycle. For a company which collects significant amounts of VAT but seeks to account to HMRC as infrequently as possible, the liability could be a significant sum. Likewise a company with a large number of employees could also have very material peaks in its PAYE collection liability.