Re-introduction of Crown preference: Government prioritises public revenue streams over enterprise
HMRC had preferential status up to 2003 until it was abolished under the Enterprise Act 2002 by the then Labour Government seeking to support entrepreneurs and their right to a second chance.
HMRC had preferential status in relation to any outstanding PAYE/NIC deductions relating to the 12-month period immediately prior to the insolvency, and any outstanding VAT for the period of 6 months immediately prior to the insolvency. Having preferential status in a corporate insolvency situation, the Crown’s claim sat ahead of floating charge holders and unsecured creditors which reduced the monies available for distribution to both of those creditors.
Banks benefited from the abolition of Crown preference as the predominant holders of floating charges who would benefit from the reduction of preferential creditor claims. As a result, what is termed the “prescribed part” was introduced for the prime purpose of ensuring that there was at least a modest return for an ordinary unsecured creditor and a small opportunity for them to engage with an insolvency practitioner during the insolvency process.
The now Conservative Government is to re-introduce Crown preference this time at the expense of lending banks rather than the unsecured creditor class. The prescribed part remains but none of its benefits will be enhanced.
Crown preference comes into force on 1 December 2020, following Royal Assent being given to the Finance Act 2020 on 22 July 2020. At this stage, there is no time limit by which HMRC can look back at arrears and therefore it appears to be retrospective.
HMRC’s claim will be limited to claims for unpaid employer NIC, PAYE and VAT. Any penalties or interest arisen will not have preferential status. These claims are often significant (particularly with additional Covid-19 support and deferrals), and despite calls from concerned parties to cap the claim by amount or time, (or indeed to scrap the proposal all together) the Act does not do that.
What will be the impact of the re-introduction of HMRC preferential status?
The attitude of secured lenders will change in relation to the security they hold and, of more concern to business seeking to survive the Covid-19 crisis, to the amount of money lent and the terms of lending.
Banks and other secured lenders may have calculated returns from the security held in the event of an insolvency but that may now be much reduced given Crown preference and they may look to what other security they can take. Given the Covid-19 crisis, chattel assets may not be as attractive as previously and secured lenders may look to directors for personal guarantees and take charges over a director’s personal property. There are already reports that due to the current restrictions on enforcement against companies due to Coronavirus that secured lenders are seeking to take action against directors as there are no restrictions on bankruptcy proceedings. Directors unwilling to give personal guarantees may find that they have no choice in the current climate.
It will probably lead to increased secured lender control of businesses and this, rather than encouraging recovery, may hamper it. In particular, businesses in certain sectors such as retail dealing with large amounts of stock which are usually within a floating charge may find increased scrutiny by lenders does not sit well with day-to-day business.
Secured lenders will want to monitor the company’s position carefully particularly in relation tax payments. They may also seek to alter their terms and conditions in relation to provision of regular financial updates by the company and examining internal company practices and how they manage debt. Those that do not have a good compliance record may find lenders trying to exit their position. The client may find itself subject to regular tax audits.
Ultimately, it may lead to lenders lending less money or looking at security they are taking more stringently. This will certainly lead to more due diligence and to enable them to have a greater understanding of the company’s tax position before even looking at the term sheet.
There are also recent provisions under the Finance Act 2020 that make directors and non-directors jointly and severally liable for tax debts if the failure to pay was fraudulent or negligent.
This may see many companies trying to restructure to ensure that debt is repaid and to rescue businesses. A potential good outcome of the re-introduction of Crown preference is that SMEs will also look to restructure their debt using some of the new insolvency restructuring tools introduced by the Corporate Insolvency and Governance Act 2020.
HMRC will have to work with insolvency professionals to make such restructuring proposals workable. Historically, the Crown has been willing to accept payments over a longer period of time but normally they would be looking for 100% recovery. If they do not make full recovery, they may well be pursuing the directors personally to make up the shortfall.