This situation, known as Crown Preference, was abolished in 2002 by the Enterprise Act. However, it’s about to be reinstated through the Finance Bill that, prorogation aside, is currently wending its way through parliament. Without putting too fine a point on it, those who trade without taking payment or security up front need to pay attention.

Security explained

According to Stewart Perry, a restructuring and insolvency partner at law firm Fieldfisher, there are broadly two different types of security: a fixed charge over immovable or larger defined assets, sometimes called a mortgage, and a floating charge over moveable items or fluctuating class or classes of assets such as stock and debtors. 

The result, as Perry outlines, is that “in an enforcement scenario, the amount a secured creditor receives from the proceeds of sale of a secured asset differs depending on whether the secured asset is subject to a fixed or floating charge.” Procedurally, a receiver, administrator or liquidator selling a floating charge asset will distribute the proceeds in an order defined by law with insolvency costs first in the pecking order followed by preferential creditors (employees currently), the ‘prescribed part’, and then the floating charge holder, unsecured creditors and, lastly, shareholders. Fixed charge assets realisations are sent directly to the fixed charge asset holders – and no one else unless there is a surplus.

In practical terms, Perry says that this leads to banks wanting a fixed charge over any assets with any significant value, and a floating charge over everything else. “This means,” says Perry, “that banks lending against floating charge assets will be concerned to know what creditors get paid before them in calculating the value of the security, and how risky the lending is.” This in turn determines the cost and availability of borrowing. Conversely, he says that the riskier a deal, the more a bank will charge to the point that it could be as expensive as an unsecured loan - or the bank may simply refuse to lend.

Duncan Swift, president of insolvency and restructuring trade body R3, echoes Perry’s thoughts. He too knows that the lower a creditor is down the hierarchy, the less of their money – if anything – they are likely to see back: “Given the importance of secure access to finance for businesses, and given the amount of money at stake, lenders are towards the top of the hierarchy. [So], the more lenders see back from insolvency procedures, the more likely they will be to lend to businesses.” 

The Crown relented to drive entrepreneurship

As noted earlier, under the old regime, the Crown (that is, HMRC), used to be a preferential creditor. The Enterprise Act 2002 removed that preference to, as Perry says, “drive entrepreneurship and a rescue culture – putting the taxman on the same level as other unsecured creditors. 

“However, in the hope they would still get some money, the government inserted the prescribed part, a percentage of the floating charge realisations that bypass the secured creditors holding a floating charge and are paid to the unsecured creditors including the taxman.” This, Perry says, is roughly speaking 20% of net floating charge monies recovered to a maximum of £600,000.

It’s interesting that Swift notes that, at the time, the Department of Trade and Industry explained the abolition of Crown Preference “as influenced by contemporaneous moves in other jurisdictions towards removing or restricting Crown or state preference, calling it more ‘equitable’.” He adds that it was welcomed by the insolvency and restructuring profession as helpful to their efforts to rescue jobs and turn around struggling businesses as “this encouraged lending, particularly in rescue situations, and helped an insolvent company’s trade creditors”.

The proposals make radical changes 

The Finance Bill aims to change the current process by re-introducing a different form of Crown Preference. If the legislation is passed, and there’s no reason to think that it won’t be, VAT and ‘relevant deductions’ (which Perry says will be stated in regulations, but are understood to include PAYE, employee NICs and Construction Industry Scheme deductions) will become secondary preferential creditor debt. In simple terms, this means that HMRC becomes placed second in line after employees and above prescribed part creditors.

Worryingly for those lending (or trading) without security, there is to be no cap to the amount or the look-back period for HMRC to reclaim tax; under the old regime, Crown Preference for VAT had a six-month look-back period while for PAYE it was one year. Further, it’s being proposed that in cases of ‘deliberate behaviour’ such as fraud, HMRC may raise assessments for the previous 20 tax years, meaning a look-back period of 21 years.

But why re-introduce Crown preference now? Peter Windatt, an accountant and licensed insolvency practitioner at BRI Business Recovery & Insolvency, says that “after a 10-year long dip in insolvency numbers, we are seeing a bit of an uptick at the moment, fuelled by Brexit uncertainties in particular.” Cynically he senses that the long-standing drought for the insolvency profession is coming to an end.

With a hint of frustration Swift says that the government launched a consultation on the proposals in late February, which subsequently closed in May. He says that despite widespread opposition, “barely any changes were made when the proposals appeared in the draft bill two months after the consultation closed”.

For the record, Matthew Davies, director of Invoice Finance and Asset Based Lending at UK Finance says his body and its members do support the overall objective of protecting tax revenues but “the estimated tax yield from this measure is likely to be insignificant compared to the impact on lending and economic growth.” He too finds it disappointing that despite the evidence put forward to government regarding the negative impact there have been few changes to the legislation. 

Many implications

Creditors ought to be worried – very worried. As Perry explains: “If you are a creditor, when anything is put above you in the process, it means you are much more likely to get less or nothing at all... other trading creditors, pension funds and consumers, etc, will all get less.”

But the implications don’t stop there as there are consequences for trading companies too. Says Perry: “The proposed changes will impact the potential recoveries an asset based lender (ABL) could make on insolvency. 

More worryingly, it impacts on those potential recoveries by an unknown and uncapped amount, meaning it will be more difficult for ABLs to assess the value of their floating charge securities.” All of this means more risk for lenders, and therefore more cost, for any borrowing and more rejected attempts to obtain finance. 

Grabbing cash

Is Crown preference in the public interest? Perry thinks not, and says: “It is, in my view, a poorly considered amendment, that can only be viewed as a cash grab.”

He says there is no moral base for the decision. In its consultation document, the government explained the reason for the reintroduction, which says that “more of the taxes paid in good faith by its employees and customers should go to fund public services as intended, rather than being distributed to other creditors, such as financial institutions.”

From Perry’s perspective, in an insolvency “society has to decide if every creditor should share the pain equally, or some should be supported more than others. In choosing to give these taxes priority, the government is saying HMRC is more worthy than other categories of creditors that could be equally or more morally worthy.” He draws comparison to the government not giving priority to pre-paying consumers, who will feel the pain significantly more than HMRC. The move also ranks HMRC above some employee debt – an employee’s preferential wages are capped at £800, so they could find that, if the employer goes bust, more of their PAYE is paid to HMRC than they received in salary.

Windatt is equally bothered. He says that the Crown has always seen itself as an “unwilling” creditor. The distinction that he makes is that “business people choose to deal with one another and, generally, when giving credit, accept the commercial risk that goes with that. But HMRC doesn’t have the same role, individuals sell items subject to VAT and the VATman expects his 20% to be put in a virtual shoe box until he comes collecting”. 

The same applies to PAYE, which is deducted from salaries and should be ready for collection around the 19th of the month following.

This is a view that Swift aligns with. But he says in response to HMRC’s assertions that “our view is that suppliers and other trade creditors fall into the same boat – no one signs a contract with the expectation that their counter-party is going to enter an insolvency process – they too also deserve fair treatment.”

And from the standpoint of a professional body, “R3,” says Swift, “has been strongly against the government’s proposals from the outset; we just can’t see any justification for the move, which will, we believe, damage prospects for business rescue.” He adds that R3 surveyed members on the topic and found that 78% of respondents thought the proposals will make it harder to rescue businesses, and 85% felt that any negative impact the proposals may have would outweigh the government’s justification for introducing the change.

Davies says his members think along the same lines. “We have expressed [to the government] the concerns of UK Finance’s members about this move and its likely impact on lending to UK businesses of all sizes, and particularly SMEs. This step degrades the security available to banks and other finance providers.” He warns the implementation is planned for when the economic outlook is already uncertain which is particularly concerning.

But there is another cause for unease – the unlevel field that HMRC plays on. It has collection and enforcement resources available to it far in excess of the majority of creditors. Some, such as Windatt, suggest that it could take action earlier in order to protect all those doing business with firms in difficulty. “Trading on, or being funded by Crown monies, should not be encouraged. However, given the low, £750, threshold for petitioning for a company liquidation and the economies of scale for the Crown doing this, relative to the cost to a trade creditor, I would encourage it to take greater action to quash companies that are not going to make the cut rather than see HMRC top slice any funds coming out of them upon failure.”

To rub salt in the wound, the introduction of Making Tax Digital (for VAT presently, but other taxes in time) is going to make it easier and faster for HMRC to see when firms are in trouble – giving it more opportunity to take action.

Worse still, and of concern to Swift, is the retrospective application of the proposal. He says: “Lenders may have to take out insurance on existing floating charge loans, while they will also have to review every borrower’s books to check for unpaid taxes that may pose a risk to their capital. The costs of this may be passed onto borrowers. 

“The increase to the cost and risk of lending will make it harder for distressed businesses to restructure and will make it harder for healthy businesses to grow.”

Another potential consequence of the government’s plans is that lenders will start to ask for a greater number of personal guarantees from directors as additional security. It doesn’t take a rocket scientist to realise that this will deter business growth, as directors, understandably, will be wary of the risk to their own finances in case of insolvency of their business; SMEs are going to suffer.

Windatt is blunter; he forecasts a domino effect of company failures increasingly leading to other failures.

Mitigating solutions

So, what can firms do to protect their position?

Windatt still hopes that HMRC will offer some crumbs of comfort to trade suppliers by enabling those creditors not on cash accounting to claim VAT bad debt relief earlier. This simple change would mean that firms will not have to pay out for VAT on what becomes a bad debt and so remove the delay before the relief becomes available.

That said, the government is not planning to include tax penalties as part of HMRC’s right to a preferential claim. This reckons Swift, is good news, otherwise office-holders would have faced costly legal battles with HMRC if they found themselves having to dispute any of the claimed penalties to try and protect returns for the wider creditor body. Even so, R3 is “very disappointed with the lack of engagement on HMRC’s part with criticisms of the proposals”.

Other changes that might mitigate the impact of the legislation would be a cap on the age of debts to be included; that pre-existing floating charges should be allowed to retain their current status relative to tax debts as that was the basis on which they will have been underwritten. As Swift says, “it seems to us to be unfair that [a lender’s] book value will drop overnight next April, when the policy is due to come into effect”.

As a matter of policy R3 would prefer that HMRC looks to improve the way it engages in the insolvency process. On this Swift refers back to R3’s member survey where it found that 78% of respondents agreed with this proposition. He explains that at the moment, “members report that HMRC can be unwilling or slow to engage in insolvencies and delays making decisions, which frustrates asset recoveries and increases costs, causing reduced returns for all creditors – including HMRC itself”.

But realistically, as Windatt emphasises, it’s up to firms to ensure that they don’t lose out to HMRC’s proposed Crown Preference. He says firms need to deploy tried and trusted business techniques. He says that “knowing your customer is important, as is adhering to credit limits and having security in place such as reservation of title and personal guarantees, and of course, good credit control. Remember: a sale is only a promise until it’s paid for.”

In conclusion

Ultimately, Swift is of the view that the move is very short-termist. He believes that the return of Crown Preference will, in the long run, reduce the Treasury’s tax base. “The government is shooting itself in the foot here and is also threatening deep damage to the UK economy and business landscape. If the Prime Minister wishes to demonstrate his business-friendly credentials, quietly dropping these plans would be an excellent start.”