Reintroduction of the ‘Crown Preference’: Implications for corporate borrowing

On 1 December 2020, the measure known as the ‘Crown preference’ was reintroduced to UK law, moving HMRC back up the creditor hierarchy so that it now ranks as a secondary preferential creditor in relation to certain tax debts on insolvency. These tax debts now rank after monies owed to fixed charge holders and ordinary preferential creditors but, importantly, ahead of floating charge holders.

This change could have far-reaching implications for corporate borrowing, with lenders potentially having to rethink their security requirements, monitoring requirements, pricing and even the amounts they are prepared to advance to businesses in order to counteract the risk of reduced recoveries from their floating charges.

What was the position prior to 1 December 2020?

By way of background, up until 2006 (or 2003 in England and Wales), HMRC used to have preferential status in corporate insolvencies for certain tax debts. However, this was abolished by the Insolvency (Northern Ireland) Order 2005 as part of a package of reforms which aimed to encourage a ‘rescue culture’ and improve businesses’ survival prospects.

From that point on, all tax claims ranked as unsecured debts on insolvency and HMRC was treated as an ordinary unsecured creditor, ranking behind floating charge holders save for a share in the ‘prescribed part’ (an amount of up to £600,000 of the floating charge recoveries which must be set aside for unsecured creditors).

However, in the Government’s 2018 Budget, it was announced that HMRC would once again benefit from a Crown preference in England, Wales and Scotland. This was extended to Northern Ireland as part of the 2020 Budget and the changes were subsequently included in the Finance Act 2020, taking effect on 1 December 2020 throughout the UK.

What has changed?

This means that, for insolvencies commencing on or after 1 December 2020, secondary preferential status will be granted to any amounts owed to HMRC which relate to certain types of tax collected by a company on behalf of others. The relevant taxes include VAT, PAYE income tax, employees’ national insurance contributions and Construction Industry Scheme deductions, but not corporation tax or employer’s national insurance contributions owed by the insolvent company (which remain unsecured debts).

HMRC’s claim for these taxes will rank behind fixed charge holders and ordinary preferential creditors (including employees in respect of unpaid wages and holding pay), but ahead of floating charge holders and unsecured creditors.

Significantly, there is no cap or time limit on the tax debts which will be given preferential status and neither the date the tax debts were incurred nor the date of the floating charge will be taken into account.

Floating charge holders could therefore find their realisations diluted by tax debts going back any number of years, regardless of whether or not these are pre-dated by the floating charge. The amounts involved could also be substantial, particularly in light of the tax arrears which are likely to have built up as a result of the various deferrals introduced to alleviate financial distress caused by the COVID-19 pandemic.

What could this mean for corporate borrowing?

In order to adapt to these new priority tax claims and mitigate against the risk of reduced recoveries from their floating charges, lenders may need to make significant changes when lending to corporate borrowers, which could end up making access to finance more difficult for businesses.

The implications are likely to include the following:

• Lenders may be less willing to rely on floating charges and may therefore seek to take alternative or additional security, including fixed charges (such as a charge from the company’s shareholders over its share capital), assignments or personal guarantees. Lenders may also seek to perfect, supplement or retake existing fixed security to ensure that it is valid and enforceable.
• Lenders will be keen to avoid the risk of charges which purport to be fixed being re-characterised as floating and, as a result, falling behind HMRC in the creditor hierarchy. They may therefore seek to impose additional restrictions to ensure that the secured assets are subject to sufficient control for the security to be characterised as fixed. Depending on the type of assets in question, this may not be workable for some borrowers.
• In order to ensure that borrowers are complying with their tax obligations and that substantial arrears are not building up, lenders may require additional due diligence to be carried out and warranties to be given before making funds available. They may also seek to impose additional monitoring and reporting obligations during the term of the facilities (such as an annual tax audit).
• It is likely that the changes detailed above will lead to increased costs for lenders, which may need to be passed on to borrowers in the form of higher pricing for facilities.
• Given the increased risk of limited floating charge recoveries, some lenders may find that they have to reduce the amounts which they are able to advance and others may simply be unable to lend unless the borrower has sufficient fixed charge assets available. This could particularly affect sectors which rely heavily on floating charges, such as asset finance.

If you have any queries about the reintroduction of the Crown preference and how this may affect you, the Banking team at Carson McDowell would be happy to help.

*This information is for guidance purposes only and does not constitute, nor should be regarded, as a substitute for taking legal advice that is tailored to your circumstances.