The Queen’s Gambit: Crown Preference

For those of you hoping this article would be about chess or the wonderful Netflix drama of the same name, you will be sadly disappointed. If you came here for insolvency news then keep reading. This article will focus on Her Majesty’s Revenue and Custom’s (HMRC’s) “gambit” to gain an advantage over other creditors through the return of the “crown preference” from 1 December 2020. This article explores what HMRC’s status as a secondary preferential creditor means and its implications for insolvency practitioners and others going forward.

Out with the Old (rules)

As insolvency practitioners will know, the order of distribution is prescribed in the Insolvency Act 1986 and Insolvency Rules 2016 and is colloquially referred to as the waterfall effect. Pre 1 December 2020, creditors could expect to be paid in the following order from realisable assets each ranking in priority to the former:

1. Secured creditors with a fixed charge;
2. Moratorium debts and “priority pre-moratorium debts” for which the company did not have a payment holiday during the moratorium but which were not paid (assuming the relevant date of insolvency falls within 12 weeks from the moratorium);
3. Fees and expenses of the Office Holder;
4. Ordinary preferential debts  (contributions to pension schemes, wages and salaries of employees, holiday pay, levies on coal and steel production, debts owed to and deposits covered by, the Financial Services Compensation Scheme);
5. Secondary preferential debts (certain deposits owed to depositors that are not otherwise protected by the Financial Services Compensation Scheme);
6. The prescribed part for unsecured creditors (if relevant i.e. if there is a Qualifying Floating Charge Holder, now capped at £800,000);
7. Qualifying Floating Charge Holders (“QFCHs”);
8. Unsecured creditors;
9. Statutory Interest;
10. Postponed debts (ie non-provable liabilities); and, finally,
11. Shareholders (to the extent there is any surplus).

Under these rules, HMRC was treated as an unsecured creditor, ranking pari passu with other unsecured creditors and, practically, being last in line for any payment behind fixed, preferential and QFCHs. Thus, though in certain cases HMRC may have been the biggest single unsecured creditor, as it had no preferential status, it was left to receive only its share of the prescribed part (if any) and a share of any other declared dividend to unsecured creditors which could be pennies in the pound. Assets which it would otherwise have received from a solvent company were used to pay off higher ranking creditors first. HMRC estimated that in the 2018-19 tax year alone its estimated tax losses were £4.5 billion as a result of insolvency.

In with the New (rules)

To deal with this disparity, the government introduced an amendment to the insolvency legislation through the Finance Act 2020 (“FA2020”) and the Insolvency Act 1986 (HMRC Debts: Priority on Insolvency) Regulations 2020/983 (the “Regulation”) to bring back certain elements of the Crown’s preferential treatment as a creditor. Specifically, sections 98-99 of the FA2020 amends section 386 and Schedule 6 of the Insolvency Act 1986 by introducing a 9^th category of preferential debts called “Certain HMRC Debts”. In order words, to treat them as secondary preferential debts so that they rank 5^th in line for payment in the priority list above.

The effect is to leapfrog HMRC from near the bottom of the pile to near the top and, importantly, rank them ahead of QFCHs so HMRC are paid out first out of remaining assets that would otherwise have gone to pay out the QFCH.

What is meant by “certain HMRC debts”?

It is important to note that not all HMRC debts automatically attract preferential creditor status and that this only applies to insolvencies commencing on or after 1 December 2020. Crucially, there are no transitional provisions to the look back period of these debts so although the insolvency must commence on or after 1 December 2020, if an insolvent company has significant book debts of deferred taxes going back a number of years these would obtain priority status to QFCHs even if the QFCH security pre dates those debts.

For now, only the following HMRC debts will be classed as secondary preferential debts:

• Value Added Tax (including in respect of any VAT sum claimed under the Coronavirus Job Retention Scheme aka furlough scheme);
• PAYE;
• Student loans;
• National Insurance Contributions (NICS) paid by the employee; and
• Construction Industry Scheme deductions

All other HMRC debts such as unpaid corporation tax, capital gains tax and employer NICs, are excluded from the definition and so these types of debts will continue to have unsecured creditor status, for now. In the Hansard transcripts from 16 June 2020, Jesse Norman, the Financial Secretary to the Treasury, explained the rationale behind the amendments was to ensure: “…more of the taxes paid in good faith by employees and customers, but held temporarily by a business, go to fund public services as intended, rather than being distributed to other creditors such as financial institutions”.

Thus, the intention behind the legislation appears to be a gambit to obtain taxes that a company collects and pays on behalf of others (its employees) to HMRC, held on trust if you like, rather than taxes it pays on its own behalf.

It is estimated that these changes will increase the amount of tax debt saved by HMRC each year and ensure £220 million is available for public services each year. It is hard to argue with that in principle unless, of course, it is just government rhetoric. Readers will remember the infamous promises made on that Brexit bus regarding the NHS.

Commentary

As is often the case, there appears to be a potential conflict behind the noble intention and the drafting of the legislation itself.

Section 99 of FA2020 deals with the powers of HMRC to amend the insolvency legislation by further regulations. Whilst the Regulation made to date has only covered those “trust like” taxes above, Sections 99(3) and (4) reserves their power to make additional regulations to supplement the definition of secondary preferential debts. This power does not appear to be fettered in any way to limit a widening of the category beyond that, say, to corporation tax losses. There is arguably room for manoeuvre although doing so could be seen as legislating through the back door, is bound to raise more than a few eyebrows and the ire of already disgruntled creditors.

Given the huge stimulus of financial packages that have been introduced by the government to support businesses struggling with the fight against Covid-19 including the furlough scheme, CBILS/Bounce Back Loan Schemes, business rates and VAT deferrals, in addition to, the “time to pay” arrangements, the government must find a way to fill the black hole in its spending which is now into the billions. Could further amendments to HMRC’s creditor status be the way to achieve that?

One thing that is clear and, that has not really changed, is that the unsecured creditors remain at the bottom of the pile on a distribution and stand to lose out the most. To offset the risk of losing out to the crown preference it is anticipated that banks and other financial lenders will (if they have not already) amend their terms and lending criteria, especially in respect of QFCHs. This may have the opposite effect of tipping more companies into insolvency who cannot access financing or have pressure exerted on them by lenders.

With the government’s VAT deferral scheme allowing businesses to defer their VAT liability and the crown preference having no longstop date on the look back period, companies may be accruing large liabilities to HMRC right now. The value of HMRC’s potential claims in future insolvencies may be considerable in leaving precious little left in the pot for other creditors.

We have already written about furlough fraud in our last CIFAR newsletter. Furlough payments (and the associated PAYE and NICS payable on them) are clearly sums collected on behalf of a third party and, therefore, arguably caught by these new rules. In future insolvencies where IPs uncover such wrongdoing, HMRC’s claims could be even more significant. Time will tell if this gambit pays dividends (excuse the pun).