How Does Crown Preference Impact Insolvencies?

The latest Finance Act has seen the return of the controversial ‘crown preference’, a tool used by the government (or more accurately Her Majesty’s Revenue and Customs, HMRC) to prioritise the payment of crown debts and certain outstanding taxes when a company becomes insolvent.

The move, which came into effect on 1 December 2020, is likely to have a range of consequences for companies facing insolvency. The biggest issue will be a lack of confidence for creditors loaning money, and therefore a lack of available funds for businesses struggling due to COVID-19. Lenders are less likely to become creditors if they are going to be further down the repayment queue when a business becomes insolvent.

In this article, we explain what crown preference is and examine how its implementation is going to impact future insolvencies in the UK.

What Is Crown Preference?

Crown preference means that HMRC has a preferential claim for payment when a company becomes insolvent.

When companies become insolvent, it’s because their debts outweigh the money coming in. A large proportion of that debt is likely to be taxes owed to the government or payments such as National Insurance contributions. HMRC is, in effect, a creditor.

However, since the Enterprise Act of 2002, these debts to the government have always been considered secondary to other debts. HMRC has, historically, not had preferential treatment when an insolvent company is liquidated and the raised funds are distributed.

Other creditors take priority over tax debts and money owed to the government by the insolvent company. For lenders, this is the ideal situation. They can confidently invest their money or offer credit, safe in the knowledge that they are more likely to claim their money back if the company fails.

However the Finance Act of 2020 has changed this. Crown preference allows HMRC to take priority over other creditors, namely unsecured creditors and floating charge holders. This ensures that when a company becomes insolvent, HMRC can claim their money over other creditors.

What Has Changed?

The Finance Act of 2020 came into force on 1 December 2020, after several delays due to COVID-19. The act sets out the budgetary measures for the year ahead. The instigation of crown preference has been one of the major talking points amongst investors and creditors.

The act means that, going forward, any business that’s become insolvent on or after 1 December 2020 is subject to crown preference. What this means in reality is that HMRC is now a preferential creditor. Importantly, this doesn’t mean that HMRC claims automatically go to the top of the list, but that HMRC has preference over unsecured creditors.

Previously, HMRC claims for unpaid taxes would be at the bottom of the list when a company was liquidated. HMRC claims were treated as unsecured creditor claims. In practical terms, this meant that any secured loans (usually to banks) would be paid first, ahead of unpaid taxes. Next, unsecured debts would be paid. If there was anything left over, HMRC would take its money after everyone else.

Now, HMRC takes money before any unsecured debts. HMRC has a secondary preference, after secured loans but before unsecured loans. This doesn’t just prioritise unpaid taxes, but other government claims too.

Crown preference prioritises the following debts:

• PAYE (Pay as you earn/Income tax)
• National Insurance contributions
• Student loan repayments
• VAT (Value Added Tax)
• Construction industry scheme deductions

What this means is that HMRC will attempt to claim any unpaid income tax from the PAYE system, National Insurance contributions owed by employees (also paid through PAYE), and any student loan repayments owed by employees (again paid through PAYE). This doesn’t necessarily affect individuals, as this money would usually be automatically deducted before they receive their payslip.

In addition, any outstanding VAT payments (currently set at 5%, although this is set to rise again to pre-COVID levels over the next few years) will also be claimed by the government over unsecured debts.

The same goes for construction industry scheme deductions, which of course only affects certain companies and businesses.

What Stays the Same?

We should note that employee claims remain ranked above the claims of HMRC. These include any outstanding salary payments, holiday payments or redundancy payments owed by the company to an employee. In this respect crown preference takes priority, not over employees (who still get preferential claim), but over unsecured debts such as money owed for stock, inventory, or services rendered. Employee claims remain the same.

The same can be said for corporation tax. Although HMRC is prioritising payments such as VAT and PAYE debts, they are not prioritising corporation tax. This also remains as it did before the Finance Act of 2020, and any outstanding corporation tax payments owed by an insolvent company remain classed as an unsecured debt.

What Does All This Mean for Insolvencies?

Ultimately, the goal of these changes and the implementation of crown preference is to raise more taxes and money for the Treasury. Given that public spending is at an all-time high due to COVID-19, this could be seen as a noble way to raise money – after all, these are debts that are owed to the government.

However, the move has proven to be controversial, precisely because it’s been enacted in the middle of a pandemic when businesses need access to as much money as they can to survive. The move to bring back crown preference was first initiated before the pandemic hit, which means this isn’t something that was necessarily put into action directly because of COVID-19.

In terms of insolvencies, crown preference is likely to have a dramatic effect on the way money is distributed amongst creditors and, most importantly, that means that lenders are less likely to issue loans exactly when they’re needed most.

To understand this, it’s important to look at what happens to a business when they become insolvent. When a company becomes insolvent, there are often several attempts to reorganise or restructure it before it’s liquidated. To do this, the company needs access to money and access to credit.

The brunt of this credit is often backed by floating charge holders, who offer up unsecured loans in the hope that the company is saved and becomes profitable again in the future. It’s these creditors that also supply much of the day-to-day credit that any ordinary company needs access to, even if they aren’t insolvent.

If a company is liquidated (because it can’t be saved), then the remaining assets are sold off in an attempt to raise funds to cover its debts. The money raised is first given to the preferential creditors. These are employees and anyone who has provided a secured loan (usually the bank). Before the Finance Act of 2020, floating charge holders could claim their money after this (if there was any left). Now, they have to wait for HMRC to claim their slice.

What this creates is an environment that favours tax payments over money owed to unsecured creditors, many of whom might be running small businesses themselves. Many creditors are likely to lose out on large chunks of money, as it’s unlikely there will be much money left once HMRC has taken its payments.

Going forwards, creditors are less likely to take on risk and loan out money to struggling businesses. This ensures that there’s less money available to save businesses that could otherwise be brought back and made profitable. There’s simply too much risk involved, now. At a time of economic uncertainty, when businesses need access to quick money more efficiently than ever before, crown preference is going to create a formidable obstacle.

Are Both Corporate and Personal Insolvencies Impacted?

The return of crown preference is targeted at raising taxes that would otherwise be lost due to corporate insolvency, rather than personal insolvency.

As employees pay their taxes directly through PAYE and remain preferential creditors, they shouldn’t necessarily be impacted by these changes in the Finance Act of 2020.

However, if a person is self-employed and becomes personally insolvent, they may find that HMRC makes a preferential claim if they still owe National Insurance contributions or VAT from their self-employed business, as HMRC will be classed as a preferential creditor in the event of bankruptcy.

If you’re experiencing financial difficulty as a company or an individual, it’s important to speak to a professional. There are many different routes that can be taken to avoid insolvency, liquidation or bankruptcy. Seeking expert financial and legal advice can save your business.

Contact Irwin Insolvency Today for Your Free Consultation

Our expert team is ready to help you understand how crown preference can affect the way we do business in the future. With decades of experience dealing with insolvency matters, our licensed insolvency practitioners can offer impartial advice that can help your business through these tough times.

If your business is in need of financial advice, then don’t hesitate to contact Irwin Insolvency today for your free, no-obligation consultation.