When the Chancellor first announced the re-introduction of Crown preference in the 2018 budget without any prior consultation, the response from the restructuring and insolvency industry was critical. The government has ploughed on with these changes regardless, and without listening to compromises from the industry that might have tempered its impact. The effect of these measures is to take the portion of insolvent companies' estates that has, since 2002, been paid to private creditors and give it instead to the state – notwithstanding this is a re-allocation that was recognised, as far back as 19821, as causing substantial hardship and bringing further insolvencies in its train. That these measures are now being re-introduced in the midst of an unprecedented financial crisis and just as we head into uncertain Brexit waters seems likely to make these problems worse.
What will the return of Crown preference mean in practice?
In insolvency proceedings opened from 1 December 2020, certain tax debts collected by a company on behalf of another business will be given secondary preferential status in the insolvency waterfall2 – ranking behind fixed charge holders' claims and ordinary preferential debts (for example, preferential employee claims) but ahead of floating charge holders' claims and unsecured creditors. The tax debts to be given such priority are VAT, PAYE income tax, employee NI contributions, construction industry scheme deductions and student loan repayments.
There is no cap on the size or age of the tax debts eligible for preferential status, unlike the old Crown preference where, for example, only VAT debts up to 6 months' old or income tax debts up to 12 months' old were eligible. This is particularly concerning in the current climate where significant VAT deferrals have been granted by HMRC as part of the COVID economic response. The re-introduction of Crown preference at this time effectively transfers the insolvency credit risk in the deferrals from HMRC to floating charge holders and unsecured creditors.
The reduced value of floating charges is likely to impact on lenders' appetite to lend and/or result in an increase in pricing, at a time when the easy flow of credit is critical to the economic recovery. UK Finance has estimated that at least £1 billion worth of floating charge finance could be removed from availability.3 Where unsecured creditors see their returns in insolvency proceedings fall, this is likely to contribute towards the domino effect of insolvencies amongst SMEs in particular, especially in those sectors badly hit by Covid.
The re-introduction of Crown preference will also limit the usefulness of CVAs. As preferential debts cannot be compromised in a CVA without the preferential creditor's consent, the new preferential tax debts will likely need to be paid in full in a CVA (unless HMRC agrees otherwise). HMRC has a potted record of supporting CVAs.4 The question will be whether there's anything left in the pot to propose a CVA which is realistically acceptable to unsecured creditors, without compromising the HMRC preferential claim.
If a CVA is unviable as a result of this change, would a restructuring plan help instead? There is no restriction on compromising preferential debts in a scheme of arrangement or a restructuring plan, but preferential creditors will usually form a different class of creditors from non-preferential creditors and so will have a veto in a scheme. Of course in the shiny new restructuring plan, it is possible to cram down a whole dissenting class, provided that the class will not be any worse off than in the relevant alternative. But the fact that the relevant alternative will often be an insolvency process (where preferential debts will rank ahead of floating charge holders) means that the restructuring plan will not usually help to overcome the problem these new preferential debts pose. And in any event, restructuring plans may be too expensive a tool for the majority of SMEs, which is where largest number of CVAs are encountered.
For more on this topic, please get in touch with your usual Ashurst contact.
1. At [1410, at 320] of the Cork Report (Report of the Review Committee, Insolvency Law and Practice, 1982, Cmnd. 8558).
2. Pursuant to section 98 of the Finance Act 2020 and The Insolvency Act 1986 (HMRC Debts: Priority on Insolvency) Regulations 2020.
3. https://www.r3.org.uk/press-policy-and-research/r3-blog/more/29398/store/491539/page/1/finance-bill-concern-around-insolvency-proposal-impact/
4. See paragraph 5 of 'A Snapshot of company voluntary arrangements: Success, failure and proposals for reform' by Peter Walton, Chris Umfreville and Lézelle Jacobs.
