Seventeen years ago the government decided1 to abolish Crown Preference (the priority status then afforded to certain tax debts owed to the government by an insolvent company). This kept the UK in step with other jurisdictions that had recently restricted or abolished Crown or State preference, for example Germany and Australia. The government of the day regarded its abolition as 'more equitable'.
The reversal of this policy by the Chancellor in his budget speech last week (details here) was described in terms of handing over monies to HMRC that have been deducted from, or charged to, third parties (such as employees and customers) where those monies are "held in trust by the business … to fund public services." The reference to a trust is, of course, incorrect. If the monies really were held on trust this sort of measure would not be necessary. Rather, the correct position is that amounts 'deducted' as withholding tax are treated for accounting purposes as a simple debt outstanding from the company to HMRC.
If the company enters administration or liquidation and does not pay the relevant taxes to HMRC, the party that currently loses out is usually HMRC. That is because any employees will still generally obtain credit for amounts of withheld PAYE even if HMRC never received the amounts withheld (provided of course the employee has not colluded in the non-payment, which will rarely be the case). Similarly where a customer pays an amount in respect of VAT to a supplier that becomes insolvent and does not pay those VAT amounts over to HMRC then, absent collusion, the customer is generally entitled to input tax recovery in the same way as normal.
Re-introducing a category of priority debts in insolvency will benefit one creditor (or group of creditors) at the expense of another. Here, the value transfer will benefit HMRC at the expense of the floating charge holder (if any) or the unsecured creditors.
When Crown preference was abolished in 2002 (at the same time that administration received a major makeover, and administrative receivership was substantially restricted), the government was adamant that the benefit of the abolition of Crown preference should not result in a windfall to floating charge holders. The 'prescribed part' was therefore introduced, which ring-fences a portion of what would otherwise be floating charge recoveries and distributes them for the benefit of unsecured creditors. The size of the prescribed part is determined by a formula that was designed to be more or less equivalent to the value lost to the Crown in an average insolvency as a result of the abolition of Crown preference.
Despite the linkage between the abolition of Crown preference and the formula for the prescribed part, there has been no suggestion (so far) that with the re-introduction of Crown preference the prescribed part should see a corresponding reduction too. Quite the opposite, in fact: the government announced plans2 in August 2018 to introduce an inflationary increase in the maximum size of the 'prescribed part' as part of a wider package of reforms.
Consequently, the recoveries being applied for the benefit of HMRC by the re-introduction of Crown preference will in effect be at the expense of the floating charge holder, or if none, the unsecured creditors, who will now be bumped further down the priority rankings. The budget document seeks to justify this on the basis that the estimated tax yield from this measure (of £185 million a year) is a tiny fraction of total bank lending. This comparison seems a little selective. For example, £185 million is also a tiny fraction of tax revenues.
As far back as 1982, The Cork Report3 noted (1410, at 320): "We unhesitatingly reject the argument that debts owed to the community ought to be paid in priority to debts owed to private creditors. A bad debt owed to the State is likely to be insignificant in terms of total Government receipts; [whereas] loss of a similar sum by a private creditor may cause substantial hardship, and bring further insolvencies in its train."
There does not therefore appear to be any clear policy justification for this re-allocation of recoveries from private creditors to the public purse.
Eroding the value of floating charges to secured lenders could result in an increase in the price, or a reduction in the availability, of credit. Both of these consequences are undesirable, particularly in the uncertain economic climate surrounding Brexit.
It is also unclear how the priority given to these taxes will respond in respect of foreign tax claims. When we last had Crown preference, foreign tax claims were not claimable in English insolvencies. They now are, as a consequence of the EU Insolvency Regulation 848/2015, and Art 13 UNCITRAL Model Law on Cross-Border Insolvency. Given the increase in global trade since 2002, foreign tax claims might be more of an issue this time around.
Internationally, this policy move swims against the tide. Both UNCITRAL's Legislative Guide on Insolvency Law (2004) and the World Bank's Principles for Effective Insolvency and Creditor/Debtor Regimes (2015) recommend minimising the categories of priority debts in insolvency. Furthermore, they stipulate that public interests generally should not be given precedence over private rights.
For a number of years now, it has been a policy objective of this government to improve the UK's standing in the World Bank's insolvency rankings, where the UK remains in 14th place for another year, behind countries such as the US (3rd), Germany (4th), the Netherlands (7th) and Belgium (8th). While there are various explanations for the recent fall in the UK's ranking (in particular a shift in the methodology applied by World Bank in 2015), reverting to the pre-2002 position on Crown preference is unlikely to help the UK's cause.
Unpaid debts owed to HMRC by insolvent companies may be a problem that needs to be addressed. But re-introducing Crown preference as a solution is out of kilter with the international trend, and potentially damaging to the availability of credit. Given the history, it also seems inequitable without a corresponding reduction to the prescribed part formula. In the meantime, this proposal and other recently proposed insolvency reforms (click here), such as restricting the use of insolvency termination triggers in formal insolvencies, might incentivise ordinary creditors to review their credit terms with a view to reducing their exposure to the potential insolvency of a trading partner. Whether this promotes or undermines a rescue culture in the restructuring and insolvency market is a matter for wider debate.
1 The White Paper: Insolvency - A second Chance (2001)
2 Insolvency and corporate governance: consultation response
3 Report of the Review Committee, Insolvency Law and Practice, 1982, Cmnd. 8558
