Back to the Future? The Partial Reinstatement of the Crown Preference in Insolvency

Introduction

Deep within his budget speech delivered on 29 October 2018, the Chancellor of the Exchequer, Philip Hammond, announced: “We will make HMRC a preferred creditor in business insolvencies to ensure that tax which has been collected on behalf of HMRC – is actually paid to HMRC.”

In the context of announcements with much greater political significance, it is easy to overlook this planned change (especially since it arrived unexpectedly). However, it is of notable significance within insolvency law. It can also be considered part of a wider agenda whereby the UK government is increasingly seeking to recover as much tax revenue as possible (which has included recent steps to reduce tax evasion). In addition, it represents a particular example of the interests of the state being preferred over certain creditors who stand to correspondingly lose out.

The Return of Crown Preference

The previous (and long-standing) Crown preference for debts due by a debtor to UK tax authorities was only abolished last decade by the Enterprise Act 2002, s 251. This preference prioritised the Crown over unsecured creditors and, where relevant, floating charge holders, in the insolvency of a debtor. Yet less than two decades later the Crown’s preference is to make something of a return.

From 6 April 2020, it was announced that Her Majesty’s Revenue and Customs will have priority as regards certain debts owed by the business. In reality, the “reinstated” Crown preference is a narrower version of its predecessor. The preferential debts will consist of sums held by a business, derived from customers and employees, which are intended to be passed on to HMRC. This will include VAT, PAYE Income Tax, employee National Insurance contributions and Construction Industry Scheme deductions. However, taxes owed by the insolvent business itself, such as Capital Gains Tax and Corporation Tax, will not be covered by the preference. By being limited only to certain debts due to HMRC, this will further add to the piecemeal nature of preferential debts within insolvency law.

Although the amount of HMRC’s preferential claim will be limited to tax payments derived from employees and customers, the claim will (apparently) allow HMRC to receive preferential payment from any part of the estate of the insolvent business. An alternative and more unusual approach would be to allow HMRC to have preferential status in relation to the whole amount of debt due to it by the business, but payable only from the sums being held in relation to tax payments by employees and customers. The method that the government seems to have chosen would mean that HMRC is able to receive a preferential payment, even if the relevant tax sums held have been intermingled with other assets and are no longer separately identifiable or have been dissipated.

Secondary Preferential Creditor Status

It should also be noted that HMRC will only become a secondary preferential creditor. It will rank behind ordinary preferential creditors, including those with employee remuneration claims and the Financial Services Compensation Scheme for debts owed to it. This means that HMRC will only receive payment after these other parties have been paid. It is the result of a policy choice relegating the interest of HMRC to those other parties. The particular justification for this remains unclear. If the recovery of payable taxes is to be such a priority, then why is HMRC not to be (at least) an ordinary (first-ranking) preferential creditor?

Perhaps this is because of a reluctance to disturb the existing order of priority except from floating charge holders downwards (however, other secondary preferential creditors will also proportionally lose out).

Businesses Affected

There are a number of other unanswered questions and problematic issues as far as the proposal is concerned. Firstly, in relation to which businesses will the preference apply? Presumably it is to extend to all parties that hold the relevant tax payments for HMRC, which would include sole traders and partnerships, as well as the likes of companies and LLPs. The fact that the Crown preference, in any event, will only apply to businesses and not to individuals outside that context is another reason why the reinstatement can only be considered a partial one: historically the preference applied in relation to businesses and non-businesses as the debts could be owed by any of these parties.

If the preference is to involve sole traders and partnerships, then for Scotland it will be necessary to amend the Bankruptcy Act 2016 to enable the Crown preference to exist in the context of sequestration (as this is the relevant insolvency process for such parties). It is unclear whether there would be any enthusiasm in Scotland to make this change, but the law relating to preferential debts regarding any type of debtor is a reserved matter and is therefore within the competence of the UK Parliament rather than the Scottish Parliament (Scotland Act 1998, Sch 5, Head C2).

A further point to note is that taxes payable to Revenue Scotland and local authorities will not be derived by businesses from their employees or customers and so will not be subject to the returning Crown preference. As such, the preference will specifically be an HMRC preference.

A Question of Trust?

On one view, the return of Crown preference in the manner proposed may not be needed. If a debtor was considered to be holding tax payments derived from customers and employees on trust for the benefit of HMRC, then this property would not form part of the business’s insolvent estate and could not be distributed to other creditors. The HM Treasury document issued along with the budget (Budget 2018 – Protecting your taxes in insolvency, available online) in fact refers to sums paid being “held in trust by the business”. It does, however, separately state that HMRC will become a secondary preferential creditor “for taxes held on behalf of employees and customers”. It would appear more accurate to state that if a trust is created, it is for the benefit of HMRC rather than for those who are contributing the property.

What would the basis of a trust be under the present law? A constructive trust is the most obvious candidate because the business concerned can be considered an agent acting on behalf of HMRC for the collection of the taxes. A fiduciary relationship, such as this, can seemingly give rise to a constructive trust in both English law and Scots law (for the latter see e.g. Ted Jacob Engineering Group Inc v RMJM [2014] CSIH 18).

Even if it is doubtful in certain situations that a trust is actually created (and this may be particularly true in Scotland), an alternative approach would be to provide, in legislation, that tax sums due to HMRC and being held by a business are held in trust for HMRC. This would enable the property to be separated from the insolvent estate and would effectively give HMRC a super-priority (albeit potentially subject to any fixed security over the “trust” property). In terms of what is actually proposed, HMRC will be subject to any fixed security creditors, expenses of the insolvency process (e.g. sequestration, liquidation, administration or receivership) and ordinary preferential creditors. As such, HM Treasury calculates that the average debt recovered by HMRC from 2020 will only be 14% and the estimated annual yield from the change will be £185 million (Budget 2018 – Protecting your taxes in insolvency). Yet this amount could be significantly greater by using a trust mechanism. The non-utilisation of trust here may, again, reflect a reluctance to disturb the priorities of creditors at the higher end of the ranking ladder.

It would be possible to run a trust argument even after the (re-)introduction of the Crown’s preferential status; however, the fact that legislation would be treating the Crown’s claim as connected with property in the estate would likely be used to defeat that argument. For if the property was trust property, it would not be part of the estate, and it would not therefore be necessary for the Crown to have preferential status for the debt due.

Crown Preference, Floating Charges and Unsecured Creditors

One of the justifications for removing the Crown preference previously (at least for corporate insolvencies) was that it was being replaced by the prescribed part for unsecured creditors (which would then include the Crown) and this would have priority over a floating charge holder. The prescribed part is now to be increased from a maximum of £600,000 to a maximum of £800,000. This is a reasonable step as the maximum amount has not been increased since the prescribed part was introduced. The government has proposed the increase to reflect the impact of inflation (see DBEIS, Insolvency and Corporate Governance: Government Response (2018), at para 1.84, available online. It is not clear, however, whether this linkage has been taken into account in making the (apparently) separate policy decisions relating to the partial reintroduction of Crown preference and the increase in the maximum value of the prescribed part.

It is true, as has been noted elsewhere (R Caldwell, “Enterprise goes into reverse for floating charge-holders”), that this, combined with the returning Crown preference, further relegates the priority status of floating charges. As Caldwell suggests, this can be considered especially problematic for raising finance in Scotland due to the difficulties in obtaining fixed security over many types of property and provides further support for enacting the Scottish Law Commission’s recent proposals to introduce a new non-possessory security (the statutory pledge) (Scottish Law Commission, Moveable Transactions Report ScotLawCom No 249 (2017) available online). It may also seem, at first glance, that unsecured creditors will almost invariably suffer too.

Yet, the extent to which parties will be winners or losers under the proposed new ranking regime is not as straightforward as it may seem. The prescribed part only operates as a proportional claim on the “net property” of the company concerned, which is the property which would otherwise be available for the satisfaction of floating charge holders (Insolvency Act 1986, s 176A). Consequently, the net property of the company will be correspondingly reduced by the new Crown preference, and so the prescribed part will also be lower than it would be otherwise. On the other hand, the partial promotion of HMRC to preferential status will reduce the unsecured claims of HMRC in relation to the prescribed part.

An example showing the differences between recoveries under the current regime and the new regime may assist. For the sake of simplicity, the example proceeds on the basis that any monies due to fixed security holders and the expenses of the insolvency process have already been allocated and there are no additional preferential creditors. A floating charge holder is due £5 million, HMRC is due £2 million (half of which consists of tax sums held by the insolvent company for HMRC) and (other) unsecured creditors are due £2 million. The insolvent company’s total estate remaining is worth £5 million. (It is necessary to use such large figures as otherwise the maximum limits of the prescribed part will not be relevant, which indicates that for most insolvent estates the increase in the limit will have no impact.)

It is clear from this example that the floating charge holder will suffer the principal losses due to the changes in the law (which helps verify the wider argument made by Caldwell). HMRC is, unsurprisingly, the principal beneficiary but the (other) unsecured creditors also receive a benefit, at least in this scenario, by virtue of both the increased prescribed part and the partial elevation of HMRC to preferential creditor status.

The Future Awaits…

Further details regarding the (partial) reintroduction of Crown preference are awaited with interest. It is hoped that such information will resolve the uncertainties noted above. Furthermore, it would be useful if the government produced material explaining the reasoning behind some of the policy choices selected and demonstrated that it had taken into account wider ranking implications when making its decision. It is hoped that interested parties can be enlightened on these fronts in the very near future.

Further information about the authors of this post can be found on our website: Alisdair MacPherson and Donna McKenzie Skene