United States: Return Of Crown Preference At The Expense Of Floating Chargeholders

Summary

Much controversy followed the British government's announcement in 2018 that it intended to reintroduce a statutory priority for certain tax debts of companies subject to the UK insolvency regime. Following consultation by the British tax authority, HM Revenue & Customs ("HMRC"), and despite widespread criticism from professional bodies such as the Association of Business Recovery Professionals, the City of London Law Society and the Law Society, HMRC has now published draft legislation to implement the announcement for companies which enter a UK insolvency process after 6 April 2020 (the "Proposal"). This alert considers the impact the draft legislation will have on financing transactions and insolvencies which, in summary are:

  • negatively impacts the availability of finance to a degree;
  • increases the administrative burden for lenders and borrowers;
  • impairs and complicates markets for rescue finance; and
  • misaligns British insolvency law with other countries' insolvency laws.

This alert will be of particular interest to credit providers, insolvency practitioners, restructuring professionals and others concerned with the British insolvency regime.

A (partial) return to the law before 2003

At present, the Insolvency Act 1986 broadly prescribes the following statutory priority regime:

  1. fixed charge holders against assets which are subject to valid fixed charges;
  2. insolvency process costs;
  3. preferential creditors (predominantly claims for certain employee entitlements);
  4. floating charge holders against assets which are subject to valid floating charges, and subject to payment of a 'prescribed part' to unsecured creditors;
  5. unsecured creditors; and
  6. shareholders.

Until 2003, the 'Crown preference' gave HMRC status as a preferential creditor (at point three above) to all taxes of UK companies in a corporate insolvency. The Enterprise Act 2002 removed the Crown preference, as part of a bid to foster an 'enterprise culture' in the UK.

Under the Proposal, HMRC will rank as a secondary preferential creditor for VAT, PAYE Income Tax, Employee National Insurance Contributions and Construction Industry Scheme Deductions (the "Certain HMRC Debts"). This will rank HMRC behind other preferential creditors, but before floating chargeholders, for these claims.

Note HMRC will remain an unsecured creditor for taxes that are levied on businesses themselves, such as Corporation Tax and Employer National Insurance Contributions. And in a significant change from the original proposal, tax penalties or interest that arose from Certain HMRC Debts will not be ranked as preferential.

The change may, in some cases, put pressure on HMRC to challenge whether fixed charges are in fact floating charges

Following the Spectrum Plus judgment and its progeny, there is a risk that a purported fixed charge may be recharacterised as a floating charge if the fixed charge holder has insufficient control over the charged assets.1 There may be an increased incidence of HMRC challenging fixed charges on this basis, in light of significant rights many borrowers have under credit documentation to dispose of assets subject to fixed charges (with the associated right to require release of the fixed charge).

A reclassification to a floating charge is also important given the government's plans to increase the 'prescribed part' for unsecured creditors from £600,000 to £800,000. The prescribed part was initially introduced when the Crown preference was first removed in 2002, and was aimed at ring-fencing recoveries for the unsecured creditors so that e.g. the removal of the Crown preference did not solely benefit floating charge holders.

Instead of now decreasing the prescribed part, the increase in (i) the prescribed part and (ii) the amount owed to preferential creditors, could leave materially less recovery for a floating charge holder. 

The impetus for the change was driven by revenue collection

When a company goes into liquidation, it will often owe payroll taxes deducted from its employees (PAYE) and value-added tax (VAT) paid by customers for onward transmission to HMRC. Currently, HMRC ranks as an unsecured creditor, meaning any debts owed to HMRC by the insolvent company would only be paid out once the fixed charge holders, insolvency process costs, preferential creditors and floating charge holders have been paid out in full.

The government argues that the tax debts held that are owed to HMRC should be used to fund public services, rather than given to creditors in the private sphere. The planned measure is forecast to raise an estimated £185 million a year for the government for the 2023/2024 tax year. The government's thinking goes against the grain of contemporary insolvency practice. Both UNCITRAL and the World Bank state that priority debt on insolvency should be minimised and public interests should generally not be given primacy over private rights.2

Following the consultation, the government decided that tax penalties or interest that arose from Certain HMRC Debts will not be ranked as preferential. The government, however, rejected the idea that pre-2020 tax debts should be capped. Instead, the Proposal is retrospective, meaning that although the measures will only apply to insolvencies from 6 April 2020, Certain HMRC Debts which pre-dated the introduction of the policy will outrank pre-existing lenders and other debts. There is also no cap on the age of Certain HMRC Debts which can qualify for preferential status.

How will this affect UK business/insolvency?

(a) Negatively impacts the availability of finance to a degree

Under the Proposal, it may be harder for companies that borrow unsecured or with the security of a floating charge to get finance. Generally, small and medium-sized enterprises ("SMEs") receive a large amount of floating charge lending which is often given through a working capital facility. Because of the Proposal, lenders may offer finance on more expensive and onerous terms to mitigate the increased credit risk of not being paid on an insolvency. Lenders may also look to take a greater amount of collateral in response to the increased credit risk. This would restrict the debtor from using assets more profitably or from using these assets as security for other sources of finance. Alternatively, if lenders are unable to take more collateral, they may reduce the amount they are willing to lend.

(b) Increases the administrative burden for lenders and borrowers

As there is no cap on the age at which Certain HMRC Debts will be treated as preferential, lenders may want to keep an ongoing track of a debtor's tax position, to see whether their claim would be potentially outranked by Certain HMRC Debts. The administrative burden for this enhanced reporting would undoubtedly fall on debtors, but further monitoring would seem necessary for lenders. This would all serve to increase the cost of providing finance secured by a floating charge.

(c) Impairs and complicates markets for rescue finance

The Proposal in some cases could also make it harder to achieve business rescue.3 New lending is often needed to enable a business rescue through administration or an informed consensual agreement among creditors. The new money is often secured by way of a floating charge. As the preferential credit pool swells, floating charge holders would be squeezed out on an insolvency, thereby increasing the risk of lending money which is secured by a floating charge. As a result, there could be a reduction in the availability of credit and/or an increased price for credit in these situations.

(d) Misaligns British insolvency law with other countries' insolvency laws

Historically, foreign tax claims were not provable in British insolvency proceedings. This changed through the introduction of the EU Insolvency Regulation (for taxing authorities in EU Member States) and the Cross-Border Insolvency Regulations 2006 (for taxing authorities in all other foreign jurisdictions). Since that time, British tax claims have ranked pari passu with tax claims of foreign tax authorities. With the Proposal allowing HMRC alone to leapfrog the tax claims of foreign tax authorities, there is an untold risk that the smooth operation of cross-border insolvency could be affected.

Next steps?

A number of representative bodies and other respondents to the consultation are likely to be disappointed that the government intends to proceed with the reform as announced in the Proposal. However, it would appear that significant further lobbying would be required to prevent the Proposal from being implemented into British legislation.

Footnotes

1 Re Spectrum Plus Ltd (in Liquidation) [2005] UKHL 41.

2 UNCITRAL's Legislative Guide on Insolvency Law (2004), http://www.uncitral.org/pdf/english/texts/insolven/05-80722_Ebook.pdf; World Bank's Principles for Effective Insolvency and Creditor/Debtor Regimes (2015) http://pubdocs.worldbank.org/en/919511468425523509/ICR-Principles-Insolvency-Creditor-Debtor-Regimes-2016.pdf.

3 'Protecting Your Taxes in Insolvency: R3 response'.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

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