Thu 13 Aug 2020

The Return of Crown Preference



 In November 2018, I wrote an online piece about "The Return of the Crown Preference"[2] and how, in my opinion, this represented a retrograde step for floating charge-holders in particular and the UK economy in general - see Enterprise goes into reverse for floating charge holders.

 I flatter myself to believe that I was one of the first practitioners or academics to pick up on the implications of this little heralded reform announced in the 2018 budget, which was delivered by Philip Hammond, the then Chancellor of the Exchequer, to the House of Commons on Monday, 29 October 2018.  Imagine then the boost to my fragile male ego which followed shortly after publication of this piece to the Morton Fraser website when I was approached by my alma mater The University of Aberdeen, and asked if I would be interested in working the "bloggy" piece into a full academic article for publication in the Juridical Review, the law journal of the Scottish universities!  This academic piece can be accessed here: Enterprise goes into reverse - Juridical Review version.[3]

 This reordering of HMRC's priority in a corporate insolvency was implemented by the Finance Act 2020[4] which received Royal Assent on 22 July 2020.  The date on which this change to the law will come into force is 1 December 2020 and it will apply to all corporate insolvencies occurring on or after (but not before) that date.  It is interesting to note in this context that the originally proposed date for this change coming into force was 6 April 2020 under the terms of both the 2018 UK budget and the draft Bill which ultimately became the Finance Act 2020.  This delay of around eight months or so does perhaps hint at some squeamishness in Government circles about bringing this change into force[5] and rightly so in my opinion as this piece will go on to argue.

 Return of Crown preference - an explanation

 Some further explanation by way of recap as to what this all means in practice is perhaps worthwhile at this stage, noting that not all readers will have had the stomach for my articles linked to above!

 In essence, what this change means is that, in any distribution of assets in the insolvency of a UK corporate entity[6] the Crown (for which read Her Majesty's Revenue and Customs) will now rank in priority to a floating charge-holder in respect of payment of certain taxes collected or deducted by corporates for payment to HMRC, including:

  • value added tax;
  • pay-as-you-earn income tax;
  • employee national insurance contributions; and
  • construction industry scheme deductions,

(the "preferred priority taxes").

Note that taxes due by the corporate itself in respect of its own business endeavours (specifically, corporation tax and capital gains tax) will remain as ordinary unsecured debts and will, therefore, continue to rank behind the claims of any floating charge-holder (subject to the prescribed part for unsecured creditors - see below).

 The effect is perhaps best illustrated by showing the priority of payments that will apply between now and 1 December 2020 and that which will apply on and after 1 December 2020:

 Pre 1 December 2020 Priority:

  • first any fixed charge holder in respect of the realisation of assets subject to the fixed charge;
  • second the administrator or the liquidator for the expenses of the administration or the liquidation;
  • third all preferential debts (note, not including any payments due to HMRC);
  • fourth the "prescribed part for unsecured creditors[7]" (noting that the cap on the prescribed part increased from £600,000 to £800,000 with the coming into force of the Insolvency Act 1986 (Prescribed Part) (Amendment) Order 2020[8]);
  • fifth any floating charge-holder for floating charge realisations; then
  • sixth the ordinary unsecured creditors of the corporate (note, including all payments due to HMRC in respect of all taxes not paid at level fourth above).

Post 1 December 2020 Priority:

As above, but subject to the following adjustments:

  • at level third preferential debts will include all payments due to HMRC in respect of the preferred priority taxes; and
  • at level sixth the ordinary unsecured creditors of the corporate will continue to include HMRC, but only to the extent of corporation tax and capital gains tax payments.

A history lesson is perhaps in order here so as to put this change into some context.  Prior to the coming into force of the Enterprise Act 2002, the Crown preference existed in respect of all payments due to HMRC[9] and therefore all such payments ranked ahead of the claims of a floating charge-holder.  Equally, there was no prescribed part for unsecured creditors ranking ahead of floating-charge holders.  The Government at the time wanted to reform the law of corporate insolvencies in order to promote a rescue culture and the Enterprise Act 2002 therefore removed the availability of administrative receivership[10] as an enforcement option for floating charge holders in most circumstances[11] replacing this with an expedited and more cost effective out of court notification procedure for appointing an administrator.  However, the Government took with one hand and gave with the other as it also abolished Crown preference in its entirety, thereby altering HMRC's status as a preferential creditor to that of an ordinary unsecured creditor, whilst at the same time providing for a ring-fenced pool of distributions for those ordinary unsecured creditors in the form of the "prescribed part" referred to above.

The assault on the floating charge

The proposed return of Crown preference and the increase in the prescribed part need to be viewed in this historical context in order to comprehend properly the extent to which the value of floating charge security has been under assault since the turn of the century.  Whereas the removal of administrative receivership as an enforcement option in most circumstances was a material and adverse change for floating charge-holders, the blow was cushioned somewhat by a package of other measures, chief amongst which was the abolition of Crown preference in its entirety.  This enlarged the fund available for distribution to floating charge-holders in a corporate insolvency and was a material concession in addressing market concerns about the impact of the Enterprise Act 2002 in this regard, paving the way for the pre-eminence of administration as a corporate insolvency process with its moratorium on creditors' action (akin to the "safe harbour" provisions of the US chapter 11 process) and its priority focus on the continuation of the insolvent business as a going concern.

With the return of Crown preference, what I think we are seeing is the Government reneging on the bargain struck with floating charge-holders in 2002.  Other than enlarging funds available to HMRC in corporate insolvencies[12] it is difficult to see the justification for this.  Indeed, the changes implemented by the Finance Act 2002 essentially give HMRC two bites of the cherry before floating charge-holders will participate in any dividend from the insolvent estate - first as a preferential creditor in respect of the preferred priority taxes, and second as an ordinary unsecured creditor to the extent of its participation in the "prescribed part" for other payments due to it (i.e. corporation tax and capital gains tax).

I have seen it argued that this change is pro-enterprise since the abolition of Crown preference through the Enterprise Act 2002 has encouraged HMRC to take increasingly aggressive debt recovery action against defaulting corporates, where previously it may have taken a more relaxed view taking comfort from the fact that, were an insolvency to materialise, it would likely largely recover as a preferential creditor in any event.  However, surely it is significantly more pro-enterprise to ensure that recoveries due from a private sector corporate insolvency are, insofar as is possible, reallocated to private sector sources from whence they can be more readily and expeditiously redeployed into the economy through private investment rather than having to wait for the deployment of the capital through the enormity of the public sector machine to see whether any residue is left for investment in capital projects and the like, or whether the inclination is there in Government to so invest any such residue?

The position becomes markedly worse when one considers the outlook for corporate insolvencies given the covid-19 pandemic and ensuing lockdown.  On the date I began writing this piece, it was announced that the UK economy is now in recession and has suffered a staggering collapse in GDP of circa 20% for Q2 of 2020[13].  This is a collapse of eye-watering proportions, denuding the UK economy of some £250bn of economic activity in one quarter alone.  Clearly, this will have consequences for an economy in enforced deep freeze and kept on life-support by the temporary largesse and munificence of HM Treasury.  The piper will have to be paid and the price will be a slew of corporate insolvencies, the vast majority of which will occur post 1 December 2020.  Those private sector lenders and financiers who hold floating charge security will therefore be penalised by this change and denuded of capital they might otherwise have redeployed swiftly and efficiently into the economy through further lending or investment.  Viewed in the context of the losses we can expect almost all sectors of the private economy to endure as a result of this economic crisis, including the financial sector, this is not an altogether welcome or helpful prospect.

Indeed, some of the reforms brought into force by HM Treasury in order to keep the economy on life-support are only going to exacerbate the problem once we start to see the expected corporate insolvencies coming through.  Let's take the VAT payment holiday which was introduced for VAT which would otherwise have fallen due for payment between 20 March 2020 and 30 June 2020.  All such accrued but deferred VAT payments must be made in full by 31 March 2021[14].  But what happens if a corporate entity owing such VAT payments goes into an insolvency process post 1 December 2020 with the VAT payments remaining unpaid?  Well, HMRC will be entitled to payment of the accrued and deferred VAT as a preferential debt ranking ahead of any floating charge-holder.  Aggregate VAT payments can be expected to be inflated beyond what they otherwise would have been as a result of the VAT payment holiday and the rescheduling of the due date for payment to 31 March 2021, as exacerbated by the change in law coming into force on 1 December 2020.

The floating charge-holder takes yet another haymaker to the solar plexus.

Who will advocate for the "humble" floating charge-holder?

The vast majority of floating charge-holders in the UK are banks and other financial institutions and non-bank lenders.  Perhaps not a constituency which engenders much sympathy amongst commentators and the general public!  But the fact remains that this sector plays a vitally important role in the deployment and circulation of capital in our economy.  At some point, somebody somewhere must surely stand up and say that enough is enough in terms of this continued and relentless assault on the floating charge?  It is not difficult to see the partial return of the Crown preference as the thin end of the wedge.  Having pushed through this reform in respect of the preferred priority taxes, what's to stop some bright spark at HM Treasury following the premise through to its logical conclusion - i.e. re-prioritising payments in respect of corporation tax and capital gains tax as well?  It's not at all difficult to see a future Government (or, indeed, this Government), denuded of tax income as a result of a collapsed economy, arriving at such a conclusion.

The position for secured creditors in Scotland is exponentially worse and one can't help but suspect that HM Treasury did not spend much time, if any at all, considering the implications for Scotland of this reform when the 2018 UK budget was at embryonic stage nor, indeed, when the Finance Bill 2020 was proceeding through Parliament[15].  This is because it is notoriously difficult to subject tangible and intangible moveable assets to a fixed security interest in Scots law and so lenders rely more heavily on floating charge security to underpin the collateral package than is perhaps the case in England.  Indeed, the floating charge was introduced into Scots law by Act of Parliament passed in 1961[16] precisely because Scots law is so inflexible in this regard, and it was accordingly felt that secured creditors had to have an easier means of taking security so as to elevate their claims above those of the ordinary secured creditors.  To see the practical benefits of holding floating charge security subjected to such sustained attack, first of all through the Enterprise Act 2002 and now by the Finance Act 2020, is most disheartening and does not bode well for the ease of availability of secured credit in Scotland post 1 December 2020, a blow which corporate Scotland can well do without as it battles to contain the fallout from the economic disaster of the covid-19 pandemic and lockdown.

Playing Devil's advocate for one moment, one might say "hang on a minute, Scotland has a separate legal system and a devolved Parliament at Holyrood; why doesn't it reform the law of moveable property in this regard to fix the problem of its own volition?"  An excellent question, to which the response would be that this is in hand through the sterling endeavours of the Scottish Law Commission, which has submitted voluminous papers to the Scottish Parliament proposing reform in this regard together with a draft Bill which would implement said reform into law[17].  The fact of the matter is that the Scots law in this area is not fit for purpose and is crying out for reform.  However, the Bill is at an embryonic stage and its passing into enacted statute is not at all imminent.  We may have many years to wait before this becomes law, particularly given the justified focus of the Scottish Government on its response to the covid-19 pandemic.

Having given Scots law a thorough dressing down for its inability to drag itself out of the 17th century as regards the law of moveable property, "whither England?" one might well ask!  Well, whilst the position in England is certainly better for secured creditors and, therefore, for corporate borrowers, England by no means escapes unscathed from this unfortunate and misconceived change in the law.  It is true to say that it is easier to take fixed security under English law than it is under Scots law since fixed security can exist in equity under English law whereas "equity" in the legal sense is an alien concept in Scots law and has no equivalent (other than in the case of a beneficiary's interest in a trust).  However, following the Spectrum Plus line of cases[18] a secured creditor must demonstrate that it exhibits contractual and practical day-to-day control over collateral in order for that collateral to be regarded as a fixed charge asset as opposed to a floating charge asset.  Take, for example, a charge over a bank account - if the charged account is not a control account or "blocked" so that the consent of the chargee is required before the chargor may utilise sums standing to the credit of the charged account, then there is a risk that the purported fixed charge will be recharacterised as a floating charge and the chargee will rank accordingly in any corporate insolvency (i.e. behind HMRC for the preferred priority taxes and behind the ordinary unsecured creditors (including HMRC for all other payments due to it) for the prescribed part (capped at £800,000)).  Accordingly, for many asset classes, fixed charge security is really quite vulnerable under English law.

The return of Crown preference is therefore a wholly unwelcome and detrimental development for providers of corporate finance and corporate borrowers across these islands.

What should be done?

Personally, I'd like to see the return of Crown preference abolished in its entirety, although that would appear to be a forlorn hope given the fact that it is now cast into law via the Finance Act 2020.  The reform was conceived of by HM Treasury under the aegis of one P. Hammond, Esq. as Chancellor of the Exchequer, not a man known for his dynamism, vim or vigour as the sobriquet "Spreadsheet Phil" would testify.  That iteration of the Government seems an eon away under the current Johnsonian version, with "Dishy" Rishi Sunak presiding over the Treasury and taking an altogether less conservative (with a small "c" you'll note, but it could also have a large "C" come to think of it…) approach to matters of a fiscal bent.  It is disappointing then that this new Government has not taken steps to minimise, if not abolish altogether, the material and adverse effects of this reform, particularly given its neuralgia-phobic response to the covid-19 pandemic.

In the absence of a return to the complete abolition of Crown preference effected by the Enterprise Act 2002, I think the best we few advocates for floating charge-holders can hope for is some endeavour to ameliorate the adverse effects of this change on the private sector, which might involve one or more of:

  • The postponement of the change across the UK until such time as the dust has settled from the fallout from the covid-19 lockdown-induced economic crisis that awaits us.  The Government has kicked this particular can down the road once before when it pushed the 6 April 2020 implementation date out to 1 December 2020.  Why not do so again and push it out to 1 December 2021, say, whilst we see how the aftermath of the lockdown plays out?
  • The postponement of the change in Scotland until such time as the Moveable Transactions (Scotland) Bill has been enacted into law.  The relevant effect of this reform will be to make taking fixed security over moveable assets much simpler, and this would largely mitigate the material and adverse effect of the return of Crown preference in Scotland.
  • The introduction of a cap for the reprioritised Crown preference, similar to that which takes effect in respect of the "prescribed part for unsecured creditors".
  • The removal of HMRC from the category of unsecured creditors entitled to participate in the distribution of the "prescribed part for unsecured creditors".

Is anyone in Government listening?  Ah hae ma doots, as we say north of Hadrian's Wall……

[1] My sincere gratitude is extended to my colleague and fellow partner, Alan Meek, for his review of, and comments and suggestions on, this piece, although he has asked me to clarify that he is not necessarily in full agreement with some of the conclusions reached herein!

[2] Hat-tip to the original Star Wars trilogy!

[3] Having blown my trumpet loudly here, it is only fair to note that my small contribution to the debate in this regard has been outshone by the prolific output of many others on the subject!

[4] See section 98 of the Finance Act 2020.

[5] Perhaps driven by the downturn in the UK economy occasioned by the covid-19 pandemic and subsequent lockdown.

[6] Essentially, a company or a limited liability partnership.

[7] Which include HMRC for corporation tax and capital gains tax payments.

[8] A change to the corporate insolvency regime also proposed in the 2018 UK budget.

[9] Subject to certain temporal limitations.

[10] Which was viewed as an anti-enterprise procedure since it was seen as favouring the appointing secured creditor over the continuation of the company as a going concern and the interests of the general body of creditors.

[11] But see the exceptions to this set out in sections 72B to 72GA of the Insolvency Act 1986.

[12] Noting that a political, economic and philosophical debate as to the desirability of such an outcome is beyond the scope of this piece!



[15] If I were a cynic (perish the thought) I might say "plus ça change plus c'est la même chose" with a Gallic shrug of the shoulders in response to this….

[16] See the Companies (Floating Charges) (Scotland) Act 1961.

[17] See: (1); and (2) /knowledge-hub/moveable-transactions-scotland-bill.

[18] See Re Spectrum Plus Ltd; National Westminster Bank plc v Spectrum Plus Ltd and others [2005] 4 All ER 209.

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