Crown preference rights allow the UK government to take insolvency payments before banks and unsecured creditors.

Hasib Howlader

New legislation introduced in the UK at the end of last year means that Her Majesty’s Revenue and Customs (HMRC) will have preferential rights in insolvency.

Known as ‘Crown preference’, these preferential rights allow HMRC to take insolvency payments before banks and unsecured creditors.

The concern is that this new ruling could stifle the creation of new businesses in the UK because banks will have little incentive to invest knowing they will recoup significantly reduced funds in the case of insolvency.

What has changed?

In the event of insolvency, fixed-charge creditors and the cost of the procedure are paid first, followed by preferential creditors. This includes employees, the Redundancy Payment Service  and the Financial Services Compensation Scheme.

Holders of floating charges, such as financial institutions and other lenders, are – with the exception of a minor prescribed element – paid in advance of unsecured creditors, who may only receive a nominal payment.

The new legislation makes HMRC a preferential creditor for certain tax debts in insolvencies taking place after December 1, 2020.

This preferential status applies to taxes collected by the company on HMRC’s behalf, including VAT, PAYE and employee National Insurance contributions.

HMRC will remain an unsecured creditor for taxes it collects directly, such as corporation tax.

HMRC previously had Crown preference until 2003, when the Enterprise Act 2002 removed that status. This left HMRC as an ordinary unsecured creditor in the event of insolvency, ranked behind floating-charge holders.

The abolition of Crown preference aimed to increase entrepreneurship and promote a culture of business rescue.

However, the new rules once again restore HMRC to an elevated position above unsecured creditors and floating-charge holders.

How will the new rules affect lending?

While the UK government estimates that the move will raise £195m a year for HMRC, the picture is less rosy for financial institutions. Banking industry body UK Finance estimates that floating-charge lenders could take a hit of around £1bn annually.

The new rules represent a culture shift for banks, whose primary purpose for lending is to make a profit. Under previous legislation, floating-charge lenders had a level of protection if a company entered a formal insolvency procedure.

Now that HMRC has preferential status over floating-charge holders and unsecured creditors, banks are likely to see lower financial returns in an insolvency situation.

If they do lend, it’s likely banks will charge higher rates to compensate for the increased risk, and will implement changes to terms and conditions

This gives them little reason to lend, as the likelihood of non-recovery of a loan will be unpredictable. Banks would need an unrealistic level of understanding of a company’s tax compliance record in order to accurately assess the risk, making lending unattractive.

This may result in a reduction in lending or a greater focus on fixed-charge security.

If they do lend, it’s likely banks will charge higher rates to compensate for the increased risk, and will implement changes to terms and conditions. For example, they may require companies to declare any significant deferred tax balances, or ask for personal guarantees from company directors in order to reduce losses.

In addition, the timing of the reforms may prove problematic. Given the impact of the coronavirus pandemic, there may be more struggling companies and more unpaid taxes, which increases the risk further for unsecured creditors. Overall, this is a backward step that will make it more difficult for banks and other financial institutions to lend to businesses.

How will businesses be affected?

The new rules will have big implications for businesses too. With banks reluctant to lend, debt will be harder to find – and with lending priced according to risk, what debt there is available will be more expensive. Rescue finance in particular will become more complex and more difficult to access, because floating-charge finance is often a key tool in business turnaround.

In addition, if lenders start asking for personal guarantees from company directors, businesses may be less inclined to borrow. Putting personal property at risk in order to secure a business loan is likely to be an unappealing prospect for most. Instead, businesses may decide to play it safe and avoid borrowing. This could lead to under-investment, stagnation and ultimately failure, and on a wider scale, suppressed economic growth.

With many companies struggling with the impact of Brexit and a pandemic, these changes seem antithetical to rescue culture at a time when what businesses need most is support. While there may be short-term benefits for the government, in the long term we’ll see a reduction in entrepreneurism, and the UK will no longer be a country where businesses can flourish.

Hasib Howlader is the director of insolvency practitioners Hudson Weir.

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