HMRC as Preferential Creditor in Insolvency: Post-December 2020

From 1 December 2020, HMRC reclaimed preferential creditor status in insolvencies under the Finance Act 2020, reversing the position that had applied since the Enterprise Act 2002. The change has materially altered the waterfall of distributions in liquidations, administrations and CVAs, reduced floating-charge recoveries and sharpened the duties owed by directors as insolvency approaches. This guide analyses which HMRC debts are now preferential, the revised priority ranking and the practical implications for insolvency practitioners, lenders and advisers.

History: Abolition and Restoration of Crown Preference

Crown preference, HMRC’s status as a preferential creditor in insolvency, has had an eventful legislative history. It was a long-standing feature of English insolvency law, allowing the Crown to rank ahead of floating charge holders for certain unpaid taxes. The Enterprise Act 2002 abolished it with effect from 15 September 2003, making HMRC an ordinary unsecured creditor in the vast majority of insolvencies. Lenders and insolvency practitioners adapted their models accordingly.

The Finance Act 2020 reversed that position. Schedule 4 to the Finance Act 2020 inserted new provisions into the Insolvency Act 1986, restoring HMRC’s preferential creditor status for a defined category of “relevant deductions.” The change took effect for insolvencies commencing on or after 1 December 2020. Cases commencing before that date are governed by the pre-2020 position (HMRC unsecured).

Which HMRC Debts Are Preferential

HMRC’s preferential status applies only to “relevant deductions”, a deliberately narrow category of payroll-related amounts deducted by the employer from third parties and held on trust pending payment to HMRC. These are:

• PAYE income tax , deducted from employees’ wages under the PAYE system and not yet remitted to HMRC;
• Employee National Insurance Contributions (NICs) , deducted from employees’ wages (the employee’s primary contribution only);
• Student loan repayments deducted from employees’ wages under the student loan repayment scheme;
• Construction Industry Scheme (CIS) deductions , amounts deducted from payments to subcontractors under the CIS and not yet remitted.

The rationale for this limited scope is that these amounts were never the employer’s money in the first place, they were deducted from employees or subcontractors and held by the employer as a collecting agent for HMRC. The employer is, in effect, a debtor for money it holds on others’ behalf.

What Is NOT Preferential

The breadth of the pre-2003 Crown preference has not been restored. The following remain ordinary unsecured claims:

• VAT , HMRC remains an unsecured creditor for unpaid VAT, notwithstanding that VAT is also a “collecting” tax. This was a deliberate policy decision and is one of the most commercially significant aspects of the reform;
• Corporation tax;
• Employer NICs (the secondary contribution), only employee NICs deducted from wages are preferential;
• Self-assessed income tax (not deducted via PAYE);
• Penalty and interest on any of the above;
• HMRC’s own costs and disbursements.

The Priority Waterfall

The restored priority ranking in an insolvent liquidation or administration, from highest to lowest, is:

1. Fixed charge holders , rank first against the assets subject to their fixed charge, before all other creditors;
2. Insolvency office-holder fees and expenses , paid from the general fund;
3. Ordinary preferential creditors , principally employee arrears of wages (up to the statutory cap of £800 per employee) and holiday pay under the Employment Rights Act 1996;
4. HMRC as secondary preferential creditor , PAYE, employee NICs, student loan deductions and CIS deductions. HMRC ranks after ordinary preferential creditors (employees) but ahead of floating charge holders;
5. Floating charge holders , from the net floating-charge realisations, after the prescribed part (see below);
6. Unsecured creditors , from the prescribed part fund and any surplus after floating charge realisations, including HMRC for VAT, corporation tax and employer NICs;
7. Deferred creditors and shareholders.

Impact on Floating Charge Holders

The most commercially significant consequence of the restoration is its effect on floating charge holders, typically banks, invoice finance providers and asset-based lenders. Before December 2020, these lenders could expect to recover from floating-charge assets (debtors, stock, goodwill) with no HMRC preferential claim ahead of them. From December 2020, HMRC’s preferential PAYE/NIC debt is paid in full from those same assets before any distribution to the floating charge holder.

In a business with, say, £200,000 of floating charge realisations and £80,000 of HMRC PAYE/NIC arrears, the floating charge holder receives £120,000 rather than £200,000. Where HMRC’s preferential debt exceeds the floating charge realisations, the floating charge holder recovers nothing or at best shares the prescribed part with unsecured creditors.

Lenders have responded to the restoration in several ways: by insisting on greater visibility of PAYE compliance in lending relationships (many now require periodic sight of P32 payment records), by tightening covenants to trigger review if PAYE is overdue and by pricing credit to reflect the enhanced HMRC risk. Insolvency practitioners advising distressed businesses should expect lenders to be more resistant to forbearance where PAYE arrears are building.

The Prescribed Part

The prescribed part, a statutory ring-fence for unsecured creditors created by s176A Insolvency Act 1986, operates by reserving a defined portion of net floating-charge realisations for unsecured creditors, preventing the floating charge holder from taking everything. The prescribed part is calculated as 50% of the first £10,000 of net floating-charge realisations and 20% of the remainder, subject to a maximum of £800,000 (as from April 2020).

The prescribed part is unaffected by the HMRC restoration, HMRC’s preferential debt is paid from floating-charge realisations before the prescribed part calculation is applied. The net effect is that where HMRC has a large preferential debt, the prescribed part is calculated from a smaller base, potentially reducing what is available to unsecured creditors.

Impact on CVAs and Restructuring

A Company Voluntary Arrangement (CVA) requires the approval of 75% by value of unsecured creditors voting. HMRC is routinely a significant unsecured creditor in distressed companies (particularly for VAT) and its voting position on a CVA can be determinative. Since 2020, HMRC’s stance on CVAs has hardened in several respects:

• Preferential debt must be paid in full. HMRC’s PAYE/NIC preferential claim cannot be compromised in a CVA, it must be discharged in full as a condition of any arrangement. The CVA can only offer HMRC a compromised payment on its unsecured claims (VAT, corporation tax, employer NICs).
• HMRC’s voting position: HMRC has a formal policy on CVA approvals, requiring that the arrangement offers a better return to HMRC than liquidation and that future HMRC compliance can be demonstrated. A CVA that proposes to pay HMRC less than the estimated liquidation dividend will be rejected.
• Time to Pay as an alternative to CVA: Where a company owes primarily HMRC debts, an agreed Time to Pay arrangement, which does not require creditor approval and has less formal structure than a CVA, may be more practical. We cover this in our resource on CVA and HMRC negotiation.

Administration and Pre-Pack Sales

In administration, the administrator’s primary statutory objective (where not achievable) is to achieve a better result for creditors as a whole than would be likely in winding up. HMRC’s preferential status must be factored into the distribution analysis when assessing whether a proposed outcome achieves that objective.

Pre-pack administrations, where a business is sold to a buyer (often the incumbent management) immediately upon or before appointment, are scrutinised by the Insolvency Service through the “SIP 16” Statement of Insolvency Practice framework. HMRC typically receives nothing from a pre-pack sale beyond any sum allocated to it as a preferential creditor from the sale proceeds, which is frequently nil if the sale price only covers the fixed charge and costs. HMRC has pressed for greater transparency in pre-pack valuations partly to ensure its preferential claim is properly recognised.

Director Duties: The Twilight Zone and HMRC

The restoration of HMRC’s preferential status has direct implications for directors in financially distressed companies. As analysed in our guide on directors’ duties in the twilight zone, once insolvency is probable, the Supreme Court in BTI 2014 LLC v Sequana SA [2022] UKSC 25 confirmed that directors must have regard to the interests of creditors as a class. HMRC is now a creditor whose preferential interests must be weighed.

Two specific consequences flow from the restoration for twilight-zone directors:

• PAYE as a priority obligation. A director who continues to trade while knowingly building PAYE arrears, diverting what should be remitted to HMRC to keep the business afloat, is preferring some creditors (trading creditors) over HMRC, who now has preferential status. This can constitute misfeasance or a transaction at an undervalue in a subsequent liquidation.
• Personal liability for PAYE/NIC failures. Where HMRC’s PAYE is not remitted because a director has deliberately caused the company to fail to comply, personal liability under s684 ITEPA 2003 (PAYE determinations) and Schedule 24 FA 2007 penalties (for deliberate inaccuracies in PAYE returns) can arise in addition to the insolvency context.

HMRC Time to Pay and Avoiding Insolvency

Where a business cannot meet its HMRC liabilities as they fall due but is otherwise viable, HMRC’s Time to Pay (TTP) scheme is the primary tool for avoiding the insolvency consequences of the restored preferential status. A negotiated TTP arrangement, agreed before insolvency proceedings commence, removes the debt from the waterfall analysis entirely, the business pays the full liability over an agreed period rather than facing it as a preferential claim in liquidation.

For preferential debts (PAYE and employee NICs), early TTP negotiation is particularly important because these debts, unlike unsecured claims, cannot be compromised in a CVA or written down in administration. Acting before the position becomes irretrievable is essential. We cover TTP negotiations in detail in our resource on HMRC Time to Pay.

Practitioner Checklist

1. Confirm the commencement date of any insolvency proceedings, HMRC’s preferential status applies only to cases commencing on or after 1 December 2020.
2. Identify the preferential HMRC debt: PAYE deducted from wages, employee NICs, student loan deductions and CIS deductions only. Do not include VAT, corporation tax or employer NICs.
3. Map the priority waterfall: fixed charges → officeholder expenses → ordinary preferential (employees) → HMRC preferential → floating charge holders → unsecured (including prescribed part).
4. Quantify the impact on floating charge holders and assess whether the lender will support a rescue or insist on enforcement.
5. Assess the CVA viability: HMRC’s preferential debt must be paid in full; its unsecured claim must be offered at least the estimated liquidation dividend.
6. In the twilight zone, address PAYE compliance first: a director who continues building PAYE arrears while trading insolvent is aggravating both the preferential claim and their own misfeasance exposure.
7. Consider Time to Pay early where the business is viable, an agreed TTP removes the preferential debt from the insolvency analysis entirely.
8. Check for personal liability risk: deliberate PAYE/NIC failures by directors carry parallel Schedule 24 penalty and PLN exposure, see our guide on personal liability notices.

Frequently Asked Questions