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Restoring HMRC’s preferential creditor status

David Gregory David Gregory

Is this a case of ‘Heads I win, tails you lose’ for HMRC?

In a return to the pre Enterprise Act 2002 era, the chancellor announced in the 2018 Budget that HMRC’s preferential creditor status in insolvencies will be restored from 6 April 2020, a move which is expected to affect asset-based lending over stock in particular. 

Preferential status is only expected to apply to taxes paid by employees and customers that a company collects on behalf of HMRC, eg VAT, PAYE, employees’ NIC and construction industry scheme deductions. The company’s own tax liabilities, eg employer’s NIC and corporation tax, should not be included, although compared to an insolvent company’s VAT and PAYE liabilities, these are often minimal; effectively making the vast majority of HMRC’s debt preferential. 

The proposed ranking of creditors is summarised in the table below:

Old (pre 2003)

Current

Proposed from April 2020

Fixed charge creditors

Fixed charge creditors

Fixed charge creditors

Preferential creditors

Ordinary preferential creditors (employees)*

Ordinary preferential creditors (employees)

Floating charge creditors

Prescribed part carve out

Secondary preferential creditors (HMRC and FSCS)

Unsecured creditors

Floating charge creditors

Prescribed part carve out

 

Unsecured creditors

Floating charge creditors

 

 

Unsecured creditors

*Secondary preferential creditors currently exist but are limited to Financial Services Compensation Scheme (FSCS) claims in specific circumstances and so are very rarely in point.

The proposed ranking could result in no funds going to the floating charge holders, as HMRC would sit above them in the order of payments in respect of relevant tax debts. Going forward, floating charge holders will need to assess the risk of default and will likely want to closely monitor the value of their security. This could have a material impact on the cost of borrowing, especially for businesses without significant assets over which they can give a fixed charge.

While little detail has been released at this stage, it is understood that the government intends to issue a consultation in January 2019. However, it is believed that the policy decision to reinstate HMRC’s preference with effect from April 2020 will not be reversed, regardless of the uncertainty in the UK’s economic position after Brexit. Therefore, the consultation is only expected to focus on specific points of implementation, some of which have been raised below.

 

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“When HMRC releases its anticipated consultation into the reinstatement of its preference, I would urge all affected parties to provide detailed responses to HMRC in order that it can fully understand the potentially significant consequences of this change”

David Gregory, head of restructuring and insolvency tax

Practical issues

Some of the specific issues that we believe will need to be considered by HMRC and all affected parties are summarised below.

Asset-based lending

When the changes are implemented, any loans that fund floating charge assets, such as stock, could lose security value overnight. As the new rules will affect the whole market equally, it will become increasingly challenging to refinance facilities to alternative funders, even if the lending market remains as buoyant as it is today.

The impact of the change in status should be included in any exit planning or pre-lend reviews that lenders undertake or commission. In addition, stock valuations may need to be updated by agents with input from insolvency practitioners. 

HMRC’s restoration to preferential status means that increased planning around the creation of greater headroom in respect of fixed-charge security is likely to be required. Consideration will need to be given to how much HMRC debt may sit in front of the floating charge assets on appointment if arrears have accrued. In the case of accelerated sale processes, the possible benefit of running a process over several weeks for a secured charge holder, under an agreed time to pay arrangement or notice of intention, may need to be balanced against the accruing HMRC liabilities and possible erosion in the return to the floating charge holder.

Somewhat surprisingly, HMRC’s initial view is that the lending market will not be materially affected by the proposed changes. Therefore, it is crucial that affected lenders respond to HMRC’s consultation outlining the anticipated consequences, including the availability of credit and pricing.

Commencement date and time limits

HMRC intends that the changes will apply from April 2020 regardless of the economic climate that the UK finds itself in. Indeed, the changes themselves could prompt a flurry of insolvencies in the run-up to April as other creditors attempt to push businesses into insolvency prior to the changes taking effect, to prevent HMRC jumping ahead of them in the pecking order, placing further stress on the economy.

Prior to the Enterprise Act 2002, HMRC’s preferential claim was limited to debts arising in the 12 months prior to insolvency.  It is thought that HMRC wishes to re-instate its preferential status without restriction as to what historical claims may be included. This could incentivise HMRC to open detailed enquiries into historical tax affairs following the appointment of Insolvency Practitioners (IPs) where funds are available for preferential creditors, in an attempt to maximise its return, to the detriment of other unsecured creditors. 

This could be a particular issue for IPs in cases where the availability of pre-appointment records is limited, or they are of poor quality.  IPs may find that they have insufficient information to challenge assessments that are subsequently raised.  At the very least, IPs may need to carry out much more detailed investigation (thereby incurring potentially substantial costs) in agreeing HMRC’s preferential claim.

Possible ways of addressing some of these concerns could be to introduce a time limit on HMRC’s claims to which the preferential status could apply, or to make the changes effective for floating charges created after 2020. It should also be noted that HMRC already has a wide range of existing powers to recover tax debts that are due, for example using tax legislation allowing the pursuit of directors in relation to unpaid taxes, and these should be used wherever possible to restrict the preferential claim and the adverse impact on other creditors.

Voting in an insolvency

In situations where there are insufficient funds for unsecured creditors in an administration, in order to pass various measures, including fixing the basis of the administrators’ remuneration, the administrators require the approval of each secured creditor and a majority vote of the preferential creditors (if there are funds available for them), only counting those who do vote in this calculation. Therefore, HMRC will be required to actively engage with administrators and it is not clear how it intends to do this.

The problem is that if no preferential creditors vote, there is no majority. At present, the preferential creditors are usually the Redundancy Payments Service (RPS) in the shoes of the bulk of the employee claims; the employees personally for residual claims; and pension trustees for unpaid employee contributions. The RPS is almost always overwhelmingly the largest preferential creditor and substantially more than 50% of the total constituency on its own. It is also an informed creditor as regards IP remuneration in a way that, with respect, the employees rarely will be.

The insolvency legislation is supposedly built on a principle of creditor engagement, so it is disappointing that the RPS, as a government department, is disinclined to engage. It is hoped that HMRC might set a better example and take on the responsibility that will come with its new status; it will be crucial that it outlines how it proposes to do this in its consultation.

Other practical implications    

It has been confirmed that the prescribed part will continue to apply to floating charge realisations, and that the planned inflationary £200,000 increase in the cap to £800,000 is unaffected; further reducing the return to floating charge holders.  By retaining its right to participate in the prescribed part in relation to tax debts that do not have preferential status (eg corporation tax and employer’s NIC), HMRC has the opportunity of a second bite of the cherry, further reducing the return to other unsecured creditors.

HMRC is adamant that it remains supportive of the UK’s rescue culture. However, it will be interesting to see whether this change impinges upon its approach to time to pay (TTP) applications. On the face of it, HMRC may have less incentive to agree a TTP for a business that is facing serious cash flow constraints if the alternative of immediate insolvency would provide a more certain outcome. In addition, it will be important for HMRC to consider the impact of the change on company voluntary arrangements (CVAs), for example, will it result in more CVAs becoming unworkable if there is nothing available for the unsecured creditors and they vote against it?

Conclusion

With all of the challenges and uncertainty that lie ahead in the coming months, April 2020 may seem a long way away.  However, the reinstatement of HMRC’s preferential creditor status in little over a year is likely to have an immediate impact on refinancing or new debt raises that are currently being considered, so businesses and lenders should be pro-actively considering the effect of these changes.

The Budget announcement stated that the reinstatement of preferential status for HMRC would raise £185 million per year. It is unclear how this figure could have been calculated, but HMRC receiving an extra £185 million must mean that other creditors, be they lenders, rating authorities, or trade creditors, will receive £185 million less. It is surprising therefore to suggest that this change will not adversely affect lending and credit decisions, or will not diminish recoveries by other stakeholders.

It is hoped that HMRC will issue its consultation in the near future in order that its position on some of the issues discussed above becomes clearer and so that they can be debated in detail with interested parties.

If would like to discuss how this may affect your business, or would like our help in putting your views across to HMRC, then please contact David Gregory.