New legislation introduced in the Finance Act 2020 gives HM Revenue & Customs (HMRC) preferential creditor status in respect of VAT, PAYE, employee NICs and Construction Industry Scheme (CIS) deductions for insolvencies commencing on or after 1 December 2020.
We take a look at some of the practical issues that may arise, as well as potential actions that should be considered by lenders and borrowers.
Commencement and time limits
The new rules will apply to tax debts (VAT, PAYE, employee NICs or CIS deductions) for insolvencies commencing on or after 1 December 2020, there is no cap on the age or amount of tax debts that attract preferential status. As a result, tax debts that accrued before 1 December 2020 (potentially up to 20 years ago in relation to cases of fraud) could still have preferential status in a subsequent insolvency.
Many businesses have significantly higher tax debts than normal due to the coronavirus support measures introduced by the government, making it even more important for lenders to understand the tax risks and profiles of their customers. For example, HMRC estimates that businesses have deferred c£28 billion of VAT until March 2021 under the VAT deferral scheme, with the option of it being repaid in instalments until March 2022. Similarly, many businesses have agreed PAYE and employee NIC deferrals with HMRC under ‘time to pay’ arrangements. In the event of an insolvency on or after 1 December 2020 this outstanding tax is preferential.
In the run up to the 1 December 2020 ‘cliff edge’, lenders will need to consider their existing customers’ tax status. In particular, this will include those borrowers known to be in financial distress, operating in challenging sectors where there are large regular payments of applicable taxes due to HMRC or where ‘aggressive’ tax planning has been implemented in the past.
Other relevant issues to consider will be whether there are any matters, such as open inquiries or litigation, that could be included in HMRC’s preferential claim in the event of an insolvency, diluting the floating charge holders’ recovery.
Origination and credit procedures
Lenders will need to assess and model the risk of HMRC debts eroding security value, whether that is in the context of pre-lend reviews, option reviews or on an ongoing basis. This will require lenders to have visibility over the borrower’s tax profile and attitude to tax risk.
As part of their origination and credit procedures lenders will need to consider how the tax position of the borrower may impact upon matters such as:
security values and how these may be maximised
the pricing of facilities to compensate for increased risk
perfecting, supplementing or taking fixed charge security
notification obligations that should be placed on borrowers if there is a change in tax status that may impact upon floating charge security (eg late payment of a tax debt).
Review and monitoring of customers’ tax affairs
Any tax matters that could impact the value of the lender's security will be of particular significance. As a result, lenders may require visibility over matters such as:
open enquiries from HMRC
whether customers have entered into or are considering time to pay arrangements with HMRC to defer tax payments
whether they have accessed the government's VAT deferral scheme
sector specific tax risks, eg IR35 for businesses with subcontractors, and proposed VAT changes for construction companies
any tax planning undertaken (especially where that planning must be disclosed to HMRC under its Disclosure of Tax Avoidance Schemes legislation)
management's approach to tax reporting and risk generally.
If particular tax risks are identified in a customer’s business, or if a business is anticipating difficulties in satisfying its tax obligations, then steps may need to be considered to mitigate that risk.
For example, if a borrower is in a VAT group and has joint and several liability for VAT debts of other group entities that sit outside the security net, then there may be benefit in considering whether the borrower should be separately registered so that it is ringfenced from wider VAT group liabilities going forwards.
Other actions that lenders may consider include regular briefings on tax status, holding additional reserves in lieu of tax or, if appropriate, the customer obtaining tax insurance.
If a borrower is suffering financial distress, this may change the options available to secured creditors, for example, enforcing may reduce the return compared to a consensual restructuring.
Putting a business into insolvency is not a decision that is taken lightly, but lenders need to protect their position and minimise their exposure to losses. HMRC’s preferential status is one more factor to consider when exploring a way forward and could make some previously viable options less attractive to the secured creditors.
In an insolvency, HMRC will need to engage with insolvency practitioners to quantify and agree its claim, including providing tax clearance before funds can be released to the floating charge and unsecured creditors.
It is unclear how HMRC intends to engage in insolvency processes, especially where it is required to vote. In addition, it will be even more important for HMRC to give meaningful clearance to insolvency practitioners that all tax matters have been addressed and that it has no objection to the distribution and subsequent closure of the case.
Currently, HMRC can take several months to give tax clearance (if at all) and this could lead to delays in distributions to floating charge holders and other creditors. Creditors will need to take this into account in their expectations of the timing of distributions out of insolvency.
There are continued calls for HMRC's preferential status to be put on hold. However we consider this unlikely given the current economic circumstances. Lenders should factor it into their decisions now, especially given the retrospective nature of the rules and that many businesses are carrying substantially higher than usual tax debts.