Reinstating the hierarchy of HMRC

It wasn’t so long ago that HMRC safeguarded substantial recoveries from insolvent companies’ unpaid taxes. It did so by virtue of the “crown preference” meaning that HMRC sat pretty as a preferential creditor in a company’s insolvency.

All taxes becoming due in the 12 months preceding insolvency (6 months for VAT), were paid to HMRC in priority to any floating charge holders and unsecured creditors.

However, following the Enterprise Act 2002, HMRC was stripped of such privilege and relegated to unsecured creditor. At the time this was intended to encourage business rescue through lending that was either unsecured or secured by floating charge only. It was also intended to allow a better chance of pay outs to trade creditors (also unsecured) lower down the pecking order in formal company insolvencies.

Despite the Enterprise Act being seen as a step forward by the banking and insolvency market, it seems we may soon be taking a step back to HMRC’s preferential status being restored… but not right back to where we began.

The budget and the consultation

In the 2018 budget, Chancellor Philip Hammond announced that from 2020 HMRC’s status as a preferential creditor would be restored. But not for all debts owing to the ‘taxman’, just for certain tax debts that originally stem from customers and employees. HMRC has now launched a consultation on the proposal and its implementation. Whilst the consultation should lead to some much needed clarity on the precise nature of the change, this is what we know so far:

• As mentioned above, the preferential status will only apply to taxes due from employees and customers. This means that VAT, PAYE and employee NICs (National Insurance contributions) will be captured.  The reasoning is that the company is just holding onto these sums having collected them from customers and employees on behalf of HMRC. When it comes to direct company taxes such as corporation tax and employer NICs, HMRC will remain an unsecured, unpreferred creditor in the payment hierarchy.
• HMRC is to become a secondary preferential creditor, after fixed charge holders and ‘ ordinary’ preferential creditors (which are mainly employees and occupational pension schemes up to certain limits). They will however rank before the prescribed part (which is a percentage of the funds realised from floating charge assets that is put aside for unsecured creditors), floating charge creditors and unsecured creditors.

So, the current preferential creditors continue to be protected on a company’s insolvency but floating chargeholders and unsecured creditors fall further down the line.

• The preferential amount will include all interest and penalties.
• There will be no time limit in respect of the debts that are due meaning the tax office could open enquiries into the historical tax affairs of the insolvent entity.
• The change is to apply to insolvencies commencing on or after 6 April 2020.

The Chancellor said that the purpose of the change was to “ensure that tax which has been collected on behalf of HMRC – is actually paid to HMRC”. It is expected that this change will generate up to an additional £185m to the Inland Revenue per year. But could this mean an equivalent £185m loss to creditors further down the pecking order? HMRC suggests that unsecured creditors such as suppliers are so unlikely to recover any of their debts anyway, they will be unaffected, but this seems to ignore the ‘prescribed part’ set aside for unsecured creditors out of floating charge assets.

The unknown future

In its economic impact assessment, HMRC doesn’t expect the change to have a material impact on lending although that assessment seems to be based on the assumption financial institutions will have fixed charges. It doesn’t seem to examine different categories of lending for different types of borrower.  Lenders may need to limit their risk exposure, based on less money flowing down to floating charge holders and monitor their security more closely. There will surely be costs associated with this and this could be reflected in an increase in lending rates.

Particular concern could be seen in the asset based lending (ABL) market. Companies which do not own significant assets over which they can grant fixed charge security as collateral for borrowings, are often able to secure lending against floating charge assets, such as stock. The borrowing base (i.e. the amount which the lender agrees to provide), is usually calculated based on a valuation of the floating charge assets, taking account for the finance credit risk by factoring in reserves which are deducted from the value of the assets.

The extent of a company’s HMRC debt which would be paid out prior to the floating charge lender will have a direct effect on the reserves applied, and therefore the funding available to companies without significant fixed assets. Additional costs involved in this type of lending are likely to be incurred conducting more in-depth reviews of a potential customer’s tax history (especially given HMRC’s ability to open investigations long after a tax period has ended). It is expected that these costs will be passed on to the client.

The announced change was greeted with scepticism in the market. Suggestions have been made that the “promotion” could result in HMRC taking a more aggressive approach to triggering insolvencies through winding up petitions, now that they are to benefit more from recoveries. HMRC has confirmed that Time to Pay arrangements will continue to be offered but with particularly unstable businesses, there may be an increased incentive to obtain a more certain payment of tax liabilities through company insolvency.

We may also see an increased appetite for creditors to take enforcement action sooner rather than later, before April 2020, to avoid HMRC trumping them in terms of the recovery proceeds after the effective date.

The consultation period ends on 27 May 2019, and when the findings are reported on we should have greater clarity on the proposed changes. However we are likely to remain largely in the dark as to the extent of the effect on the cost of borrowing until the change is introduced and has had time to settle in the market. As the uncertainty around Brexit looms, it does perhaps seem the wrong time for further uncertainty in the market for borrowers and funders alike.