HMRC’s crown preference scares away rescue finance lenders

Scheduled to take effect on December 1, a change to make HMRC a secondary preferential creditor in respect to certain taxes will make it more difficult to raise capital for business restructuring according to insolvency practitioners, as HMRC gets pushed up the creditor priority ladder above unsecured floating charge creditors.

“[This change] will make access to business rescue finance more difficult. Floating charge finance is one of the most readily used tools for business turnaround,” says Duncan Swift, head of restructuring and insolvency at Moore UK and past president at R3, trade body for insolvency and restructuring.

“Many insolvency practitioners like myself typically try to rescue the company without needing to go into the formal insolvency process. This change makes that more difficult because of the reduction in business rescue finance.”

HMRC’s secondary preferential status will enable it to collect certain debts before floating charge and unsecured creditors. The relevant taxes which will rank as a preferential debt are limited to tax collected on behalf of HMRC such as VAT and PAYE. Assessed taxes like corporation tax continue to rank as an unsecured (non-preferential) claims.

“The direct impact is that, for those relevant taxes, HMRC is going to come out ahead of the floating charge-holders and unsecured creditors. That means recovery of those creditors is going to be lower,” says Kate Stephenson, partner at Kirkland and Ellis.

“The indirect impact is lenders may be less willing to lend in the first place, or they may look to charge a higher rate to reflect the increased risk.”

Swift echoes this sentiment giving an example of a food manufacturing client who saw the amount of money they could raise with floating charges decrease by 40 percent because of this change. He adds that for floating charge financiers, the reforms make lending unattractive.

“If you’re the lender, it’s going to be unattractive because you will need to have a pretty good understanding of your borrower’s tax compliance and record keeping in terms of tax records going back several years.”

HMRC previously held preferential status until 2003, when the Enterprise Act of 2002 abolished it. The government’s intention of returning HMRC’s preferential status was first announced in the Autumn budget of 2018, but it was not legislated on until the Finance Act of 2020 in July. With the bill receiving royal ascent, HMRC’s preferential status will be reimposed starting on December 1.

This could possibility create a pinch point to creditors of distressed businesses says Amy Gallimore, legal director for restructuring and insolvency at Ashfords.

“Some lenders may take action in advance of the December 1. Lenders where their debtor is close to distress or insolvency might be accelerating those companies into a process to make sure they get priority before the December deadline.”

Whereas in the pre-2003 preference HMRC could only have priority for outstanding tax in the 12 months prior to insolvency, the new reforms have no time limit.

“Any relevant tax which has been deferred or not paid by December 1 will be captured by the reforms, at least on the face of the Finance Act. There is potentially a higher amount of unpaid taxes given the current coronavirus impacted market, which in turn further increases the risk for other creditors,” says Stephenson.

The government’s 2018 budget briefing suggested that returning HMRC secondary preferential status could raise up to £195mil annually. However, UK Finance estimates the indirect adverse displacement of floating charge capital to be at least £1bn per year.

“That assessment didn’t take into effect the bigger impact of access to finance for struggling companies, which may cause more companies to fail,” says Swift . “This in turn may cause a greater loss for taxpayers through having to fund the redundancies payments and the loss of tax revenues from a rescued business.”

HMRC during insolvency proceedings

Another potential problem that arises with HMRC’s new status is within Company Voluntary Arrangements (CVAs). Interviewees have said there are concerns within the industry that giving HMRC preferential status will provide them too much influence and that their interests may not always align with those of other creditors.

According to Stephenson, “within CVAs, you can’t compromise preferential creditors without their consent. Once those taxes get preferential status, they cannot be compromised in a CVA unless HMRC specifically consent.

“The government is trying to assuage concerns in this regard, but until the reforms take effect, and we start to see how HMRC acts in some of these procedures, we can’t say for sure.”

Swift says that HMRC as a creditor during CVAs have become “disengaged” making it more difficult to save a company as a going concern.

“HMRC [over the past six years] have not been exercising their rights in formal insolvencies. For instance, an administrator may have proposals as to how a business can be best rescued, but HMRC sits on their hands and the proposal doesn’t get approved. Or in another example, the administration can end in a CVA where it’s commercially good sense, 30p to 50p to the pound can be available to unsecured creditors, if HMRC will accept the haircut.”

He hopes that if HMRC becomes a preferential creditor they will take a more proactive role in future insolvency procedures.

“If HMRC expects to have and will now be given such priority they should step up to the plate and use the powers and the responsibilities that is expected of them as a major creditor to assist the insolvency practitioners in seeking to get the best recovery for creditors as a whole.”

Gallimore says a possible “silver lining” is that HMRC may become a bit less liberal with their use of winding up petitions.

“If HMRC is put in this better position, it might be more relaxed, about winding up companies and actually exercising its rights because it will be better placed if a process were to happen.”

According to those interviewed, the viewpoint within the insolvency and restructuring industry is that this change will be for the detriment of both businesses and taxpayers.

Swift says R3 will continue to lobby against this reform and for its repeal.

“We’ve gone to great lengths to demonstrate the adverse consequences of this proposal. It’s coming in at the worst possible time when the government is seeking to withdraw coronavirus related working capital support. Let alone the fact that there was never a good time for it to be introduced.”