Last year we reported on the UK government’s consultation to crown HMRC with a promoted ranking in the insolvency of corporates and individuals. The consultation is now over and the new legislative provisions that will bring this coronation into law took effect from 1 December 2020 via the Insolvency Act 1986 (HMRC Debts: Priority on Insolvency) Regulations 2020.

What was the position before 1 December?

HMRC ranked as an unsecured creditor for tax debts owed by insolvent entities. Corporate insolvency law provides for the following priority of repayment of debts from any money available in an insolvency (usually generated from the sale of the insolvent entity’s assets):

  1. Fixed charge holders
  2. Fees and expenses of the insolvency practitioner
  3. Preferential debts, primarily limited to certain amounts due to employees
  4. A prescribed amount set aside for unsecured creditors from the proceeds of selling assets subject to floating charges known as the “Prescribed Part” up to a maximum of £800,000
  5. Floating charge holders
  6. Unsecured creditors, usually ordinary businesses and individuals, who rank equally among themselves

Often unsecured creditors will see little if any repayment in an insolvency.  Research by R3 - the Association of Business Recovery Professionals - suggests that unsecured creditors receive an average repayment of 1% - 3% of their debt in corporate insolvency.  Before 1 December, HMRC fell into this final category.

What’s changed?

From 1 December, HMRC will jump up from 6th to 3rd in the above list of priorities, becoming a “secondary preferential” creditor ranking behind existing preferential creditors (such as employees).  This means that HMRC will be paid ahead of floating charge holders and unsecured creditors.

Despite close scrutiny, and criticism, of the changes by government and interested third party lobbyists, the government has nevertheless enacted the vast majority of the original proposal on which it consulted.

The new law will apply to insolvencies commencing on or after 1 December 2020. Both new and existing floating charges are affected.  The taxes that will enjoy the new secondary preferential status include VAT, PAYE income tax, student loan deductions, Construction Industry Scheme deductions, and employee National Insurance contributions.  However, HMRC will still remain an unsecured creditor in an insolvency for taxes like corporation tax, capital gains tax and employer National Insurance contributions.  As the government recently improved the position of unsecured creditors by increasing the Prescribed Part (4th in the above list of priorities) from £600,000 to £800,000 in respect of floating charges created on or after 6 April 2020, it will also benefit from that legislative change when recovering non-preferential taxes.

What’s the rationale?

Employees and customers pay tax to businesses, which businesses hold on trust before accounting to HMRC.  The rationale is that HMRC should receive these funds in an insolvency so that it can use them to fund public services.  When HMRC initially announced the proposal, it expected the changes to raise up to an additional £195m a year and advised that doing so would enable more taxes “paid in good faith to go to fund public services as intended.”

What’s the impact?

The changes will adversely affect the value of floating charges – usually held by banks who lend money to businesses – in insolvencies where preferential debts are owed to HMRC.  Floating charge debts will rank behind the newly crowned secondary preferential HMRC debts, meaning that once HMRC has received payment of preferential debts from the funds available in an insolvency, there is likely to be far less (if anything) left in the pot to repay debts owed to the floating charge holder.  In addition, other unsecured creditors like pension schemes and consumers, which rank 6th in the above list and used to rank alongside HMRC, will be disadvantaged and receive a lower return in insolvencies by the elevation of HMRC.

Industry’s response suggests the changes will likely have an adverse affect on the lending market. It is possible that access to finance could become more difficult by way of inflated costs of finance.  Banking and finance industry body UK Finance estimates at least £1 billion worth of floating charge finance will be removed from the total pool of money available to companies.

Scotland is expected to be impacted more significantly than England & Wales: taking fixed security in Scotland over moveable assets is generally unworkable and, therefore, more uncommon in comparison to England & Wales.  North of the border, lenders therefore rely much more on floating charges to protect their position.

Directors may increasingly be expected to give personal guarantees to obtain funding - exposing them to potential personal liability.

What can lenders and debtors do to mitigate the impact of the changes?

There are a number of options available to mitigate the increased risk of lending posed by the changes.  Some key strategies include:

  1. Lenders reviewing existing security packages to ensure maximum protection in insolvency scenarios – legal advice should be sought to:
    1. ensure that all existing securities are valid and are being used appropriately; and
    2. evaluate whether fixed security over particular assets is available where it is not already held, so that proceeds from the sale of that asset in an insolvency will rank as fixed charge realisations (ie. 1st in the above list of priorities – ahead of HMRC) in any debtor’s insolvency.
  2. Encouraging debtors to keep up to date with tax payments as they fall due – this can be achieved both informally on the front line by relationship managers but also by agreeing with debtors to amend loan documentation and include new representations, warranties, and undertakings in respect of tax liabilities.  Ultimately, if there are no/minimal tax liabilities, HMRC’s new ranking in insolvency will pale into insignificance.

Whilst the consequences of these new laws are set to be significant and far-reaching, lenders and debtors have the opportunity to take some steps to mitigate the risks.  It’s therefore important that the planning is done now, and not left until the stage of a debtor entering into an insolvency process.