Currently, employees and the Financial Services Compensation Scheme (FSCS) are the only preferential creditors in an insolvency. However, in a few months’ time HMRC will join the FSCS as a secondary preferential creditor in relation to outstanding taxes ‘paid’ by employees and customers that are held by a business on its behalf, such as PAYE, VAT, employee NICs and Construction Industry Scheme (CIS) deductions.
HMRC will remain an unsecured creditor for corporation tax and any other taxes owed directly by a company. Crucially, the legislation does not include a cap the on the age of tax debts that can have preferential status.
This means that in an administration or liquidation, HMRC will move up the rankings of who gets paid out first, jumping ahead of floating charge and unsecured creditors.
1 VAT, PAYE (including student loan repayments) Employee NICs and Construction Industry Scheme deductions
2 All other taxes
Read next: Practical implications of HMRC’s preferential status >>
How will this affect lenders?
HMRC states this change will "ensure that when a business becomes insolvent, more of the taxes paid in good faith by that business’ employees and customers will fund public services, rather than these being distributed to other creditors such financial institutions". Lenders should consider very carefully the potential implications that this may have and what steps can be taken, both in relation to its immediate effect and the longer term implications, for example in relation to origination and credit procedures.
Reduced returns for unsecured creditors
HMRC can be one of the largest creditors in an insolvency. Moving up the rankings means that it will receive funds that would previously have been shared equally among unsecured creditors.
Increased risks for creditors with floating charge security
HMRC’s claims in respect of the above taxes will now take precedence over any floating charges held by secured creditors – which can often be asset backed debt provided by financial institutions. The assets used in a floating charge are usually current assets, such as stock, receivables or cash. When the changes become effective, the value of security available for lenders will be depleted and any loans that fund floating charge assets could lose security value overnight.
Pre-insolvency planning
If a borrower in a lender’s portfolio is suffering financial distress, these new rules may change the options available to secured creditors. In some cases, enforcing insolvency may reduce the return compared to a consensual restructuring. HMRC’s preferential status is one more factor to consider when exploring the way forward and could make some previously viable options less attractive to secured creditors.
Impact on asset-backed lending
This legislation is expected to have a negative impact on asset backed lending at a time when the market is already facing significant challenges. Lenders are typically able to support borrower’s growth and turnaround by relying on floating charge assets for security. This could be inventory facilities or loans secured by cash flow. With funds available for floating charge security potentially being significantly reduced, it could mean that asset backed lenders reduce or withdraw their levels of finance. As the new rules will affect the whole market equally, it will become increasingly challenging to refinance facilities with alternative funders.
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What should lenders do?
Lenders will need to consider the tax position of potential borrowers when conducting due diligence and assess what impact it may have on unsecured debt or floating charge security.
Consideration should be given to whether the security position could be supplemented, or whether fixed charge security is appropriate.
They should also require their customers to deliver better and more regular information on any changes to their tax affairs and any HMRC arrears in order to understand when HMRC debt may be increasing, especially at the moment when businesses generally have higher than usual tax debts.
The pricing of facilities should be reviewed to compensate for any increased risk.
For more information or advice on these issues contact Chris Laverty, or for specific tax advice contact David Gregory.
Camilla Fawkner
