The return of HMRC preference

The return of HMRC preference

Sweet Midsummer night dreams?

After a year in which numerous businesses have relied on various forms of government support to stay afloat, many will be hoping that 2021 offers the chance to emerge from this period and resume some degree of normal trading. Certainly, the coming year will be make-or-break time for those businesses that have been most impacted by the pandemic – and as government assistance is wound back, the demand for working capital funding is likely to be high.

It is against this background that the re-introduction of "Crown preference" comes into force. Effective as of 1 December, this brings in preferential treatment for HMRC in respect of certain tax debts when a company enters administration or liquidation, and is a major change to the order of priority in which creditors are paid out in a company’s insolvency. The key change is that HMRC will now be paid out ahead of lenders with floating charge security and all unsecured creditors.

The direct consequence of this will be a significant reduction in the amounts available to distribute in a company’s insolvency to creditors – both to secured floating charge lenders, and to unsecured creditors such as trade creditors and customers. It raises fears that the indirect outcome of the changes could be to reduce the availability of floating charge lending to businesses that may be struggling to obtain funds elsewhere, while also negatively affecting the likelihood of business rescue.

What has changed?

In a company’s insolvency, the order in which creditors are paid out of the company’s assets is set by legislation, and a lender advancing finance will seek to minimise its insolvency risk by ensuring that it comes as high up the ladder as possible. Typically (in England and Wales), a lender will take a fixed charge in relation to any assets over which the borrower does not need to have day to day control – such as plant or equipment. If the company were to go into an insolvency procedure, the lender would be entitled to the proceeds of sale of any fixed charge assets before any other creditors were paid out.

However, a fixed charge by itself may not be sufficient to secure all of the funding needs of a business, and in particular small-medium enterprises often have limited fixed charge assets. The lender will therefore also typically take a "floating" charge over the remaining pool of the company’s assets, including items such as stock in trade and book debts.

Prior to the changes brought in on 1 December, only the expenses of the insolvency, limited preferential debts, and a ring-fenced amount for unsecured creditors (the “prescribed part”) would be paid out in priority to the floating chargeholder [see table below].

Order of priority pre-1 December 2020New order of priority
Fixed charge holdersFixed charge holders
Expenses of the insolvency processExpenses of the insolvency process
Preferential debts (primarily in relation to limited classes of employee claims)Ordinary Prefential debts (primarily in relation to limited classes of employee claims)
Prescribed part set aside for unsecured creditorsSecondary preferential debts to HMRC
Floating charge holdersPrescribed part set aside for unsecured creditors
Unsecured creditors (including HMRC)Floating charge holders
                                                            Unsecured creditors (including HMRC in relation to debts which are not secondary preferential debts)


However, the Finance Act 2020 has made a substantial change to the pre-existing order of priority. HMRC now ranks as a "secondary" preferential creditor in relation to certain debts including VAT, PAYE, Employee NICs and construction industry scheme deductions. In respect of any arrears relating to these taxes, HMRC will be paid in full before the floating chargeholder receives any return from the realisation of floating charge assets [see table above].

It is worth noting that not all debts owed to HMRC will receive preferential status – HMRC remains an unsecured creditor for taxes directly related to the business, such as corporation tax and employer NICs, and amounts due in relation to penalties and interest. Notwithstanding this, the effect of the new class of secondary preferential debts is to reduce the value of a floating charge dramatically. In cases where an insolvent company has built up substantial tax arrears, little or nothing may remain for distribution after the debt to HMRC has been paid – and the floating chargeholder and unsecured creditors will be left out of pocket.

The repercussions of this re-introduction of Crown preference on business finance are exacerbated by its retrospective effect. The new class of preferential debts takes precedence not just over floating charges created after 1 December 2020, but over floating charges whenever created. It therefore significantly elevates the risk level in relation to floating charge security which may have been taken some time ago, and well before the changes made in the Finance Act 2020 were on the policy radar.

Furthermore, it does not apply only to tax arrears built up over a specified period (for instance in the year prior to insolvency) but to all historic tax debts in the specified classes. The net result is that not only new lending, but also existing business funding is affected by what could be potentially a large reduction in floating charge realisations.

What challenges does this present for businesses?

The government rationale behind this policy is that taxes which employees and customers have paid to businesses in good faith should be used to fund public services, rather than be distributed to creditors. The intention is to capture taxes which have been collected by a company on behalf of HMRC, on the grounds that the funds were never truly the property of the company to use in meeting payments to creditors. In its 2018 Budget briefing, the government suggested that the increased tax revenue attributable to Crown preference could raise up to £185m annually for public services. The government has stated that this represents a small fraction of the SME lending market in the UK and therefore should not have significant impact on access to finance.

There can be no doubt about the urgent need for public funds at the present time. However, there are widespread concerns over the challenges posed for businesses and lenders by the elevation of HMRC’s status on an insolvency. The unfortunate outcome of the government’s decision is that the floating charge finance, relied on by many companies, may become harder to obtain or be subject to more onerous terms. Existing floating charge facilities could also be reduced in response, pushing some borrowers into default.

The businesses likely to suffer most are also those who are most in need of assistance, notably small to medium enterprises – particularly in struggling sectors such as retail, which rely heavily on floating charge lending to purchase stock. Such businesses may have benefitted from VAT deferral and possibly defrayed other tax debts (with HMRC’s agreement) to see themselves through periods of lockdown. Unfortunately, they could now find that this build-up of tax liabilities means that they struggle to access lending on reasonable terms, just as they seek to restart their business and adapt to new trading realities.

Lenders will have to assess both new and existing finance and security structures, on the basis of an evaluation of the borrower’s tax position potentially going back several years. This will impose an increased cost and administrative burden for lenders as they seek to gain a clear picture of a borrower’s liabilities in relation to the new class of preferential debts. No doubt the cost of such due diligence will ultimately be added to the lender’s fee, whilst the time involved in doing so could also delay the agreement of loan facilities. Meanwhile, pricing of lending secured by a floating charge is also likely to increase, to take into account the risk of floating charge realisations being reduced – or even wiped out altogether – by HMRC’s preference claim.

Will this cause more insolvencies?

Insolvency figures for the past few months have been artificially suppressed due to government support measures and restrictions on the ability to issue statutory demands and winding up petitions. Although further extensions of at least some of these measures into next Spring are possible, indeed likely, it is inevitable that we will see an uptick in insolvencies as and when they are eventually lifted.

The return of Crown preference will not itself be the cause of these company failures. However, pressure on directors will undoubtedly be increased if they face a funding shortfall, at a time when their company may already be struggling and facing an uncertain outlook. If lenders are unwilling to lend with the reduced benefit of the floating charge, then, in the absence of an alternative, this could lead to more insolvencies.

Meanwhile, the ability to rescue businesses, through procedures such as administration and company voluntary arrangements (CVAs), could be impacted. Increased insolvencies may rebound on other small businesses such as suppliers, particularly as the likelihood of there being any dividend for unsecured creditors is severely reduced.

Floating charge funding is often a key source of rescue finance, and lenders might now be less willing to lend in distressed situations, making it harder to rescue struggling companies. Meanwhile, CVAs, which are often used to restructure a company’s debts, will become difficult to achieve with HMRC as a preferential creditor, as it will not be possible to compromise their claim without their consent (which is unlikely to be given). Meanwhile unsecured creditors, who will be set not to receive any return due to HMRC’s prior claim, may simply not engage with the process as they will see little return. The consequence may be more companies falling into liquidation, as it is not possible to rescue them through other procedures.

What are the options available to companies?

UK Finance has estimated that the amount of floating charge financing available to companies will be impacted to the tune of £1bn, which in real terms could represent a large number of businesses seeking alternative methods of obtaining funding. However, it may be that predictions of a large-scale funding crisis are overstated. Lenders have a number of other methods of protecting themselves from a borrower’s insolvency, which will no doubt be relied upon now that the value of their floating charge is compromised.

One consequence of this is that, as well as seeking to secure assets by way of fixed charge, assignment or trust so far as possible, lenders are likely to look increasingly to corporate and personal guarantees. Directors should be aware of the risk to their personal assets, given the heightened likelihood of any personal guarantee now being called upon in an insolvency.

Alternative forms of working capital financing exist which may ameliorate the funding gap – for instance the use of invoice discounting lines and invoice factoring. More complex structures may also be explored in relation to larger loan facilities, for instance separating liabilities or assets into ring-fenced special purpose vehicles (SPVs) within the group. However, the cost and complexity of such structures mean they are unlikely to be employed in relation to standard small to medium business loans.

A price worth paying?

It may be that, through alternative methods of securing corporate borrowing, the impact of Crown preference on company funding can be ameliorated. However, for companies already on the brink of insolvency, it is likely that it will severely impact the business rescue culture that has developed in the UK since the Enterprise Act of 2002 (which removed the old Crown preference).

With challenging times ahead for all, the unintended results of the introduction of HMRC preference may well prove to outweigh the relatively small boost to the public purse. It is hoped that flexibility and innovation in the lending industry will reduce the effects, but at present, it seems that the costs to business could be high.

First published in World Financial Review, see here. Republished with permission.

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