Happy New Year and welcome to our January 2021 article on the restoration of Crown Preference. Click here to read the previous article on these matters.
For almost 20 years, taxes collected by UK corporates for payment to HMRC have ranked as ordinary unsecured debts on an insolvency. But, back in 2018, along with various other proposed legislative reforms, the government announced that it would be changing the way in which business insolvencies will be handled, so that HMRC would once again get preferential treatment over non-preferential and floating charge holders, in respect of certain taxes – the so-called ‘Crown Preference’.
From HMRC’s point of view, the change (which has taken effect from 1 December 2020) gives it an improved chance of reclaiming the predicted c.£185m per year it previously lost, which was paid by employees and customers to UK corporates but not passed on to the Exchequer when the company subsequently became insolvent. For one, the measures are negative news for those businesses – especially SMEs – which, as a result of the fall-out from the Covid-19 pandemic, have taken advantage of the option to defer VAT payments, or fallen behind with payments and therefore have greater than normal liabilities to HMRC.
Pursuant to section 98 of the Finance Act 2020 (the “Act”) and The Insolvency Act 1986 (HMRC Debts: Priority on Insolvency) Regulations 2020, in insolvency proceedings opened from 1 December 2020, certain tax debts will be given secondary preferential status in the insolvency waterfall, ranking behind fixed charge holders’ claims and ordinary preferential debts (for example, preferential employee claims) but ahead of both floating charge holders’ claims and unsecured creditors.
The tax debts to be given such priority are VAT, PAYE, employee NI contributions, construction industry scheme deductions and student loan repayments (“Priority Taxes”).
The preference applies to all such Priority Taxes, regardless of when they arose. It is not limited to a specific period pre-insolvency nor is it restricted to any such tax debts arising on or after 1 December 2020.
Note that HMRC will remain an unsecured non-preferential creditor for all other tax debts, such as employer National Insurance contributions and corporation tax. These taxes are not specified deductions for the purposes of the Act as they are collected by HMRC, directly.
Impact on lending
Many lenders have typically taken security over a borrower’s assets by way of floating charges (security interests over non-constant assets, that change in quantity and value) unconcerned that HMRC could rank ahead of them on the borrower’s insolvency.
However, under the new regime, an insolvent company’s unpaid Priority Taxes could have a significant impact on a lender’s recovery and, in fact, make lenders think twice about advancing money on the back of changing assets. This is because any such liabilities will now be paid to HMRC from the proceeds of floating charge assets, before amounts owing to the floating charge holder and other unsecured creditors.
To compound matters, this is not the only recent change relevant to the insolvency order of priority that affects floating charge holders. On 6 April 2020, the Insolvency Act 1986 (Prescribed Part) (Amendment) Order 2020 came into force, increasing the maximum amount of the prescribed part (the monetary amount set aside for the benefit of unsecured creditors out of the floating charge realisations) from £600,000 to £800,000.
Floating charge lenders will therefore need to be mindful that they may be subordinated by a further £200,000 to preferred creditors, in addition to an effectively uncapped amount for HMRC, in respect of Priority Taxes.
To put further strain on matters, reduced lender returns might also be exacerbated by the significant amount of tax due to HMRC, as a result of deferrals introduced by the government during the Covid-19 pandemic. Any deferred amount could, potentially, form part of any insolvency claim by HMRC, should an insolvency event occur prior to these tax liabilities being settled.
Greater emphasis on fixed asset security
It seems inevitable that there will be greater emphasis from lenders on taking fixed charge security and the valuation of fixed charge assets. This could negatively affect companies which, by their nature, are heavily reliant on floating charge assets, such as stock and receivables and which would essentially be required to ‘lock up’ their businesses to be able to provide fixed security over assets.
The increased insolvency risk to lenders means that companies that cannot provide fixed asset security might find that the amount of credit available to them is reduced. Alternatively, lenders might request further security in the form of corporate or personal guarantees. For directors, this potentially means more exposure to financial risk and personal liability.
Given the retrospective nature of the legislation, lenders must carefully review and possibly refresh existing security packages to get the benefit of fixed security, if that is feasible. By way of example, in appropriate cases, plant and machinery security could be taken in the form of a chattels mortgage, so that title to the assets is transferred to the lender, until the debt has been repaid.
But fixed charge security is often more easily written than achieved. Legally, it is not sufficient merely for the security documents to describe fixed charges and associated restrictions – the lender must be able to demonstrate that it exercises control over the secured asset in practice, to avoid the risk that the charge is characterised as floating, rather than fixed. For most lenders, this level of control is practically challenging and may actually increase underlying asset monitoring and preservation costs.
Due diligence and ongoing obligations
Lenders who are willing to take floating charge security are likely to more closely scrutinise the tax position of a borrower before they advance monies. Companies should expect to be more open about their tax position and to make more detailed disclosures to a potential lender, including any significant deferred tax payments due to HMRC.
Representations and warranties in legal documentation relating to tax compliance are likely to become even more important. Lenders will not only want to fully evaluate a company’s tax position before lending, but also on an ongoing basis, to ensure that borrowers are complying with their tax obligations. This is likely to be reflected in the loan documentation – for example, repeating representations through the lifetime of a loan that tax payments are up-to-date and including information undertakings to regularly provide taxation information and disclosure of any significant deferred tax balances. Lenders may also potentially seek the ability to ‘audit’ the company’s tax affairs, with complete and accurate tax records becoming a condition precedent to financing.
The re-emergence of Crown Preference may also reduce the use of Creditor Voluntary Arrangements (“CVAs”) as a restructuring tool. A CVA cannot bind secured or preferential creditors without their consent, so the new preferential tax debts will likely need to be paid in full in a CVA (unless HMRC consents otherwise). Given it is unlikely that CVAs will propose any compromise to HMRC preferential claims, the issue is likely to be whether there’s anything left in the troubled company to propose a CVA, which is realistically acceptable to unsecured creditors.
On the other hand, there is no restriction on compromising preferential debts in a scheme of arrangement or the new restructuring plan introduced by the Corporate Insolvency and Governance Act 2020 but, in a scheme of arrangement, preferential creditors will usually form a different class of creditors and so may have a veto right. The restructuring plan introduces a form of ‘cross-class cram-down’, provided that the members of the dissenting class would not be any worse off than in the event of the most likely ‘relevant alternative’ scenario. But the fact that the ‘relevant alternative’ will likely be an insolvency process (where preferential debts rank ahead of floating charge holders) means that the new restructuring plan will not help to overcome the problem the Crown Preference now poses.
The government has stated it believes the change will not have a significant impact on the SME lending market. However, the diminished worth of floating charge security as a result of these measures may well affect asset-based lenders’ appetite to lend and the cost and availability of finance for SMEs, at a time when inflow of credit is critical to the economic recovery.
The Office for Budget Responsibility has forecasted the change will generate £185m for the government, each year. This is a decent figure, but only a tiny proportion of the UK’s total annual tax revenues. The impact of getting this amount into the Exchequer’s coffers should be weighed against the broader cost to the UK economy, if the result is to cause lenders to limit the availability of finance to SMEs. If the reform does have a material impact on willingness to lend, it will be interesting to see whether the government reviews the position again.