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The Impact of HMRC Gaining Preferential Creditor Status

The Finance Act 2020, which gained Royal Assent in July this year, means that from 1 December 2020, HMRC will once again become a preferential creditor in insolvencies. This was due to come into force in April 2020 but its introduction was delayed as part of the measures to counteract Covid-19. However, unlike other measures that have been extended further as the pandemic becomes more drawn out than previously thought, this change is quietly being pushed through.

Currently, HMRC ranks equally alongside unsecured creditors in the insolvency of a company, but the changes that will take place in December mean that HMRC will move up the rankings of who gets paid out first, putting them ahead of floating charge and unsecured creditors.

In an already volatile time for the economy, this change will have quite a stark impact on business.

Business Borrowing
From banks to private lenders, business borrowing won’t be the same. It can’t be. There will be more risk for financiers. Currently, a funder will provide an overdraft to a company, with the benefit of a charge over the assets of a business, knowing that if the company were to fail, they would likely make a significant recovery under their floating charge thereby mitigating the risk. Under the new measures, HMRC would leapfrog the funder and be first in the queue to recover against their preferential debt.

Here is an active example of what might happen now. Let’s say a funder provided a £50k overdraft facility based on tangible assets within the business with a value of £100k. As a consequence of the measures put forward by the Government to support the economy, during 2020 the business amassed significant crown debt, they deferred the payments of their March and June VAT periods and have been unable to pay the last 6 months PAYE/NIC liability. This is indicative of the companies that I have been advising recently where the HMRC debt has been in the region of £50k to as much as £250k.

Now let’s say the overdraft is due for renewal on 1 December 2020. The funder, taking into account the changes to make HMRC a preferential creditor, asks the business as part of the renewal process to disclose what HMRC arrears that it has. They declare that they owe HMRC £75k. The funder determines that if the business were to fail, those assets of £100k may realise £50k and this will be absorbed by HMRC. Overnight their security has become valueless. What are the potential consequences? Well for starters, the overdraft may not be renewed, or worse, the directors could be asked for a personal guarantee to support the borrowing. The removal of the overdraft facility could unfortunately push the business into an insolvency process.

This could not come at a more dire time for business. With so many businesses facing cashflow issues, and many others being forced to close for periods, they need all the help they can get. Yet many investors simply won’t be able to take the risk now and offer the support that is so desperately needed. Even support that has been offered, such as Bounce Back loans, is likely to get caught up in the resulting problems, with many companies being unable to pay back what they borrowed.

What does this mean for trade creditors in an insolvency?
HMRC previously had preferential status, but they agreed to downgrade their status in the Enterprise Act 2002, in the main to enable money to flow down to trade creditors. As part of the wide raft of changes, legal charges created after September 2013 no longer had the power to appoint an Administrative Receiver, and the “Prescribed Part” was created that ensured that Banks didn’t just get the benefit of HMRC giving up their preferential status.

With these changes we will be a negative regression back to the days pre 2012 and ultimately trade suppliers to companies will bear the brunt in insolvency. Any chances of making a recovery are likely to now be non-existent.

It will be interesting to see how the credit agencies and credit insurers react to the changes, and are we also likely to see credit being restricted to businesses by its suppliers?

Earlier this year, R3 hit out at the changes. Past President Duncan Swift warned that “HMRC’s new creditor status will harm business rescue efforts at a critical time for the economy.” He further noted the irony of the decision, saying that “this measure, which is being brought in to try and boost the tax take, is likely to reduce the amount of tax collected, as potentially viable companies are not able to be rescued and are forced to close, while growing businesses are less able to tap into the funding they need to invest and expand.” He then added, “There are better ways of improving returns to HMRC than a proposal which works to the detriment of other creditors and the business rescue process.”

I couldn’t agree with this more. How can the government be serious about implementing a change to boost the economy when it will undoubtedly simultaneously lead to financial distress across many businesses?

Until December, we simply won’t be able to know what the impact will be, but it’s hard to see how this won’t make raising finance more challenging, and ultimately it will be unsecured creditors that once again bear the brunt of the pain of a business closure.

If you have any concerns about the financial situation of your business and how this change could affect you, please contact the team at BLB Advisory.