HMRC is currently an unsecured creditor in an insolvency process for tax debts. The Finance Bill 2019-20 will make HMRC a secondary preferential creditor for VAT and certain tax debts paid by employees and customers in insolvency proceedings commenced on or after 6 April 2020. As a consequence, HMRC will rank above floating charge holders and unsecured creditors for the relevant taxes paid to insolvent businesses by their customers and employees through a deduction by the business, for example, from wages, PAYE, employee NICs and Construction Industry Scheme deductions. There are no restrictions on HMRC’s claim in time or amount and the claim could potentially absorb all floating charge realisations.
In addition, the Government plans to increase the “prescribed part” for unsecured creditors (ring-fencing recoveries for unsecured creditors in priority to floating charge holders) from £600,000 to £800,000.
What does this mean for asset-based lenders?
HMRC’s recent consultation paper “Protecting your taxes in insolvency” (26 February 2019) states: “the government does not expect it (the elevation of HMRC to secondary preferential creditor) to have a material impact on lending, and the Office for Budget Responsibility made no adjustment to its forecast as a result of this measure.” The reasoning behind this statement is that, “Financial institutions will remain above HMRC in the creditor hierarchy for fixed charges they hold over assets and the debts they will no longer recover are a very small fraction of total lending.”
However, this new legislation will have an adverse effect on the asset-based lending industry. It is not feasible or practical to procure fixed charges over certain categories of assets and it will increase the risks for lenders providing funding using floating charges as security as it reduces the realisations available in insolvency under the lender’s floating charge. Lenders will have to take into account the prospective deductions in calculating availability and assessing their exit strategies. As a consequence, lending by asset-based lenders to SMEs will be reduced.
HMRC argues that unsecured creditors will also not be affected, “Other unsecured creditors – such as suppliers – are usually unable to recover any of their debts and so most will be unaffected. They currently only recover 4% of debts owed on average.” This provides little comfort for unsecured creditors whose prospects of recovery from insolvent debtors are not enhanced by this legislation. Prudent unsecured creditors may refuse to extend credit without the benefit of credit insurance and this may result in an increased demand for the bad debt protection provided by many discounters. Indeed, the new legislation favours funders who structure their funding to SMEs as an outright purchase of debts as their title to the purchased debts is not affected by the change in priorities.
When does the legislation take effect?
On 6 April 2020. The new rules will apply to lending facilities entered into prior to this date as there are no transitional provisions.
How should asset-based lenders prepare for the change?
Asset-based lenders should review their availability calculations and forms of Borrowing Base Certificates to reflect the new priorities. They should also consider how to monitor the level of secondary preferential debt owed by their borrowers to HMRC through reporting obligations and audits, whether reserves and Net Orderly Liquidation Value calculations in inventory appraisals need to be adjusted and whether their pricing of relevant facilities is affected. It is possible that ABL Facility Agreements will need to be amended to accommodate the impact of the changes and the application of revised controls and processes.
It is probable that CVAs will be less viable if HMRC has preferential status as a CVA cannot compromise a preferential creditor’s claim.
Note that HMRC will remain an unsecured creditor for taxes levied directly on insolvent businesses, such as Corporation Tax and employer NICs.
For further information about how you can prepare for the Finance Bill 2019-20, contact partner Chris Willison or your usual adviser at Francis Wilks & Jones.