Michael Mulligan, Insolvency Partner at Shakespeare Martineau, discusses the impact of HMRC’s status following from unanticipated news revealed towards the end of 2018.
In a bold, unexpected move in the Autumn Budget 2018, the Government declared that HMRC’s status as a preferential creditor in the insolvency regime is to be restored. Whilst this announcement may have seemed relatively insignificant to neutral observers, it is actually a significant move which could seriously affect the creditors of insolvent businesses.
When a company goes into administration or liquidation, it can be a very stressful time for employees, creditors and customers. It is vital to understand the order of priority of payment and who ranks above whom when money is owed by a bust company.
When a company enters administration or liquidation, each class of creditors must be paid in full (the exception being the ‘prescribed part’ creditors) before funds are allocated to the next class. The insolvency practitioner usually ranks first (for his or her fees of overseeing the insolvency process), followed by secured creditors with a fixed charge (including banks, asset-based lenders and other finance providers), preferential creditors (certain employee claims), secured creditors with a floating charge, followed by the unsecured creditors (currently HMRC, suppliers, contractors, landlords and customer) and, finally, shareholders. It has been this way since the Enterprise Act 2002 abolished Crown preference in 2003. Prior to the introduction of the Enterprise Act, HMRC had ranked ahead of unsecured creditors.
The Enterprise Act marked a turning point in the way the insolvency process was handled in the UK and by removing HMRC’s preferential status, more money was left in the pot for unsecured creditors, who often found themselves left significantly out of pocket when one of their suppliers or customers went bust.
Part of the Enterprise Act reforms was the introduction of the ‘prescribed part’, a ringfenced fund that was made available to all unsecured creditors during an administration or liquidation. The size of this fund was not particularly large – up to £600,000 – and so often, in situations where large numbers of unsecured creditors were affected, some parties found themselves getting very little. Nevertheless, in comparison to the pre-2003 regime, where HMRC took the lion’s share of the unsecured assets, this was at least some small form of compensation. It is uncertain what will happen to the ‘prescribed part’ under the proposed reform and where it will rank.
The recent Budget has added to the general sense of uncertainty which pervades the UK economy at present and creditors of businesses facing insolvency seem set for further hard times. Those who will be the hardest hit are no doubt the unsecured trade creditors.
The beginning of 2018 serves as a good example of what can happen to businesses further down the chain when one of their biggest customers goes bust. Carillion’s collapse made national headlines, and rightly so. One of the UK’s largest contractors went bust overnight, leaving a trail of destruction in its wake. With a supply chain of enormous proportions, hundreds of companies found themselves in tricky situations, and the future of numerous high-profile construction sites hung in the balance.
The impact of this collapse, however, was not immediate, and it is only now that the UK is beginning to see the full effects, with projects running out of capital and beginning to struggle. This makes it all the more disappointing that the Autumn Budget included such a dramatic change to the position of HMRC in insolvency situations, further damaging the fortunes of smaller companies. With businesses already smarting from the tough economic climate and high-profile administrations and liquidations across many sectors, this move is bound to be seen as rubbing salt into an already raw wound.
The reinstating of HMRC’s preferential status may cause other creditors to take a more aggressive stance to the detriment of creditors further down the chain, for example, banks with floating charges. The changes proposed by the Government will mean that the Crown will rank in preference to floating charge holders. Banks with fixed charges will be unaffected, but the knock-on effect of the proposed reform is likely to be that terms of borrowing will tighten significantly (with lenders working out how to take fixed security over assets whenever they can) and SMEs in particular will find themselves in a worse position when it comes to securing finance. With the banks taking a more cautious attitude to lending, many businesses who cannot offer fixed charge security could find themselves in a deadlock situation, unable to secure the funds necessary for growth.
Changes like this are unlikely to be well-received by stakeholders, especially not in the middle of the turbulent times caused by Brexit and its implications for the UK’s debt mountain and a steep rise in interest rates. The restructuring and turnaround industry may consider this a step in the wrong direction.
Luckily, there may be light at the end of the tunnel. HMRC’s preferential status is not due to be reintroduced until 2020, before which a lengthy consultation process will have to be navigated with insolvency practitioners, business leaders, lenders, suppliers and pension funds. Also, this reform will only apply to taxes collected and held by businesses on behalf of other taxpayers (VAT, PAYE, Income Tax, employee NICs and CIS deductions). The rules remain unchanged for taxes owed by businesses themselves, such as Corporation Tax and employer NICs.
In terms of preparation for any change, there is little businesses can do, other than ensure that contractual documentation is watertight whenever a new supplier agreement is negotiated. Robust and enforceable retention of title clauses are especially important and provide some reassurance at an early stage that it will be possible to claim goods and equipment back, in the event of a customer or debtor becoming insolvent. However, their success hinges on proactivity and at the first signs of trouble, steps should be taken to recover goods.
Crown preference was abolished for good reasons in 2003. Prior to the Enterprise Act, HMRC took an aggressive approach to winding up failing businesses. If they are back first in line (after fixed charge lenders) for recoveries when a business does go under, it is highly likely that we will see this more aggressive approach returning once again.
Restoring HMRC’s status as a ‘preferential creditor’ is a bold – and perhaps dangerous – move. There are few positives to be taken from this by businesses and creditors who find themselves affected by insolvency and the underlying ethos contradicts the forward-thinking and innovative approach that the UK turnaround industry has been striving to promote. Only time will tell whether the draft legislation is enacted in its current form.