Crown Preference – How might financiers and borrowers prepare for its return?

With the stated aim of reducing the amount of taxes paid by employees and customers that end up in the hands of other creditors, HMRC are set to have their creditor preference reinstated.

In the October 2018 Budget the then-Chancellor introduced a proposal for HMRC to rank as a secondary preferential creditor (after employee preferences) in the insolvency of a company. The relevant taxes due include PAYE, VAT, CIS and Student Loan deductions and employee NICs due from the insolvent company. The intention is for this to apply to insolvencies arising on and after 6 April 2020.

The proposal was the subject of consultation and much criticism on numerous grounds but, other than reversing the suggestion that penalties and interest due to HMRC also be included, the Government remained largely unmoved. Despite representations concerning the problems to lenders and borrowers which it may cause, there will be no cap on the amount HMRC can claim nor any backstop date, so the change effectively will be retrospective. HMRC also will remain an unsecured creditor for direct business taxes such as Corporation tax, Capital Gains and employer NICs.

With Brexit uncertainty still in play and the prescribed part due to increase to £800,000, many say these changes are very badly timed.

Back to the future?

Many will recall that HMRC was a preferential creditor (ranking in the insolvency before floating charge holders and unsecured creditors) before the Enterprise Act 2002 came into effect. That Act was designed to promote a rescue culture via out of court Administration, give unsecured creditors a better chance of some recovery via the prescribed part and to encourage entrepreneurs and financiers to support new and growing businesses.

The current order of payment priority is:

1. Fixed charges
2. Insolvency fees and costs
3. Preferential creditors (mainly employees)
4. Floating charges (with the prescribed part set aside for unsecured creditors)
5. Unsecured creditors
6. Shareholders

In relation to the relevant taxes, the current proposals would move HMRC from fifth place to third place alongside other preferential but unsecured creditors (but after the employee preferred payments) ahead of both the floating charge holders’ secured claims and the prescribed part.

The previous regime did have backstops to claims (12 months for PAYE and 6 months for VAT) but the current proposals do not, which is a significant change. Not only will it be almost impossible for financiers to calculate the amount which may now take preference to their floating charge realisations, but unsecured creditors might now receive less than they would have done prior to the Enterprise Act 2002 coming into force.

So what should financiers do?

It's almost certainly best not to do nothing! Circumstances will of course differ widely between lenders and their arrangements with borrowers but given the concerns expressed by lenders and their advisors during the consultation period, here are some practical steps that might assist lenders adapt to the new regime:

• Based on the best information available, review and adjust as necessary any reserves for preferential creditors
• Given the increased administrative burden that monitoring tax payments will create, consider whether any increase in charges is appropriate
• Review lending structures and ensure that as many borrower assets as possible are either assigned to the lender, held in trust for the lender or subject to a mortgage or fixed charge in favour of the lender, thus minimising the value of assets subject only to a floating charge
• Given that HMRC will now have a vested interest in having fixed charges re-characterised as floating charges where the lender has not exercised sufficient control over the charged assets, consider re-negotiating consents to asset disposals and whether taking new fixed charges with greater control (by the terms of the charge and in practice) is appropriate/possible
• Consider what practical steps can be taken to monitor payment of taxes by the borrower and what verification can be undertaken before advancing funds
• Consider whether it is possible for the borrower to create and retain tax reserves
• Provide debt purchase facilities rather than secured loans wherever possible
• Consider whether directors could provide either a warranty or a guarantee that all taxes are paid up to date and add provision for tax compliance to Directors’ Certificates
• Change the mindset to view floating charge lending as unsecured lending unless the tax payment position is ascertained and in order
• Where the deal size and sophistication justify it, might it be possible for floating charge assets to be held in a stock holding SPV within the borrower group
• Monitor how HMRC behaves in distressed situations to see if the new regime brings with it a change in appetite to support turnarounds, restructurings and “time to pay” arrangements
• Add tax compliance checks to audits
• Review default/termination events and include tax payment default wherever possible
• Review existing facility terms in light of the new regime to see if tax defaults would trigger covenant breach and/or cross-default provisions
• Discuss with insolvency professionals how the new regime may affect the landscape for business rescues and monitor what happens in practice once the new regime comes into effect

And how might borrowers adapt?

• Understand why the tax position is relevant to lenders and why it may cause them concern
• Be prepared to explain and provide supporting documentary evidence to lenders regarding their tax position
• Think about what ongoing reporting regime they could commit to and offer that up to lenders to help mitigate their anxiety about the tax position
• Think about the structure of the borrowing facilities to minimise the lender’s reliance on a floating charge
• Consider whether it is possible to set up a designated tax reserve account from which payments will be made to HMRC on their due date
• Take advice from legal and accountancy professionals regarding their tax circumstances and any remedial action that may be required
• Be pro-active in suggesting risk mitigants such as Directors’ certificates, personal warranties etc to give lenders comfort where it is appropriate and reasonable to do so.