The return of HMRC’s preferential status - ReSolve Group UK

The return of HMRC's preferential status

ReSolve Group UK

The return of HMRC's preferential status

This article, by our partner Lee Manning, was first published in Accountancy Daily.

If you own a business, invest in them or are a creditor to them, you may be aware that on 1 December 2020 HMRC became a preferential creditor for all company insolvencies. This means it will have the right to be paid before other creditors (such as providers of floating charge finance, suppliers and customers) but sits behind any preferential claims that employees may have in respect of arrears of wages (up to a limit of £800) and an unlimited amount for accrued holiday pay. HMRC’s status as a preferential creditor cannot be compromised and it can demand that it be paid ahead of other (unsecured) creditors even if that means the unsecured creditors receive nothing.

The fundamental change is that previously, HMRC would sit alongside all other creditors in an insolvency process. Now HMRC can look to be second in line (behind employees preferential claims for arrears of wages and holiday pay) even ahead of floating charge debenture holders, from the proceeds of the sale of assets such as stock, work in progress, movable plant and equipment, furniture and IT assets, trade debtors, and sometimes even cash at bank.

The real challenge is that HMRC is a creditor that has no ongoing trading relationship with a company but has a role to collect debts for the Treasury, as such it has little incentive to consider the need to support a business that has run up significant debts. It arguably does not have to think about how the insolvency of that company will affect its future prospects if that company ceases to trade because there is no trading relationship (with HMRC) to begin with that requires protecting.

Consequently, HMRC is likely to be more “trigger happy” given its enhanced preferential status; especially where it believes there are significant assets that an appointed insolvency practitioner would be able to realise to either partially or wholly satisfy its debt.

This enhanced status for HMRC will mean that conventional floating charge security enjoyed by traditional lenders to companies, including banks, asset finance companies and private equity companies, will be faced with materially shrinking security values if they had relied on floating charge assets for their security. In future, these lenders are also likely to be less willing to lend money to companies and/ or will build in significantly higher buffer levels in anticipation of preferential claims of HMRC in the event of an insolvency. This will drain companies of much needed working capital as lending percentages against asset values are reduced accordingly.

The role of CVAs

In situations where a company faces material losses and a cash flow crisis that damage their balance sheets and threaten their viability, a Company Voluntary Arrangement (CVA), allows a company to come to an agreement with its creditors to pay them back some or all of their debts over a period of time.

CVAs are recognised as a veritable corporate lifeline as they allow directors to retain control of the company’s trading and enable companies to survive and thereby avoid being wound up. A company that has no choice but to fall into administration or liquidation impacts the overall economy, including the Government’s finances, due to unrecovered taxes, an increase in unemployment benefits and lower future tax revenues. Insolvency also affects the entire supply chain, as each company that shuts its doors means there is one fewer provider or purchaser of goods or services. It may also impact Directors, who may have given personal guarantees on their company’s borrowings and impinges on creditors that may be owed a substantial amount of money.

However, CVAs must satisfy certain criteria to be legally binding on creditors. This includes the need for at least 75% of the creditors in value to vote in agreement with the proposed CVA terms. It is feared that HMRC, now as preferential creditor and often holding a significant percentage, more than 25% of many companies’ debts, will likely impede CVAs from meeting the requisite voting approval threshold. This is because it often votes against CVAs that do not continue to make creditor repayments for at least five years, irrespective of whether the deal being offered to creditors (including HMRC) in the CVA is demonstrably materially better than could be expected from a formal insolvency process.

To CVA or not CVA?

This puts financially distressed companies in a predicament – do they attempt a CVA even if they cannot offer HMRC full payment and therefore can expect HMRC to vote against the CVA? Do they attempt a CVA and offer HMRC full repayment even if it leaves the other creditors with nothing and would likely lead to them voting against the CVA? Or perhaps the company ought to skip the CVA and go directly to its bank for an additional loan even though it has less collateral to work with due to HMRC’s preferential status on its current debt?

These questions are not easy to answer and add to the psychological stress that business owners are dealing with today. Therefore, my advice would be to avoid the question altogether by either HMRC adopting a commercial viewpoint and agreeing to approve a CVA or at least abstain from voting if it is clearly demonstrable that it (using its expected preferential return) and the other creditors are receiving a greater return than if the company had gone into administration or liquidation.

Either action would allow CVAs to continue aiding businesses through this difficult time and make it more likely that the Government will receive what is due once COVID-19 and the economic turmoil have subsided.

Biting the hand that feeds it

The UK Government is and should be commended for its effort to protect all aspects of the UK in view of the unprecedented impact of COVID-19, which is affecting every facet of our life and making a massive dent in the Treasury. Eventually, the Government will need to recover the monies and UK businesses will be an important contributor. However, now is not the time to attempt this. With companies desperate for secured lender support, the Government should have postponed the return of preferred status for at least six months to a year. Instead, it has gone ahead and is biting the hand that feeds it – which is of course its own.

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