UK: Crown Preference Returns?

In a return to the pre-Enterprise Act 2002 era, Chancellor Philip Hammond announced in the 2018 Autumn Budget that HM Revenue and Customs' (HMRC) preferential creditor status in insolvencies will be restored from 6 April 2020 onwards.

Read Upside - Autumn 2019

HMRC's preferential creditor status was abolished as part of the Enterprise Act 2002, a measure that was part of a number of reforms introduced by the then-Labor Government to encourage business rescue and to make the insolvency process fairer on unsecured creditors.

Under existing legislation for insolvency processes, HMRC's claims for unpaid taxes are unsecured and rank below floating charge holders and preferential creditors for the proceeds from the sale of floating charge assets such as stock, non-assigned debtors and plant and machinery.

This ranking has allowed lenders to businesses, in particular asset-based lenders (ABLs), to rely more readily on floating charge assets for security. This ultimately has enabled ABLs to offer higher levels of funding in support of a borrower's growth or turnaround (either via higher advance rates from invoice finance facilities, inventory facilities linked to changing stock levels and, in some cases, 'cash flow' loans). It has also afforded ABLs greater flexibility when a borrower needs additional support.

As part of the proposed legislative changes, the Chancellor announced that HMRC would revert to secondary preferential status in all insolvency processes commencing after 6 April 2020 for those taxes collected on its behalf, which are limited to:

  • Value Added Tax (VAT)
  • Pay-as-you-earn tax (PAYE)
  • Employee National Insurance Contributions (NICs)
  • Construction Industry Scheme (CIS) Deductions

The new legislation will not impact taxes collected directly from a company such as Employer NICs and Corporation Tax, which will remain as unsecured claims in insolvency processes.

These changes will deplete the security pool available to lenders that are reliant upon floating charges to collateralise their lending facilities. Where an ABL is particularly reliant upon floating charge assets, they may be forced to reduce or even withdraw existing facilities.

The move is likely to have a significant impact on the funds recovered from insolvency processes by both secured floating charge creditors and unsecured creditors and, by extension, business rescues and the availability of funding as well as the pricing of that funding.

The Government's consultation regarding the proposed legislation closed in May 2019, during which many in the ABL community and restructuring profession lobbied for the repeal of these proposed changes.

In addition to requesting for the full repeal of the proposals, the ABL and restructuring professions suggested various alternative arrangements in the event that the proposals are still enforced, such as allowing for a cap on the age of tax debts eligible for preferential status and/or that the proposals should only apply to tax debts arising and floating charges created after 6 April 2020.

However, the Government rejected this widespread feedback and has confirmed that the proposed changes will proceed, with the only minor amendment following the consultation process being that tax penalties will not form part of HMRC's preferential claim.

The Government anticipates that this measure will achieve additional recoveries from insolvency processes after April 2020 of approximately £185m per annum and that the proposals will not "lead to any particular difficulties." However, in our view, it does not appear that sufficient consideration has been given to the squeeze on floating charge related lending facilities, and therefore the overall impact upon business rescue and funding. Preferential claims are in addition to the Insolvency Service proposing an increase in the 'prescribed part' – money which would otherwise be paid to floating charge holders, but which is ring-fenced for unsecured creditors – from a maximum of £600,000 to £800,000. Whether this move was coordinated or not, floating charge realisations available to floating charge holders and unsecured creditors will be further reduced.

If your business is currently funded by any form of ABL facility, and especially if you benefit from either a high invoice finance advance rate (85% plus), stock facility or cash flow loan, we recommend undertaking an urgent review of your existing facilities.

Duff & Phelps can assist in this regard. The review is time efficient and low cost and will benefit both your business and your funder. We can advise on any likely adverse consequences of the HMRC rule changes and also what actions can be taken to mitigate their impact. This could include changes to facility types or structural changes that separate collateral assets and preferential liabilities, thus safeguarding facilities in their current form.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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