Insolvency: HMRC moves up the rankings

From 1 December 2020, the priority rules on insolvency have changed, impacting the recovery that can be achieved from holders of a floating charge on the insolvency of a debtor.

The new rules (Finance Act 2020, s 98) give HMRC priority over floating charge holders and ordinary unsecured creditors in relation to taxes collected by the insolvent company for HMRC (i.e. VAT, PAYE, income tax and NICs).

Crown preference

Previously, on insolvency, the order of priority of creditors was:

1. fixed charge creditors;
2. administrator's/liquidator's fees and expenses;
3. ordinary preferential creditors;
4. secondary preferential creditors (currently only employees and the Financial Compensation Scheme);
5. floating charge holders (less the prescribed part);
6. unsecured creditors (including HMRC); then
7. shareholders.

From 1 December 2020, on insolvency, HMRC will leapfrog up the ranking and be treated as a “secondary preferential creditor” in relation to taxes that are collected by the business, as agent, for HMRC (known as the “Crown preference”). These taxes are PAYE, VAT, employee NICs and Construction Industry Scheme (CIS) deductions (however, HMRC will remain an unsecured creditor in relation to all other debt, e.g. corporation taxes).

This means that the claims of HMRC on insolvency will rank behind claims of employees but now rank ahead of floating charge holders, meaning that the remaining sums available for distribution to any such floating charge holder on insolvency may be reduced.

As of 1 December 2020, the order of priority is:

1. fixed charge creditors;
2. administrator's/liquidator's fees and expenses;
3. ordinary preferential creditors;
4. secondary preferential creditors (expanded to include HMRC for taxes held “on trust”);
5. floating charge holders (less the prescribed part);
6. unsecured creditors (including all other HMRC debt);
7. shareholders.

Impact on floating charge holders

HMRC's ability to recover these debts as secondary preferential creditor is not subject to any cap, either on the age of the tax debt or the value of any such debt. Therefore, any unpaid liabilities (regardless of when they were incurred), at the time of insolvency proceedings commencing on, or after, 1 December will benefit from the new priority.

It is worthy of note that additional changes, including time to pay arrangements for VAT and PAYE/NIC, allow companies to defer payments that were previously due between 20 March and 30 June 2020 until 31 March 2021. Consequently, many businesses are likely to be carrying a greater HMRC liability than may have previously been the case.

Increase in the prescribed part

The position for floating charge holders is further eroded by the recent increase (from 6 April 2020) in the cap under the prescribed part from £600,000 to £800,000. The prescribed part is the portion of the funds (subject to the aforementioned cap) realised by a liquidator or administrator from assets captured by a floating charge (created on or after 15 September 2003). The prescribed part is a percentage of the total proceeds from insolvency and is provided to the body of unsecured creditors, who may not otherwise receive any proceeds from the insolvency.

The change to the limits applies to holders of floating charges created on or after 6 April 2020, or to floating charges that were created before that date but rank equally with, or behind, a charge created on or after 6 April 2020. These changes will reduce the remaining balance of proceeds under the floating charge that will be available to any floating charge holder.

Considerations for floating charge holders

To try and mitigate these changes, many lenders may choose to look to other forms of collateral to protect their position, including an increased use of fixed charges (e.g. standard securities or fixed charges within any debenture). Of course, when compared to a floating charge, this will prevent the charge holder's ability to dispose of the asset (without lender consent), and therefore may be a point for negotiation. Additional use of personal guarantees may be sought; however, the willingness of directors to provide personal guarantees in this climate may be limited, which may have an impact on the level of funding corporates will be able to receive.

In making their credit decisions, lenders will need to make an educated guess as to the possible HMRC liabilities of their debtor (potentially involving extensive due diligence) to allow them to determine any potential return under the floating charge.

Additionally, lenders may choose to incorporate increased covenants within their loan agreements around the borrower's ongoing tax liabilities, and additional undertakings to provide the lender with any demand letters received from HMRC.