Stephen Wainwright, Partner, comments on HMRC becoming the preferred creditor.
What impact will the new rules have for HMRC?
Prior to the Enterprise Act 2002, which was implemented in September 2003, HMRC held the position of preferential creditor. This was in respect to PAYE and NI accrued within 12 months of an insolvency as well as Value Added Tax accrued in the six months before an insolvency. In order to stimulate business recovery and to enhance the return to non-preferential creditors, the claims of HMRC changed status to that of a non-preferential creditor.
It is anticipated that following the controversial move, revenue will increase by an estimated £185m in respect of taxes already paid and retained by businesses in respect of VAT, PAYE and NIC. However, HMRC will sit behind ordinary preferential creditors (relating to the claims of employees) but ahead of floating charge holders.
While the government feels that the overall changes will have little impact on lending levels, it is inevitable that clearing banks and lenders will see a reduction in its recoveries following an insolvency. Therefore, it is highly likely that security reviews will take place prior to 6 April 2020 when the new proposals come into force.
We anticipate that the cost of borrowing for some companies will increase following a security review.
What is the argument in favour of HMRC taking priority of unsecured creditors? Will it make much difference?
HMRC have always taken the view that they are an ‘involuntary’ creditor in insolvencies and therefore originally, their preferential status was intended to reflect this. They have returned to this mantra to justify their anticipated return to preferential status in April 2020. The wider business community would counter that no-one is a ‘voluntary’ creditor when an insolvency event occurs at their door. Furthermore, it could be argued that compared to trade creditors, HMRC has a significantly more effective toolkit and resources for pursuing debts prior to an insolvency than trade creditors.
HMRC are often the largest unsecured creditor in insolvencies. I would suggest that in the vast majority of SME insolvencies, the implementation of preferential status for HMRC will seriously erode funds for floating charge holders and wipe out prospects for other unsecured creditors.
The most obvious effect will be that HMRC will sit ahead of floating charge creditors and will be able to leapfrog banks and other lenders in respect of returns from floating charge assets. They will also break away from pari passu with other ordinary trade and expense creditors, creating their own creditor group.
The ramifications of HMRC’s new priority status is likely to be significant to SME’s who, very often, have to provide security to clearing banks, finance houses and other lenders, all of whom will be concerned at their potential exposure from 6 April 2020.
Which taxes are included in this?
The legislation suggests that the changes will apply to taxes recoverable by the HMRC for VAT and PAYE. Prior to the introduction of the Enterprise Act 2002 and its implemented in September 2003, HMRC’s preferential claims were limited to 12 months for PAYE and NIC and six months for Value Added Tax. This has caused concern within the industry that the preferential claims may not be capped and could relate to all outstanding PAYE and VAT.
In any event, there will be an increased burden of work placed upon insolvency practitioners in checking and agreeing to HMRC claims. The accuracy of these assessments will now have a direct impact on the return to floating charge holders and non-preferential creditors.
What are the potential risks from this strategy for suppliers and small businesses? Is there an argument that they should be given greater precedence? What impact could this have on employees?
Under the provisions of the 2016 Rules, It was anticipated that creditors would have increased engagement with insolvency practitioners when dealing with insolvent estates. Current data suggests that the average return to non-preferential creditors is 4p in the £. This will reduce following the implementation of the new directive and, as a consequence, there is likely to be even less engagement by creditors.
The Enterprise Act in 2003 also added something called the ‘Prescribed Part’ to Insolvency legislation. In simple terms this is a ring-fencing of a proportion of funds available to floating charge creditors, to become available to all unsecured creditors, including HMRC. When HMRC become preferential again, it will have a drastic knock-on impact on the availability of funds to enable prescribed part distributions. In such cases, it will render what is now a modest return to ordinary creditors into nil return.
Employees claims are, to a great degree met by the Government in insolvencies. Employees will, therefore, be the only creditor group largely unaffected by this. Their claims will remain preferential for wages and holiday pay and, even after the changes, will rank above HMRC. There will be an effect on the ability of the Redundancy Payments Office to recover unsecured claims such as redundancy pay and pay in lieu of notice, which rank with other unsecured claims.
There have been a large number of high profile CVAs, and it will be interesting to see what impact the new directives will have in relation to voting rights in the future.
There will be much interest in determining what the HMRC stance will be regarding winding-up petitions and time to pay arrangements now that their position has been elevated.
Could this have a knock-on effect on the willingness of banks to lend to suppliers who will be vulnerable to customers going out of business?
There is already anecdotal evidence that banks and other lenders are undertaking security reviews with existing borrowers. There will undoubtedly be a knock-on effect on lenders attitude to risk, and in serious cases may well force lenders into a more active role in the appointment of IPs as well as the timing of such appointments. The lending sector has had a reluctance to force the issue for largely reputational purposes for well over a decade, but this may well change.
There will also be a significant shift in attitude to risk by the ‘modern’ lenders such as crowd funders and other social lenders, who will be new to this level of scrutiny.
I expect to see all lenders carrying out much more stringent pre-lend reviews while scrutinising existing arrangements.
How can small businesses/suppliers minimise the risk to themselves of becoming embroiled in a customer insolvency? What are the warning signs?
Trying to identify a supplier that is facing financial difficulties at an early stage enables you to source products, materials, etc. from other sources, therefore, diminishing the knock-on effects on your own business, and is probably easier to spot the signs of a deteriorating trading situation.
By contrast, the effect of a client or customer entering into a mode of insolvency can have a devastating impact on your own business especially if a significant customer is involved.
Identifying the signs of potential insolvency in a customer may not be easy. There are a number of steps a business can take to protect against the possibility of losing a client or customer.
Before entering into any contract whether it be the supply of materials, goods or services, it is important that you carry out your own due diligence. Companies House have a website which enables you to search online all registered limited companies in the UK. Whilst this information will provide you with the last financial statements, details of company officers, charges and indeed, insolvency-related matters, the information, particularly accounting information is very often out of date and I would suggest that this information is only used as a barometer.
There are a number of online programmes that, for a small annual cost, can be purchased and these are able to monitor entities of interest be they, customer or supplier. As and when there are changes to the financial structure whether it be directors or the financial position, the information is made available to you on a regular basis and can, therefore, be of great assistance in mitigating possible risks with clients and suppliers. Again, care must be taken as this information is derived from what is already in the public domain.
If you supply physical goods, it is important that your terms and conditions of sale meet current legislation and, where possible, to have an “all monies” retention of title clause incorporated therefore giving some protection in the event there is an insolvency. It is very important that your terms and conditions of trade with a customer are signed off by both parties at the outset or at the earliest opportunity in the relationship.
It is important to keep in close contact with customers. You or your staff may pick up on subtle changes in behaviour such as avoiding contact, changes in personnel or key staff leaving, including directors. If any of these situations occur then I would strongly recommend having a meeting with a director or certainly a key decision-maker of the company, seeking assurances that the relationship is secure. It is also important that if there are changes in directors or key personnel, these are adequately explained and suggest that you meet any new directors. This is particularly an issue for you if such changes directly affect the interaction with your business.
If the customer is critical to your business, then I would feel entitled to seek confidence in the financial performance of them. Without obviously being disrespectful to the client, request some up to date financial information such as management figures. As mentioned, the financial position on public record may well be up to 12 months old.
Some of the more obvious and tangible signs of distress would include the discovery by you that a county court judgment has been made against a customer and I would certainly make contact to determine how this has arisen and whether there are other judgments pending.
Monitoring payments for goods and services provided would provide an indication of whether or not there is an issue. If a client has historically paid in line with the credit terms but then payments start to drift, this can be an indication that there is a possible issue.
Complaints regarding your product, whether or not you consider it to be spurious or malicious, could be an outward demonstration that all is not well and giving justification for slow or non- payment. These and any other disputes should be swiftly resolved and not be allowed to fester. It would only be to your detriment.
In the above instances, good credit control and robust collection procedures will help, together with monitoring of the credit limit allowed.
When entering into a contract with a customer there will always be the risk that they may fail and it is crucial, therefore, that however good the contract can be for the business, that credit checks are carried out on a regular basis and that communication is maintained with all customers. Insolvency events are a nasty shock to creditors. Monitoring and using one’s own balanced judgement of the more nuanced elements of the relationship are all important.
I’d love to hear what you think about this topic, so get in touch.