Background
The Finance Act 2020 received Royal Assent on 22 July 2020 and will restore HMRC as a preferential creditor on insolvency (Crown Preference) with effect from 1 December 2020.
There had been speculation that the Government would shelve or at least postpone the reintroduction of Crown Preference in the wake of Covid-19. In fact, even before the pandemic, the proposals had been widely criticised by the restructuring and insolvency industry as harmful to the UK’s corporate rescue culture.
This has not happened - in an insolvency commencing or after 1 December 2020, HMRC will rank as a preferential creditor in respect of certain taxes.
What is changing?
Prior to the Enterprise Act 2002, HMRC ranked ahead of floating charge holders in respect of unpaid taxes. The Enterprise Act then removed this preferential status.
The current position is that HMRC is an ordinary unsecured creditor in a company’s insolvency. This means that it ranks alongside other unsecured creditors and behind floating charge holders.
The new law partially reverses the effect of the Enterprise Act so that, from 1 December 2020, HMRC will rank ahead of floating charge holders and unsecured creditors in respect of certain taxes that the relevant company collects on behalf of HMRC, including VAT, PAYE income tax and employees’ national insurance contributions (the Priority Taxes).
Unfortunately, there are no transitional arrangements for the introduction of the new law, which means that HMRC will enjoy preferential status for Priority Taxes ahead of floating charges created long before 1 December 2020. Nor is the new Crown Preference subject to any time limit or financial cap1. This means HMRC will also have priority in relation to historic arrears of Priority Taxes.
The current position will not change in respect of taxes that HMRC collects directly (e.g. corporation tax and employer national insurance contributions). HMRC will remain an ordinary unsecured creditor in respect of these taxes.
Impact on asset-based lenders
At present, a lender who is relying on its borrower’s floating charge assets does not need to worry that HMRC could rank ahead of them on their borrower’s insolvency. This is because HMRC currently ranks alongside other ordinary, unsecured creditors in the insolvency distribution waterfall.
However, under the new regime, such a lender will need to be aware that an insolvent company’s unpaid Priority Taxes could have a significant detrimental impact on their recoveries. This is because such liabilities will be paid to HMRC from the proceeds of floating charge assets before amounts owing to the floating charge holder itself and other unsecured creditors.
To make matters worse, this is not the first change relevant to the insolvency distribution waterfall this year that adversely affects floating charge holders. On 6 April 2020, the Insolvency Act 1986 (Prescribed Part) (Amendment) Order 2020 came into force increasing the maximum amount of the prescribed part from £600,000 to £800,0002 and the Corporate Insolvency and Governance Act 2020 has altered the insolvency distribution waterfall3.
Impact on borrowers
The increased risk to asset-based lenders means that borrowers may find that the amount of funding such lenders are willing to make available to them is significantly reduced. Such lenders are likely to take a conservative view of the risk and take steps to enhance their security position, reduce their exposure against floating charge assets and impose tighter controls on borrowers.
Fixed v floating charges
The reintroduction of Crown Preference does not affect fixed charge holders, who will continue to rank ahead of preferential creditors, including HMRC.
Asset-based lenders should therefore revisit the security packages they have in place on existing deals and examine their underwriting and operational procedures for new business in order to increase the likelihood that, wherever possible, they have the benefit of fixed rather than floating security.
The approach required will be different depending upon the nature of the secured assets, as set out below.
Receivables
If the lender purchases the borrower’s receivables and their associated rights and these vest in the lender, they will not form part of the insolvent borrower’s estate and so will not be affected by the Crown Preference.
However, where the lender is relying on a security interest over the receivables, it must take care that it has the level of control over both the receivables and their proceeds necessary to evidence a fixed charge.
It is important to note that it is not enough merely for the security documents to contain controls and restrictions – the lender must also be able to demonstrate that it has such control in practice in order to avoid the risk that the charge is characterised as merely floating. This can pose some practical challenges and may increase costs, depending upon the structuring required to achieve such control.
Plant and machinery
Where possible, lenders should take a chattel mortgage over plant and machinery, since a chattel mortgage transfers title to the assets in the lender until the debt is repaid.
The assets to be mortgaged should be clearly identified by a detailed description and, where applicable, a serial number and listed in a schedule at the back of the mortgage document.
In addition, where it is practical to do so, the lender should require a plate to be fixed to the asset stating that the asset is subject to the lender’s security. This reduces the risk that a third party will attempt to argue that it doesn’t have notice of the lender’s security.
Inventory
Inventory loans are typically secured by means of a floating charge in favour of the lender.
In certain circumstances, it may be possible for the lender to improve its security position in relation to inventory. For example, where inventory is held in a third party warehouse, the lender could require that inventory can only be released on the lender’s express instructions.
This may make it more likely that the lender has fixed rather than floating security over the inventory – however, lenders will need to be very careful to ensure that the documentation as well as the practical arrangements are consistent with the existence of a fixed charge.
Tax due diligence and monitoring
Where lenders continue to rely on floating charges, they will need to have a good understanding of the borrower’s tax compliance and may want to see evidence of accurate tax records going back several years as a condition precedent to financing.
In addition, lenders are likely to require strong representations and warranties in relation to tax compliance and the ability to audit the borrower’s tax affairs in order to ensure that payments or Priority Taxes are up to date.
Lenders and borrowers will need to consider the cost of such enhanced protections.
Conclusion
The return of Crown Preference is an unfortunate development and of particular concern now, when many businesses are struggling with the impact of the Covid-19 pandemic. Floating charge funding is one of the most frequently used tools for business turnaround and there is already evidence that the proposed changes are making it harder for businesses to access rescue finance. We have heard of borrowers seeing the amount of money they can raise with floating charges decrease by as much as 40 percent because of the changes.
Lenders and borrowers need to consider the impact of the reintroduction of Crown Preference now and plan accordingly in order to mitigate the impact of the changes.
1 This is different from the original pre- Enterprise Act version of Crown Preference, which was subject to certain time bars. It is possible that future regulations could provide for time bars (as the relevant provisions of the Finance Act 2020 appear to allow for this). However, at the date of writing, the draft regulations which have been published do not include any.
2 The prescribed part is the monetary amount set aside for the benefit of unsecured creditors out of the floating charge realisations. The cap increase applies for any new floating charges created on or after 6 April 2020. The increase also applies to a floating charge created before 6 April 2020 if a later floating charge over the company’s assets ranks equally or in priority to the pre-6 April 2020 floating charge.
3 The Corporate Insolvency and Governance Act 2020 (“CIGA 2020”) introduced a new moratorium for distressed companies and altered the insolvency waterfall such that financial debt which fell due before or during a moratorium (but which is not debt which was accelerated during the moratorium) will enjoy “super priority” in the event the company goes into insolvency within 12 weeks of the ending of the moratorium. For further information on CIGA 2020 see “Corporate Insolvency and Governance Act 2020 – How does this impact secured lenders?”