The first day of December witnessed an early visit from the ghost of Christmas past for the rules relating to the order of priority on insolvency. For insolvencies commenced on or after 1 December 2020, Her Majesty’s Revenue and Customs (HMRC) will once again rank as a preferential creditor in respect of certain tax liabilities, irrespective of the date that the tax debts were incurred. This marks a return (albeit not quite on the same terms) to the position prior to 2002 for HMRC, when it enjoyed “crown preference” status.

What Is Crown Preference?

In an English insolvency process, including, for example, administration or liquidation, money from realised assets is currently paid to creditors in, broadly speaking, the following “order of priority”:

• Holders of fixed charges (in respect of proceeds relating to fixed charge assets)

• Any moratorium and pre-moratorium debts (if applicable)

• Expenses of the insolvent estate

• Preferential creditors

• Prescribed part of any assets subject to a floating charge

• Holders of floating charges

• Unsecured creditors

Since 2002, HMRC claims have ranked equally alongside all other nonpreferential, unsecured creditors for all debts, often receiving very little or no return when a debtor company became insolvent. With its elevation up the waterfall to preferential status, the effect is that once again HMRC will be paid ahead of the ordinary, unsecured creditors, and also ahead of creditors whose claims are secured by floating charges, In short, for insolvencies commenced on or after 1 December 2020, the Crown is preferred.

What Tax Debts Are Covered?

HMRC will not enjoy preferential status in respect of all tax claims, rather those debts which the debtor will have (or should have) collected on behalf of HMRC (i.e., those debts which are deducted by the debtor from payments in the ordinary course) will be preferential. Going forward, preferential claims will include the following tax claims (which could represent a substantial sum):

• Value-added tax (VAT)
• Pay as you earn (PAYE)
• Employee National Insurance Contributions (NIC)
• Student loan deductions
• Construction Industry Scheme (CIS) deductions

Any claims for tax that would be collected directly by HMRC (such as corporation tax) will continue to rank alongside the claims of ordinary, unsecured creditors.

Implications for Lenders

One person’s gain is another person’s loss; and with HMRC jumping ahead of the queue for what may be a sizable debt, there will necessarily be less available for trade creditors and, in particular, floating charge holders (many of which will be lenders of working capital, and may be significantly exposed in a debtor’s insolvency). It is therefore increasingly important for lenders relying on floating charge security to keep track of the borrower’s tax liabilities.

Implications for Borrowers

For trading companies without a significant fixed-asset base (against which lenders may take fixed-charge security) and whose valuable asset base is changing on a regular basis, floating charges are often the only type of meaningful security available to secure lending. With HMRC’s potentially sizable preferential claim jumping ahead of payments to floating charge holders, there is a greater risk to floating charge lenders, and this will undoubtedly be reflected in an increased cost of borrowing. At best, borrowers should expect to be subject to much more stringent controls and reporting requirements to lenders with respect to their tax liabilities.

Key Takeaways

With HMRC now enjoying preferential status with respect to certain taxes, floating charge lenders should pay greater attention to the debtor’s fluctuating liabilities to HMRC and carefully monitor the likely impact on the lender’s exposure. This is also likely to become a key issue in any continuing or future restructuring negotiations.

For any new financing, lenders should consider additional checks and controls to take account of the borrower’s tax liabilities, with appropriate enforcement triggers.

Borrowers should ensure that funds that should be ear-marked for HMRC are not used to fund the company’s working capital without ensuring that there is an alternative means to fund the tax payments when they fall due. Borrowers may also need to rethink their existing and future financing structures to ensure that lenders have sufficient comfort to continue to fund, and to avoid the risk of the borrower breaching its financial covenants.