Jumping the Line? From December 1st, HMRC are Preferential Creditors.

What’s the story?

By virtue of the Finance Act, which was passed in July this year, the HMRC gave themselves preferential creditor status in insolvencies. This came into effect from the 1st of December.

These changes come at a critical time for the UK economy which is in the process of Covid-19 recovery. Prior to this, and since 2003, the HMRC had been an unsecured creditor in respect of all taxes owed to it on any basis. This meant that the holder of any class of charge (fixed or floating) ranked in priority to the HMRC.

Under the Finance Act, HMRC will be paid after share holders and the expenses of insolvency practitioners but before floating charge holders, company pension schemes, suppliers, and customers. The objective of this policy is to ensure that taxes are paid in good faith and are directed towards public services. However, it is worth noting that these rules only apply to taxes which the government states are ‘held by businesses on behalf of other taxpayers.’ These include:

· PAYE Income Tax
· Employee National Insurance Contributions
· Student loan deductions

The value of outstanding taxes has increased significantly since the onset of Covid-19. For example, HMRC estimates that businesses have deferred roughly £28bn of VAT until March 2021 under the VAT deferral scheme. There is a risk that these new rules will be damaging to businesses. Take for example floating charge holders (who provide investment in return for security over non-constant assets), being paid after the HMRC under the new rules could mean that borrowers would find it difficult to secure investment from these traditional sources. Investors may feel that their money is less secure, particularly at a time of economic uncertainty and difficulty. This is very unfortunate, as investments secured by floating charges are often lifelines for struggling businesses.

How will this affect law firms?

The change in rules will affect the ways that lenders structure financing arrangements. For example, where a significant amount of collateral consists of stock or other assets which are normally subject to a floating charge. Lenders could potentially ring-fence the assets in a Special Purpose Vehicle (SPV) which is not subject to VAT.

Lenders could also consider continuous diligence to ensure that their borrowers are up to date on their taxes. This would likely be added into a Commercial Loan Agreement as an indemnity or representation. Alternatively, lenders could require, as part of the Loan Agreement, that borrowers set aside a reserve of money specifically for payment of taxes.

For firms, the restructuring of financial arrangements would mean redrafted agreements to protect clients from the risk of losing money should the borrower become insolvent. It could also mean potential litigation if any of these inserted terms are violated. In the SPV scenario, the lender will require legal services to establish the subsidiary company. In this scenario, lawyers who specialise in structured finance would see a new stream of revenue.

On a more pessimistic note, if the businesses are unable to secure investment due to these new rules, it is likely we will see an increase in insolvencies. Company insolvency requires a wide array of legal skills in areas like tax, employment, insolvency and real estate. However, in the long-run, the potential decrease in the number of businesses would mean a more saturated market with less businesses, therefore meaning a decline in overall legal revenue and fiercer competition to attract and retain clients. This is my personal belief (and I hope I am wrong) as we have yet to see the effects of these new rules.



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Legal Digest

We aim to write short and easy-to-read articles on current business stories and their impact on the legal sector.