The law of unintended consequences – HMRC as second preferential creditor

On 1 December 2020, despite strong opposition from the insolvency and restructuring profession, HM Revenue & Customs (HMRC) became a secondary preferential creditor in insolvencies, both corporate and personal, meaning it will be paid in priority to floating charge creditors, suppliers, pension schemes, customers and before deduction of the prescribed part.

Only the holders of fixed charges and first ranking preferential creditors (employees for arrears of wages and salary, capped at £800 per employee), employees for holiday pay arrears and contributions to occupational pension schemes (limited to the twelve months leading to the date of insolvency in respect of employers’ contributions and four months for employees’ contributions deducted but not paid over) rank ahead of HMRC’s secondary preferential claim.

The amounts owed by the insolvent entity in respect of the following taxes will form part of HMRC’s secondary preferential claim:

  • VAT
  • PAYE deductions
  • Employees’ National Insurance Contributions (NIC) (but not employers’ NIC)
  • Student loan deductions
  • Construction Industry Scheme deductions

There is no timeline demarcation limiting the value of the HMRC’s claim; if it is owed to HMRC on the date of insolvency and falls into one of the categories above, it will be a secondary preferential claim in the relevant insolvency process.

So, not only will tax payments deferred as a result of the lockdown become preferential, but it is entirely possible that tax payable as a result of an enquiry which has taken, say, five or more years to conclude, will also be treated the same way.

What unintended effects have become obvious in the months following the introduction of HMRC’s secondary preferential status?

The obvious one is a reduction in funds available to cash-starved businesses already struggling with the effects of the pandemic

Funders have understandably been reducing facilities as their covenants are breached – and not only will HMRC’s preferential claims rank before their floating charges, there is also a corresponding increase in the maximum limit of the prescribed part (rising from £600,000 to £800,000) which will also adversely affect the return to charge holders.  Less funding obviously correlates to less money with which to pay other creditors, creating a domino effect throughout the economy.

In addition to funders trimming existing facilities, for the same reasons it is more difficult to obtain new finance as asset cover has been eroded by the change in HMRC’s preferential status.  Both effects will almost certainly drive businesses into insolvency processes.

Those insolvency processes themselves may be more terminal than might be expected.  By that we mean that another unintended consequence of HMRC’s preferential status is that it is harder to secure approval of Voluntary Arrangements as the return to unsecured creditors is significantly eroded by virtue of HMRC’s preferential status.

By way of an example:

A professional services business has assets (being primarily debtors and unbilled WIP) estimated to realise £250,000 if the business continues to trade, but significantly less on a cessation.  The business owes HMRC £200,000 (largely due to deferrals resulting from the various lockdowns) and other creditors £250,000.  Funders, who have a fixed and floating charge, are owed £350,000.

In a liquidation scenario, there is no projected return to unsecured creditors.  The business therefore intends to make a proposal to its creditors for a Voluntary Arrangement.  The funder has approved the arrangement which provides for contributions over a five-year period totalling a minimum of £250,000.

Prior to HMRC acquiring secondary preferential status, the return to creditors would look like this:

Contributions 250,000
Costs of VA 50,000
Available for creditors 200,000
Creditors 450,000
Estimated divindend 44p in the £

As a result of HMRC’s secondary preferential status the picture changes:

Contributions 250,000
Costs of VA 50,000
Available for HMRC 200,000
HMRC 200,000
Available for creditors 0
Creditors 250,000
Estimated dividend – HMRC 100p in the £
Estimated dividend – creditors 0p in the £

It is not likely that creditors will vote in favour of a proposal that could see them receive little or nothing and we would expect any such proposal to be rejected and the business to cease trading to the detriment of the secured creditor and HMRC.  All employees would lose their jobs and all creditors would lose another customer.  Nobody wins from this scenario.

To illustrate the point, in April 2021 there were just 5 CVAs approved by creditors, a 76% reduction on April 2020 and an 81% reduction on April 2019.  Those companies that would traditionally have survived under a CVA have likely opted for a more terminal insolvency process.

Pre-packaged Administrations are also likely to be affected; a key element of such transactions is often the rolling-over of the secured creditors’ debt from “oldco” to “newco”, especially when a connected party sale is involved.  That will obviously not be so easy, and may not be feasible if HMRC needs to be paid before any return is made under the floating charge.

There is, however, some hope in the form of the Restructuring Plan, also known as the Cross Class Cram Down, introduced in the Corporate Governance and Insolvency Act 2020.

Although the Restructuring Plan has been sparingly used thus far, and is very much in the embryonic stage in terms of its development, it is likely to become increasingly popular as it may be possible to bind all creditors simply by obtaining HMRC’s approval to what is being proposed as the votes of the senior classes of creditors can be forced onto dissenting junior classes – as long as they will not be worse off than in any other insolvency process (and that doesn’t mean they have to receive anything).

The process commences with an application to court.  If the court is satisfied with the composition of the different classes of creditors it will summon votes to be held.  There is no need to hold a meeting for those classes who have no economic interest (ie those that will not receive any dividend)

75% of those voting in each class is required to secure approval of the plan.

The Court gives final approval to the plan and may do so even if one or more classes do not vote in favour (hence the cram down, which has two conditions):

  1. 75% of a class which will receive some form of dividend have voted in favour of the arrangement
  2. Dissenting junior class(es) would not be worse off than in any other process

Certain classes of creditors, such as consumers or employees, can be excluded altogether.

In our example above, the agreement of HMRC (who are expected to be paid in full) would be sufficient to negate the rejection of other creditors (who are not expected to receive anything at all).

Creditors tend not to be favourably disposed to an arrangement where they only receive a nominal dividend over a protracted timescale; if that was a significant dividend they would more likely than not support such a proposal.

The likely consequences of HMRC’s secondary preferential status therefore appear to be:

  • Reduced facilities for cash-starved businesses potentially leading to unnecessary insolvencies
  • Less likelihood of obtaining funding from other lenders
  • Less likelihood of creditors supporting processes designed to promote survival, such as Voluntary Arrangements, again forcing businesses into more terminal processes
  • Reduced dividends to creditors in all insolvency processes which will probably lead to an increase in the number of overall insolvencies
  • A speedier development of the Restructuring Plan as a viable process, potentially at the expenses of Voluntary Arrangements

Surely all of these consequences are unintended?

Stephen Goderski

Director, London

t: 0207 516 2224


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