Back in the 2018 Budget, mixed in with many other tweaks, the government announced a seemingly innocuous change to the way in which business insolvencies will be handled from 6 April 2020. The move will see HMRC gain preferential treatment over non-preferential and floating charge holders – often banks that have loaned money to firms – for VAT, PAYE income tax, student loan repayments, employee National Insurance Contributions (NICs) or construction industry scheme deductions, reversing a move in 2003 when it became a non-preferential creditor for all forms of tax, with the intention of supporting an enterprise culture. The logic for doing so from HMRC’s point of view is simple: it will see the government move ahead of others in the pecking order and give it a better chance of reclaiming the £185m per year it loses, which has been paid by employees and customers but had yet to be passed on by the business when it became insolvent.
A spokesperson for HMRC told economia: “We want to make sure taxes paid by employees and customers fund vital public services as they expect, rather than being diverted to businesses’ other creditors.” It is also keen to point out that it will remain a non-preferential, unsecured creditor for direct business taxes, including corporation tax, capital gains tax and employer NICs, and that it already offers support to firms struggling to pay tax through its Time-to-Pay and Business Payments Support Service structure. Yet many organisations are deeply unhappy at the move, both in principle and practice. “Obviously they’re trying to raise extra tax, but at what price?” asks Charles Worth, head of business law at ICAEW.
“If you’re just looking at it from a ‘let’s find canny ways to raise a bit more tax’ point of view, it prob - ably makes sense, but there are lots of ways that make sense if that’s the only thing you want to do. A government should have a broader perspective.” He takes issue with the idea that the money owed is not the organisation’s. “It suggests that the companies are holding it on some kind of trust, which they aren’t,” he says. “It might be owed but everyone knows that until it’s paid to HMRC it’s money in the business’s bank account and it uses it as it uses any other money. You can see how you can sell it to the man on the street in that context, but it’s intellectually lame.” “The government’s decision to push ahead with the return of ‘Crown preference’ is frustrating and misguided,” adds Duncan Swift, president of insolvency industry body R3. “It’s a short-sighted plan for a quick cash-grab for the Treasury at the expense of long-term damage to the UK’s enterprise and business rescue culture, and to businesses’ access to finance. The government could undo 15 years-worth of progress on building an enterprise culture.”
One obvious ramification of HMRC’s rise up the pecking order is that suppliers – who tend to be unsecured creditors and can often be smaller businesses – are even less likely to receive anything from an insolvency situation than they were before. Swift cites one member currently in a situation where unsecured creditors will get 40p in the pound, but who estimates this would go down to nothing were HMRC a preferential creditor. This is unusual, however; HMRC estimates the average unsecured creditor receives just 4p in the pound. There are also steps firms can take to reduce the chances of becoming over-exposed to an insolvency situation.
“Small businesses can protect themselves by keeping their payment terms as tight as possible and limiting the number of days that credit is offered for,” says Rick Smith, managing director of company rescue and insolvency firm Forbes Burton. “By keeping the amount of credit offered small there is a much lower chance of anything going wrong and, if it does, you’ll be losing out on less.” It’s also prudent to run credit checks before entering into agreements, he adds, and to spot the warning signs that a customer might be struggling, such as requests for extensions or to make part-payments.
Stephen Wainwright, a partner at insolvency practitioner Poppleton & Appleby, believes preferred status for HMRC will “erode funds for floating charge holders and wipe out prospects for other unsecured creditors”. He urges firms to stay in close contact with customers. “You may pick up on subtle changes in behaviour such as avoiding contact, changes in personnel or key staff leaving, including directors,” he says, adding that it’s also a good idea to track the customer’s financial performance and keep an eye on any county court judgements. It’s also possible to take out debtor protection insurance, says Richard Pepler, CEO at Optimum Finance. “This insures the debtor book of a company so if customers go into insolvency or are late paying their invoices, the insurer will cover the outstanding debts,” he says. “We’ve seen the number of client businesses seeking to protect themselves from customers defaulting more than double from 30% to 65% in the last 12 months, possibly as a reaction to the ongoing political and economic uncertainty.” Malcolm Weir, director of restructuring and insolvency at the Pension Protection Fund (PPF), warns there could also be consequences for pension schemes. “The proposals would mean that recoveries from the insolvent employer would transfer to the government rather than the scheme, which may result in pensioners seeing a reduction in the pension they receive if their scheme can buy out benefits with an insurer,” he says.
“Also, the likelihood of the scheme being able to buy out benefits with an insurer may be reduced, which could lead to an increased number of claims on the PPF. Finally, the proposals would also mean that these assets would not be available to the PPF if the scheme transfers to us. To compensate for this loss of income, because we cannot increase our other sources of funding, there is a possibility we would need to increase the levy we charge.” Then there’s the issue of floating charge holders, which will fall down the list. “They’re typically banks and other financiers, but they’re lending money to businesses on the basis that if it all goes wrong they’re quite high up the list of priorities,” says Worth. “It’s almost self-evident that if this takes money away from them then it will impact their thinking about whether they lend and on what terms.” It’s a concern shared by Paul Muscutt, partner at Crowell & Moring.
“We are likely to see a reduction of lending, as well as increased pre-lending and monitoring costs, a reduction in the ability of SMEs to leverage funds on floating assets, and a reduction in the diversity of finance generally,” he warns. This will also extend to existing borrowing, says Caroline Sumner, technical director at R3, who warns of lenders having to re-evaluate current arrangements. “They have told us that there are a number of companies where they have no concerns currently in terms of the riskiness of their lending, but once these rules come into force they will rate them differently and they will be a higher risk,” she points out. It’s even possible this could prompt banks to call in debts or even be forced into insolvency, suggests Clive Gawthorpe, tax partner at UHY Hacker Young. “It may also be the case that higher rates come into force to reflect the additional risk by lenders, along with tighter lending conditions,” he says. But overall the impact on banks will be limited, he adds, pointing out that the £185m per year that HMRC hopes to recover under the new legislation is a fraction of the £57bn lent to SMEs by banks in the 12 months to July 2018. HMRC, for its part, points out that the government does not expect the reform to significantly impact on access to finance, and points out that the independent Office for Budget Responsibility has not made any adjustments to its economic forecast as a result. The potential consequences, though, of any tightening of lending could be severe.
“Firms will close,” predicts Dean Shepherd, senior product manager for compliance at Wolters Kluwer UK. “There are many profitable businesses that rely heavily on bank funding just to exist, simply because the cashflow cycle is so long. When lending to small businesses shrank in 2008, fewer businesses expanded, unemployment rose and wages stagnated. This economic contraction was propped up by a dramatic and sustained reduction in interest rates – an option no longer available should our economy go through a similar contraction in future.” There are now, however, more alternative sources of finance available to firms in the event of bank finance becoming harder to find. Invoice finance is more established than it was a few years ago, with the short-term nature of the debt making it less likely to become embroiled in an insolvency situation than a longer-term loan. “This sector alone lends more to SMEs than clearing banks lend on overdrafts,” says Pepler.
“Banks usually assess a company’s assets and past performance while invoice financiers tend to look at outstanding invoices and future potential. This can make the latter a better fit for SMEs, many of which are asset poor but have extensive sales orders.” Linked into this is the concept of supply chain finance, where a customer uses a bank or third party to pay supplier organisations, based on their own credit rating rather than that of the supplier, as is the case with traditional invoice finance. “This allows suppliers to receive their payment immediately and affords customers more time before the money leaves their account, accelerating cash flow in both instances,” says Carlos Carriedo, senior vice president at American Express Global Commercial Services Europe. Crowdfunding, in its various forms, is also more mainstream today.
“There are now many different types of crowdfunding models which range from peer-to-peer lending, to part-debt/part-equity funding, and totally pre-funded projects such as those on sites like Kickstarter,” says Shepherd. “Investors are seeing low returns on more traditional investment avenues so are willing to take on more risk for the opportunity of seeing a greater return.” Other lenders are also entering the market which has been traditionally served by banks. Caple, for instance, offers long-term, unsecured lending between £500,000 and £5m based on the future cashflows of the business, targeting mid-size SMEs looking to grow. “Smaller businesses are able to access finance from peer-to-peer platforms,” says Dominic Buch, co-founder and managing partner. “Larger businesses, or those with assets, are well served by banks and specialist debt funds. The significant issue is for growing businesses which do not have assets to use as security.”
The move to make HMRC a preferred creditor is still not a done deal. In an unusual sequence of events, the government announced a consultation into the proposals after it had announced them, and has pledged a formal response later this year. HMRC, though, says it remains committed to making the change, reiterating the need for taxes paid by employees and customers to go towards financing public services. One possible compromise could be to impose a time limit on how far back preferential claims can go, as was the case pre-2003, when claims were limited to 12 months for PAYE and NICs and six months for VAT.
“One of the things that we have been calling for is for HMRC to amend their plans so there is a time limit for the amount of outstanding tax that they are classing as preferential,” says Sumner. “We understand this is a policy that will come in, but there are some very simple things they can do to make it more workable.” Others, though, are still hopeful it might be scrapped altogether. “The £185m which the OBR forecasts the change will generate for the Exchequer by 2022-23 certainly sounds like money worth having for public services, but it’s a tiny fraction of the UK’s total tax revenues,” says Muscutt. “This figure must also be weighed against the broader cost to the economy if the result of the measures is to cause lenders to limit the availability of finance to SMEs. This could strangle business growth, which would have knock-on impacts for the overall tax take, as well as the attractiveness of the UK as a place of doing business; something which should not be overlooked against a backdrop of huge economic and political uncertainty.”