With effect from December 1, 2020, Her Majesty's Revenue and Customs ("HMRC") ranks ahead of floating charge holders and unsecured creditors with respect to recovering certain pre-insolvency taxes from an insolvent business ("Crown preference"). Directors can also now incur personal liability for the unpaid taxes of an insolvent company where they are involved in tax avoidance, evasion, or phoenixism.
As a consequence of these changes, funds available to floating charge and unsecured creditors could be significantly reduced. The tax evasion measures could make unpaid taxes a personal liability for directors in certain circumstances.
Looking ahead, lenders will need to consider carefully the nature of their security and their likely recovery in the event of insolvency, given the increased leakage from floating charge realizations. As a consequence, the cost of lending could increase, particularly
in respect of those business sectors that largely comprise floating charge assets.
Priority of Certain Taxes in Insolvency
The Finance Act 2020, which received Royal Assent on July 22, 2020, has established that with effect from December 1, 2020, HMRC benefits from ranking ahead of floating charge holders and unsecured creditors with respect to recovering certain pre-insolvency taxes from an insolvent business. These changes have reinstated, in part, Crown preference, which was previously abolished pursuant to the Enterprise Act 2002.
The reforms apply only to taxes collected and held by businesses on behalf of their employees and customers, namely value-added tax ("VAT"), pay-as-you-earn ("PAYE") income tax, employee National Insurance contributions ("NICs"), Construction Industry Scheme ("CIS") deductions, and student loan repayments. The rationale is that these taxes should be used to fund public services rather than form part of funds available to floating charge and unsecured creditors (including HMRC), as was previously the case.
The rules remain unchanged for taxes owed by the insolvent business itself, such as corporation tax and employer NICs. Creditors with fixed charges over assets are also unaffected to the extent their claims can be settled in full by proceeds from the sale of assets subject to fixed charge security. This is because a fixed charge still ranks ahead of any Crown preference. However, in circumstances where a lender's security comprises largely floating charge assets, the impact of the reforms could be material, particularly in light of HMRC's additional COVID-19 support and deferrals.
It will be interesting to observe if the reinstatement of Crown preference has any impact on HMRC's appetite to issue winding up petitions (COVID-19 restrictions permitting) or otherwise to participate in company restructurings in the event of arrears, or to support a restructuring where a large part of a company's debt will likely be paid in any event. Although the recent amendments are likely to result in modest collective value, many will be concerned that the government will look to extend the scope of the Crown preference in the future at the cost of floating charge holders and unsecured creditors.
The above reforms follow the government's introduction with effect from April 6, 2020, of an increase in the cap on funds available to pay the "prescribed part" (the part of the proceeds from realizing assets covered by a floating charge set aside to satisfy unsecured debts) from £600,000 to £800,000 and the introduction of a new statutory moratorium available to companies in financial distress pursuant to the Corporate Insolvency and Governance Act 2020.
Costs and expenses incurred by the company during the new statutory moratorium will be payable on a super-priority basis out of floating charge realizations. In these circumstances, suppliers of goods and services (who are also no longer entitled to terminate contracts on the basis of insolvency) will be paid in priority out of floating charge realizations together with: (i) any other unpaid costs incurred by the company during the relevant moratorium period; and (ii) the fees of the insolvency practitioner appointed as monitor to oversee the business of the debtor for the duration of the statutory moratorium.
Critics of the reforms argue that the changes are likely to increase the costs of lending and potentially lead to more insolvencies. It certainly is the case that lenders will need to consider the nature of their security and, in the event of insolvency, consider the potential additional leakage from floating charge realizations.
Insolvency and Phoenixism Risks
The Finance Act 2020 includes provisions aimed at tackling the situation where directors repeatedly place companies into an insolvency proceeding, leaving arrears outstanding to HMRC. In such circumstances, directors typically either acquire the business and assets out of an insolvency proceeding or continue trading successor businesses where the cycle begins again.
HMRC now has the power to make directors, shadow directors, and officers of a company who regularly abuse the insolvency regime in an effort to avoid or evade tax jointly and severally liable for a company's unpaid tax liabilities. It is hoped that the potential for personal liability will promote more responsible behavior and reduce the perceived abuse of insolvency proceedings by directors. Personal liability for directors in the case of tax avoidance, evasion, or phoenixism was proposed by the government prior to the outbreak of COVID-19.
In a post-COVID world where we are likely to see more businesses being restructured using phoenix structures, directors and other company officers entering into these transactions in good faith and without the intention of avoiding or evading unpaid tax liabilities will need to ensure that they take appropriate legal and financial advice in order to minimize the risk of personal liability.