Impending update to insolvency legislation that may affect directors of businesses facing difficulty

In a controversial budget announcement last year, it was announced that any insolvencies commencing on or after 1 December 2020 will feature HMRC ranking as a secondary preferential creditor for certain taxes. What this means is that the distribution of the assets of an insolvent business will be different.

At present the flow of money is:

• Liquidator’s fees and expenses
• Preferential claims by employees for wages and holiday pay and pension contributions
• Lenders

The new distribution sequence will be:

• Liquidator’s fees and expenses
• Preferential claims by employees for wages and holiday pay and pension contributions
• Preferential claims by HMRC for PAYE, NIC and VAT
• Lenders

Lenders often seek to bolster their security with personal guarantees from directors. A personal guarantee is an agreement that means a business director takes a level of responsibility for their company’s debts in the event that they cannot be paid back by the business. It is likely that, given the coming changes, these guarantees will be called upon more frequently and the claims under the guarantees may be larger because there will be less money recovered by lenders when a business goes bust.

A liquidator or administrator will realise the company’s assets which will result in a finite pool of funds which are disbursed in accordance with the order of priority referred to above.

After the expenses of a winding up are paid, the preferential claims are paid and then the remaining funds are applied to any debts covered by a lender with a floating charge over the assets of the company. The new preferential claims will reduce the prospect of secured lenders recovering funds.

Current position

Many years ago, HMRC did previously have preferential status but this was removed in 2003 and that change contributed to a business environment which in the past 15 years has seen an increase in options available for businesses seeking funding. Asset based lenders, for example, have had confidence to do business with the knowledge that they have a reasonable amount of visibility as to what they could expect to recover in the worst case scenario of a customer failing.

Implications to consider

This will now be much more difficult to predict which is widely expected to restrict options for borrowing and consequentially inhibit growth. That, however, isn’t the immediate concern.

Our concern is that there may be directors of companies who have given personal guarantees on existing facilities and in the past months they may have relied on that lending and will have also built up liabilities to HMRC through the COVID support provided by government (for example deferring VAT).

The well-intentioned government interventions this year may have inadvertently created conditions building to a worst case scenario for directors by deferring likely business failures to 2021 when HMRC will have its new preferential status – for example, VAT payments deferred to 2021 will be classed as preferential.

What should businesses do to prepare?

As with most risks relating to directors and insolvent businesses, being ‘forewarned is forearmed’. If your business is likely to face the difficulties covered in this article, and/or you are a director that has provided a personal guarantee whose likely exposure will change as a result of this new legislation, then the earlier you seek advice, the more options you are likely to have to mitigate any problems you may encounter.

If left too late, and the business is allowed to reach a crisis point, it may be that the only option is the immediate closure of the business. In that case, it is unlikely there will be any opportunity to mitigate the issue at all.

It has been suggested that we may see an increase in company voluntary arrangements starting before 1 December 2020 to “ringfence” large HMRC liabilities before HMRC gets its new status as a preferential creditor. Some businesses may wish to consider this but seeking tailored advice on options is strongly advised.

For further information on this topic, please speak with your usual Kreston Reeves contact, or contact me here.