From December 1 2020, HMRC ranks above unsecured and floating charge* secured creditors where a business becomes insolvent, taking what is known as ‘preferential creditor’ status in respect of VAT and PAYE deductions.
This change is going to have significant consequences for businesses in need of funding. Lenders will now be much more cautious in lending to borrowers with debts to HMRC. So, why does HMRC’s new status make such a big difference to lenders? How should businesses looking to borrow respond and why do the changes cause an issue for businesses that have been deferring tax payments during the Covid-19 crisis?
As floating charge lenders will now be further down the pecking order to receive what they are due if the borrower goes insolvent, many are likely to alter their terms and conditions or even be more reluctant to lend altogether. This is particularly the case for facilities specifically secured by floating charge assets such as stock, unspecified Plant & Machinery and, where no Invoice Discounting is in place, book debts.
This change will make cash flow based borrowing more difficult for people based service businesses, where VAT is not recoverable on their costs, and those costs include PAYE deducted from salaries. This will affect consultancy firms, accountancy firms, advertising agencies, lawyers, recruitment firms – particularly those working on high volumes and low margins. Due to the nature of their work, these businesses can find it difficult to obtain Invoice Discounting and will need to think carefully about their funding options.
A term loan with floating charge security will rank behind HMRC in respect of VAT and PAYE collected but not paid over – even if those amounts have not yet fallen due for payment. The change in the priority of HMRC may result in some lenders withdrawing from this market, or, more likely, additional costs where, in order to compensate for a higher risk of losses on loan defaults, lenders opt to increase the return on their loans.
HMRC’s move to preferential creditor status is retrospective. This means all existing lending arrangements will be impacted, alongside any agreements with lenders that are put in place in future.
This is particularly important in light of the decision to allow businesses to defer VAT payable in the second quarter of 2020. There are now thousands of businesses across the country with significant amounts of deferred VAT currently owed to HMRC. If those businesses become insolvent, HMRC will now ‘jump the queue’ by claiming the full amount owed in deferred VAT and / or PAYE arrears under a Time to Pay agreement. In many cases this will materially reduce the assets available for floating charge creditors, and may result in unsecured creditors receiving very little from the insolvency process.
Lenders are likely to take additional steps to ensure they are comfortable with a business’ deferred tax balance before offering any funding, such as:
stipulating that a proportion of any tax debt is repaid to HMRC on day one of the loan or even before the loan agreement is signed
asking for proof of the tax position of the borrower before agreeing a deal to find out just much how the borrower owes HMRC
adding a covenant requiring the borrower to provide financial updates throughout the duration of the loan
Businesses that export goods also need to consider that VAT arrangements will change substantially after January 1 2021, when the Brexit transition period comes to an end, and they will be required to deal with VAT for the first time in many years, with VAT becoming due as soon as an invoice is raised. Lenders will therefore be looking to ensure that exporting businesses have the right processes in place to ensure that VAT is paid on time.
Similarly, seasonal businesses that have historically been able to borrow in the short term to repay suppliers and VAT liabilities accrued in their peak period of sales will need to produce cash flow forecasts to ensure they can demonstrate to any prospective funder that there will be sufficient headroom throughout the term of the facility to cover the VAT.
It is highly advisable for businesses with funding secured by a floating charge to take steps now to reduce the risk of funding being withdrawn or declined when needed.
Asset Based Lending stock facilities will be particularly badly hit – ACP Cadence Advisory are able to work with borrowers in order to model alternative funding options, advise on structure and negotiate with lenders.
For floating charge secured cash flow loans, ACP Altenburg Advisory have strong working relationships with many lenders in mainstream, alternative and private debt sectors and can help borrowers determine which funding options are most suitable for your business.
ACP is a leading independent debt advisory association for SME and mid-market companies, advising clients from day one all the way through to drawdown.
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*A floating charge creditor is a lender whose debt is secured against a group of assets owned by a company that (such as its inventory) that may change in value or quality over time. Floating charge creditors rank below fixed-charge creditors when a business becomes insolvent. The debt of a fixed charge creditor is attached to a particular asset of a business, e.g. a particular property or piece of machinery