Issues with borrowing SMEs if the standing of the HMRC creditor adjustments
Problems with SME borrowing are ahead as HMRC is now a preferred creditor to be paid before variable or unsecured creditors in the event of corporate bankruptcy.
What does this mean for companies trying to source supplies?
Previously, under the Enterprise Act 2002, creditors of a bankrupt company were paid by a liquidator from available funds in the following order:
- Fixed fee creditors
- Ordinary preferred creditors (effectively employees)
- Secondary Preferred Creditors (FSCS)
- Cut out the prescribed part
- Floating charge creditors
- Unsecured creditors (including HMRC)
As of December 1, 2020, the Finance Act 2020 means that HMRC is now a "secondary preferred creditor" payable before creditors with variable debits. This is important as the HMRC is often one of the largest creditors in bankruptcy. Companies levy various taxes (PAYE, NI, VAT) that are paid by their customers and employees on behalf of HMRC. When a business fails, it usually fails with significant amounts owed to HMRC in taxes that have been levied but not yet paid.
Prior to the change, HMRC may not be able to get this tax revenue back if the insolvent business was also owed to variable-rate creditors. This is because often there are no funds left to distribute to HMRC when the fixed and variable fee creditors have paid all or part of their debts.
HMRC describes the change as necessary to "ensure that when a company goes bankrupt, more taxes, which the employees and customers of that company pay in good faith, finance public services rather than distributing them to other creditors such as financial institutions".
This is HMRC's view, but many lenders who rely on variable fees for security reasons may disagree.
Small and medium-sized enterprises (SMEs) are often referred to as the “engine room” of the economy. You need flexible working capital facilities to trade successfully because there is a liquidity gap between buying and selling goods. There are a number of ways to fill this void, including borrowing from suppliers, borrowing from customers, selling stocks to raise capital, and borrowing from directors. The list goes on.
A common source of working capital funding for SMEs is a revolving working capital facility that is secured by a corporate debt security. A bond is a fixed and variable fee for all of a company's assets that change daily during the normal course of trading. They allow goods to be bought, converted, and sold at any stage without the express permission of their resource provider.
Working capital facilities provide the company with an agreed amount of funding, typically a discounted value of the variable fee element. If the floating charge assets (typically paid shares, intellectual property, movable machinery and equipment, commercial debtors not otherwise assigned, furniture, fixtures and fittings) are worth £ 1 million, a financier may provide a facility limit of 30% or £ 300,000 secured against the variable load value. The discount takes into account valuation inaccuracies, the cost of a process to enforce the variable charge, and the discounted selling price of the assets if they are sold as bankrupt stock.
Without a working capital facility, the company's growth is limited, as the old adage “Cash is King” often sounds very accurate in SME countries. Without cash, growing businesses risk over-trading rather than sustained growth.
The government's move is hindering the alternative financial market from providing these facilities and could be viewed as short-sighted given that taxes are only payable when businesses act, employ and profit. VAT, NI, PAYE are taxable aspects of the trade. Without trade there is no tax and without working capital facilities there is reduced trade.
Bank lending to SMEs is not what it was twenty years ago. It's difficult for SMBs to even open bank accounts now, let alone get overdrafts. The asset-based lending market is the main source of working capital financing for SMEs, and the amount of financing available will be reduced by the change in the preferential status of HMRC.
Asset based lenders bring real funds, cash, into businesses and it may therefore be reasonable that they expect to be paid before HMRC, a "passive creditor," unless they get back funds to do business in the US have provided first place. A better option for HMRC could have been to prevent individuals from becoming company owners if they have set up and liquidated companies in the past and left significant arrears on HMRC, rather than restricting the ability of all companies to access working capital.
Either way, it has happened and the Asset Based Lending sector is now looking at what changes it can make to ensure it stays secure and its SMB customers are as little affected as possible.
It remains to be seen whether HMRC is now more likely to involve troubled companies in insolvency proceedings. Prior to the December 1 change, the financial sector was relatively well aligned with the HMRC mindset, and lenders had a good idea of when HMRC would call and enforce companies rather than giving them time to pay. These calibrations now need to be reconsidered. Will HMRC act sooner than before because it is better able to collect funds in the event of bankruptcy? Such measures can affect variable fee holders who would continue to support a distressed business if they found a turnaround plan viable.
Time will tell how much this change will affect the ability of UK SMEs to source supplies. However, as the economy opens up this year and the government-guaranteed emergency loans are withdrawn, it won't take us long to find out.
Chris Williams, Co-Founder and Director of Seneca Trade Partners.
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