U.K. Companies Face Lending Risks Under New Bankruptcy Rules

New U.K. insolvency rules that prioritize tax debt in bankruptcy will make it hard for struggling businesses to access loans.

Under rules that come into force Dec. 1, Her Majesty’s Revenue and Customs will become a secondary preferential creditor in the event that a company goes bankrupt, meaning that it will be paid ahead of unsecured lenders.

The problem is exacerbated for companies that took advantage of the government’s pandemic stimulus plan that allows businesses to defer value-added taxes owed until 2021—and pushed tax debts into next year, elevating their overall debt.

As a result, companies with large tax debts may struggle to obtain loans at a time when they may need extra credit, further hurting their—and the economy’s—prospects, practitioners say.

“Any restriction of finance will lead to business growth being diminished, which in turn could lead to a rise in the number of insolvencies, more redundancies and ultimately increased costs to the government and lost funds for HMRC,” said Simon Rothenberg, manager at the Blick Rothenberg accounting firm.

Jumping the Queue

The government has defended the rule change, arguing that the U.K. loses out on as much as 2 billion pounds ($2.6 billion) each year in tax revenue that goes unpaid when companies fail.

“This reform represents a balanced and proportionate change to the system that will ensure more of the taxes paid by individuals in good faith go towards public services as intended,” the government said in an emailed statement Nov. 11.

In the event of an insolvency, company debt is paid out according to the legal order of priority, David Gregory director, head of restructuring and insolvency tax at Grant Thornton UK LLP said. Until now, the government has ranked behind secured and floating-charge creditors, bringing up the rear with unsecured creditors. Only shareholders ranked lower.

Floating charge loans give lenders a claim on proceeds from the sale of specific assets with a non-constant value, like inventory, after preferential creditors and fixed charge lenders are repaid.

The priorities for creditor repayment have largely been in place since the Enterprise Act of 2002. While lenders holding secured loans have been in the pole position, they have also frequently provided additional credit lines to businesses using floating charges, moving some of their unsecured lending higher up the list.

The changes in December, with the new regime moving the government ahead of the floating charge loans in the case of certain unpaid taxes like employee national health contributions and VAT.

Industry Objection

In the two-year consultation period before the new rules were adopted, bankruptcy experts had warned HMRC that changing the order of creditor priority would make floating charge loans less attractive to banks.

“We were all against it because there has been a company rescue culture over the past two decades, with a focus on saving the company first, rather then recovery of debts,” Keith Steven, managing director of KSA Group, a corporate turnaround specialist and insolvency practitioner.

What this all means is that the bank will expect to recover a lot less money from its floating charge if there is a tax debt and there is always, tax debt, Steven said, adding: “Time to pay arrangements will just make this problem a lot worse.”

Lenders issuing new loans may demand onerous terms from borrowers, such as that they post their homes as collateral, he said.

Even if banks wish to continue lending on a floating-charge basis, they will have to carefully scrutinize the tax risks a company faces.

“Frankly, most lenders have never had to focus on their customer’s tax risk profile, and they haven’t needed to,” Grant Thronton’s Gregory said. “From lender perspective that would be really hard. I wonder if lenders are really geared up for this.”

HMRC has said there will be minimal impact on lending behavior.

“The government does not expect this reform to significantly impact access to finance, the lending market or wider economy,” a spokeswoman HMRC, an Stacey Ellis, said an emailed statement.

But she acknowledged that, “We recognize that floating-charge creditors will recoup less than they would under current law, as a result of the way these tax debts are currently treated by asset-based lenders.”

Businesses and banks nonetheless say they are worried.

“Lenders are currently focused on continuing to support their business customers in managing the impacts of the pandemic,” said Natalie Bruce, a spokeswoman for UK Finance, the banking and finance lobby. “However, from a lending perspective, these new rules will significantly degrade or even remove altogether the value of any assets that can only be secured via a floating charge.”

The result will be diminished access to finance in industries where borrowing relies heavily on floating charges, she said, including retail, certain manufacturing operations and some areas of technology.

“This could severely limit the ability of businesses to trade themselves out of difficulty,” Rothenberg said, “particularly when many have exhausted their reserves during the lockdown period.”