How PSCs with bust agencies or clients are set to suffer

With all eyes still firmly fixed on the IR35 contents of the Budget (which post-April 2020 could cause more ContractorUK readers to have to read up on closing a company, here and here), it’s easy for contractors to miss another section of Red Book 2018 which could have a significant bearing on them, writes Gareth Wilcox, director at Opus Restructuring & Insolvency.

Another reason it may have gone under your radar is that it accounted for only a single line in the chancellor’s speech (“We’ll make HMRC a preferred creditor in business insolvencies to ensure that tax which has been collected on behalf of HMRC -- is actually paid to HMRC”).

But you really cannot afford to overlook this throwaway line. Because it is a vow to elevate HMRC in the order of priority on a company’s insolvency. This is due to bite from April 2020. So with IR35 reform hitting then as well, it really will be an All Fools’ month PSCs may take personally.

The Order of Priority

The Order of Priority refers to the order in which the remaining funds/assets are distributed in an insolvent liquidation (i.e. one where it is recognised that there is, or is likely to be, insufficient assets to pay all creditors in full). 

Broadly speaking the order of priority (following the payment of the costs and expenses of the insolvency process itself) is:

1. Liabilities to a creditor holding a secured charge on a specific asset (or category of asset);
2. Liabilities to preferential creditors;
3. Liabilities to secured creditors holding a floating charge;
4. Liabilities to all other unsecured creditors.

Claims are paid pari-passu which effectively means ‘pound-for-pound’ in each category. i.e. if there are insufficient monies to pay a category in full, a dividend of a certain pence in the pound will be declared for each of the creditor in that category. 

By way of an example, if there were sufficient assets to pay categories 1-3 in full but only £100,000 left to pay £1,000,000 of ordinary unsecured creditors, those creditors in category 4 would receive a dividend of 10p for every pound owing to them.

‘I thought HMRC was a Preferential Creditor already’

The above statement is a common misconception. While HMRC did historically enjoy preferential status, following the implementation of the Enterprise Act 2002, HMRC forwent its preferential status, with the ‘prescribed part’ rules (more on those later) put in place to enhance returns to unsecured creditors (i.e. the general body of creditors) as a whole.

In this context, the prescribed part is a proportion of assets which is set aside for unsecured creditors, provided there are sufficient assets available. The prescribed part is deducted from the ‘net property’ remaining after preferential creditors are paid, but before distributions are made to creditors holding a floating charge (i.e. between 2 and 3 above).

The calculation of the ‘prescribed part’ to be set aside is as follows:

• 50% of the first £10,000 of net property; then
• 20% of the remaining net property, up to a total cap of £600,000.

While the above is designed to enhance realisations to unsecured creditors, there are circumstances whereby the rules can be disapplied. It is also important to note that it is only deducted from ‘net property’ insofar as any remains. As such, if there are insufficient assets to pay the costs of liquidation, fixed-charge holders and preferential creditors, there will be no residual net property from which to draw a prescribed part.

Today’s preferential creditors

Since HMRC’s preferential status was withdrawn, the only creditors retaining preferential status are employee claims relating to:

• Employee wages (capped at £800 per employee) or quasi-wages e.g. sick pay;
• Any accrued holiday pay;
• Deductions made in respect of certain occupational pension schemes;
• Protective awards made by employment tribunals for failure to undertake redundancy consultation.

In practice, employee claims owed by an insolvent company are usually paid by the Redundancy Payments Office (RPO) which will also make payments in relation of other employee liabilities which are non-preferential (e.g. residual wages, redundancy and notice pay). Where the RPO makes such payments, it stands in the employees’ shoes as a creditor in the liquidation (known as a ‘subrogated claim’).

What Budget 2018 proposes

It has been proposed by chancellor Philip Hammond that HMRC will now enjoy preferential status in respect of certain liabilities due to it, after payment of preferential employee claims. To put this into perspective, the amounts included in the provision would now be inserted between category 2 and 3 in the order of priority (detailed above), whereas such claims would presently be provable as a debt alongside ordinary unsecured creditors (i.e. at 4). 

This differs from the historic position, where HMRC enjoyed equal status with preferential employee claims, in respect of all liabilities.

HMRC liabilities: what’s included

The liabilities which are proposed to be included are those which are collected from other taxpayers, and notionally held by a company for a short period before passing them onto HMRC. Examples of this include:

• PAYE deducted from an employee’s income;
• Employee National Insurance contributions, similarly deducted from an employee’s income;
• VAT received on sales.

In each of the cases of the above, taxes are paid to the company (as either a deduction from the salary of an employee or on a customer invoice), before the company then pays the liability to HMRC on or around the time its next VAT or PAYE return is due. 

It is not uncommon, however, for substantial liabilities to accrue where a company is in distress, particularly in respect of VAT which is often paid on a quarterly basis, with the payment received representing cash capable of being used to settle other expenditure until such time as a VAT return is due.

Why the change?

The chancellor has stated that the change will result in an estimated £185million increase in tax receipts each year.

While it is noteworthy that the above does not include taxes payable directly by the company such as Employer National Insurance Contributions or Corporation Tax, it is unlikely that the latter will have a significant bearing in insolvent scenarios since it is ordinarily a prerequisite that a company is profitable before such a liability will arise.

Our impact assessment

The most obvious implication resulting from Mr Hammond’s proposal is that your company (being a limited company engaged by another entity), will find itself further down the order of priority if the entity engaging it (such as an end-user / client company or a recruitment agency), goes into an insolvency process.

This will clearly lead to there being poorer returns for contractors in such a scenario, through no fault of their own. Ultimately, depending on the size and exposure of a contractor company to a debt, in the worst circumstances it could lead to that company itself requiring an insolvency process.

How can I mitigate my risk?

Unfortunately, there is little that a contractor company can do to avoid the insolvency of its engager (and it is unlikely that said-entity will admit to having a sizeable unpaid VAT bill). As such, the most practical steps that contactors can take is proper credit control, ensuring that invoices are paid on time and seeking proper detailed explanations for any delay. While there can be a certain amount of commercial sensitivity in such scenarios, proper credit control is the most effective tool in circumstances where it is not feasible to seek alternative sources of income.

Final considerations (incl. Director Loan Account)

It is important to remember that a contractor is almost invariably also a director of the limited company used for their trading. In all cases, including a contractor company, a director owes a ‘duty of care’ to the stakeholders of a company over which they are appointed. Where a company is insolvent, the primary duty of a director shifts from being owed to the shareholders (i.e. owners) of that company, to its creditors.

Considering the above, if a contractor (whether following the insolvency of its engager or otherwise) has doubts as to the solvency of their company, they should seek professional advice as a matter of urgency. In the worst cases, a director can be held accountable for additional losses incurred in a situation where they knew, or ought to have known, that there was no prospect of their company avoiding insolvent liquidation. This is known as Wrongful Trading.

One final point to consider if you’re a contractor, is that while often your only creditor is HMRC, there are regularly cases where contractors loan money to their company as a director’s loan account. Under the current rules, in the event of liquidation such loans would be provable pari-passu with liabilities due to HMRC, whereas from April 2020, they may find that they rank lower (for example where there is unpaid VAT). As such, contractors may want to  think twice before loaning any additional amounts to their company.

As emphasised, and it cannot be stressed enough due to the complexity of this area, if a contractor is in any doubt as to the solvency of their company -- after April 2020 due to this proposal or now, without it, they should seek advice from a qualified insolvency professional without delay.