Directors were obliged to consider creditors once tax mitigation scheme was challenged

26 July 2023

The High Court has considered the point at which the directors’ duty to consider the interests of creditors arose in the context of a tax mitigation scheme that ultimately failed

The judge found that the duty to consider creditors’ interests had arisen once the directors had become aware that there was a real risk that the scheme would fail and that the company would therefore be unable to pay its debts.

Although not legally binding, the decision is useful guidance for company directors when considering the impact of a company’s tax and financial arrangements on their duty to consider the interests of creditors and when that duty will arise.

Once a company enters insolvency or is bordering on insolvency, the directors must start to take the interests of the company’s creditors into account.
This duty becomes relevant once the directors know or ought to know that the company has become insolvent or is bordering on insolvency. This will be a question of fact in each case.
Where the company faces the risk of a significant potential liability that would drive it into insolvency, the directors will need to take professional advice and evaluate that risk with scepticism and impartiality.

Hunt v Singh [2023] EWHC 1784 (Ch) concerned a service company that provided management services to other companies within its group.

In 2002, the company entered into a “conditional share scheme” and operated that scheme until 2010.

The scheme was designed to allow staff to receive non-contractual gratuitous bonuses in a way that, if the scheme were effective, would eliminate the company needing to make Pay as You Earn (PAYE) and National Insurance Contributions (NICs) to HM Revenue & Customs (HMRC). It was, in essence, a tax mitigation scheme.

The company notified HMRC of the scheme in May 2003.

In due course, HMRC decided to challenge the scheme. In doing so, it took several steps that ultimately culminated in legal proceedings. They were as follows.

June 2004: HMRC notifies the company that it is initiating an enquiry into its tax return.
July 2004: HMRC notifies the company that, if payments under the scheme in fact amount to earnings, then PAYE and NICs are payable, together with interest.
December 2004: The Paymaster General announces a crackdown on schemes that attempt to avoid PAYE and NICs.
September 2005: HMRC makes a market-wide offer to participants, including the company, to settle any claims in relation to this kind of scheme in exchange for the scheme operator paying any NICs and related interest.
November 2005: HMRC writes to the company again offering to settle. The company declines.
Early 2006: HMRC notifies the company that it intends to issue formal determinations of the company’s liability to pay PAYE and NICs and commences protective legal proceedings.
May 2009: The First-Tier Tribunal rules that a scheme similar to the company’s was effective to eliminate PAYE payments but ineffective to eliminate NICs.
July 2010: The Upper Tribunal upholds the First-Tier Tribunal’s decision and rules that the scheme was also ineffective to eliminate PAYE payments, meaning it had failed completely.

In August 2010, the company stopped operating the scheme.

Except for one year, the company’s accounts for its financial years ending 2002 to 2011 all showed either positive net assets or a small deficit. However, this was based on the assumption that the scheme was robust and effective.

But, following the Upper Tribunal’s judgment and taking into account the fact that the scheme was ineffective, the company was in fact “substantially insolvent” during this period.

The company’s fortunes became worse and, in May 2013, it entered creditors’ voluntary liquidation.

In 2017, the company’s liquidator brought claims against the directors, claiming that the directors had breached their duty to take the company’s creditors into account (see box below: “What is the duty to consider creditors’ interests?”).

The question for the court was: at what point had the duty to consider creditors arisen?

The directors of a company owe a duty to promote the success of the company for the benefit of its members as a whole (section 172(1), Companies Act 2006). For a commercial company, “members” almost always refers to shareholders.

The directors owe this duty to the company itself. If they breach their duty, it is the company that has a right to claim against them, rather than the members (although, in some circumstances, the members can seize control of legal proceedings through a so-called “derivative claim”).

However, the duty to promote the company’s success is subject to any rule of law that requires the directors, in certain circumstances, to consider or act in the interests of the company’s creditors (section 172(3), Companies Act 2006).

When a company is insolvent or approaching insolvency, the directors are under a duty to consider the interests of the company’s creditors, rather than its members. This is sometimes called the “rule in West Mercia”, after a case in which it was first explored.

The scope of this duty, including when it arises, has historically been the subject of debate.

However, in its landmark judgment in BTI 2014 LLC v Sequana SA and ors [2022] UKSC 25, the Supreme Court explored when the duty arises and set out various principles.

Arguably, the court’s decision did not move the dial much, and the central question remains one that must be decided on a case-by-case basis according to the facts. However, the Supreme Court judges did set out various principles that are useful in understanding when the duty arises.

The duty does not arise simply because there is a real and not remote risk of insolvency.
Rather, the duty arises when insolvency is probable or imminent.
The Supreme Court identified four situations where the duty is likely to arise. These are where a company is insolvent; where a company is bordering on insolvency; where an insolvent liquidation or administration is probable; and where a transaction would place the company in one of those situations.
The directors do not need to realise that insolvency is imminent. The duty arises if a “reasonably diligent and competent director” would know that there is no reasonable prospect of avoiding insolvency proceedings. In other words, an “objective test” applies.

It is important to bear in mind that the directors continue to owe their duties to the company itself, not to the company’s creditors. This means creditors cannot bring direct action against directors who fail to take their interests into account. Instead, if the company enters insolvency, the liquidator or administrator will need to bring action against the directors on behalf of the company. However, any receipts should swell the pot for creditors.

What did the court say?

The court referred heavily to the Supreme Court’s decision in BTI v Sequana (see box above: “What is the duty to consider creditors’ interests?”), noting that the duty arises “when the directors know or should know that the company is, or is likely to become, insolvent”.

However, the judge felt that the decision in Sequana left “unresolved” the question of whether, when a company is actually insolvent, the duty arises irrespective of the directors’ state of mind, or whether the directors need to know that the company is insolvent or bordering on insolvency.

This point was not argued before the court, which proceeded on the basis that some form of directors’ knowledge is required to activate the duty.

In the context of a potential liability, the judge effectively said that the duty arises once the directors know, or ought to know, that there is a real prospect of that liability arising:

“… where a company is faced with a claim to a current liability of such a size that its solvency is dependent on successfully challenging that claim, then the creditor duty arises if the directors know or ought to know that there is at least a real prospect of the challenge failing.”

Importantly, the court referred to there being a “real prospect” of insolvency occurring (by virtue of a challenge failing).

The judge specifically recognised that the Supreme Court had rejected this test in Sequana. But he noted that, in Sequana, the Supreme Court had been examining a company that was solvent at the time the duty had allegedly arisen.

In this case, however, the company was plainly and unarguably insolvent, and so the situation was different. The appropriate test was one of “real risk”.

Once the company’s directors knew there was a real risk that the scheme might fail, they had become aware that the company’s creditors were potentially being affected by their actions and decisions (as it is the company’s creditors which have the primary economic interest if the company is insolvent).

On the facts, the judge found that the company’s directors had become aware of that risk in September 2005 (when HMRC made its market-wide offer). The duty to consider creditors had therefore arisen at that point and continued all the way up to the company’s liquidation.

What does this mean for me?

We need to treat this judgment with a degree of caution for various reasons.

In particular, the key question – whether the directors of a company need to know that a company is insolvent or bordering on insolvency in order for the duty to arise – was not argued before the court.

In addition, the court took an explicitly different approach from the Supreme Court in Sequana. Although the court justified that approach by distinguishing the two sets of facts, we cannot know whether the Supreme Court would have taken the same view.

However, the decision delivers a clear message for company directors.

Once directors become aware of a potential liability that may push their company into insolvency (or may already have done so), they must consider the potential consequences of that liability. In the case of a tax mitigation scheme, that includes a successful challenge to the scheme.

The difficult question is: when do directors become aware of a potential liability? It is clear from this judgment and Sequana that this is a dual test. The directors will become aware of a liability when they actually know about it (a “subjective test”) or when they ought reasonably to know about it (an “objective test”). In other words, directors cannot simply turn a blind eye.

Once they become aware, directors will need to make a reasoned and impartial judgment as to the likelihood of that liability crystallising. It is important for the directors not to be swayed by personal motivations or a misguided sense that the company can trade beyond the potential insolvency around the corner. In this respect, it is critical to take professional advice.

Read the judgment in Hunt v Singh [2023] EWHC 1784 (Ch).