Directors’ Duties in the Twilight Zone: HMRC, Creditor Interests and Misfeasance

HMRC became a preferential creditor in December 2020, a change that transformed the risk profile for directors of financially distressed companies. Combined with the Supreme Court’s landmark ruling in BTI 2014 LLC v Sequana SA [2022] UKSC 25, which precisely calibrated when the creditor duty arises and HMRC’s increasing willingness to trigger both Personal Liability Notices and disqualification proceedings, this is a risk area demanding sophisticated practitioner understanding.

The Seven Statutory Directors’ Duties

The Companies Act 2006 codified the general duties of directors in ss 171–177. The seven duties are:

1. s171: Duty to act within powers
2. s172: Duty to promote the success of the company for the benefit of its members as a whole
3. s173: Duty to exercise independent judgment
4. s174: Duty to exercise reasonable care, skill and diligence
5. s175: Duty to avoid conflicts of interest
6. s176: Duty not to accept benefits from third parties
7. s177: Duty to declare interest in a proposed transaction or arrangement

These duties are owed to the company. The enforcement mechanism is generally a derivative claim by a shareholder or, on insolvency, by the officeholder (liquidator or administrator). Section 172(3) CA 2006 preserves the common law rule that in certain circumstances the duty under s172 is modified by reference to creditor interests, what is known as the creditor duty.

The Twilight Zone Concept

The “twilight zone” refers to the period during which a company is experiencing financial difficulties but has not yet entered formal insolvency proceedings. During this period, the directors’ primary duty to promote the success of the company for the benefit of its members (s172(1)) is progressively modified. As insolvency becomes more likely, directors must give increasing weight to the interests of creditors as a whole, even at the expense of shareholder interests.

The twilight zone may be brief or extended, depending on the circumstances. A company that deteriorates rapidly from solvency to liquidation may experience a very short twilight zone. A company that trades in financial difficulty for a prolonged period, for instance, by using HMRC as an involuntary creditor while paying trade creditors, may be in the twilight zone for months or years. In those extended cases, the potential misfeasance exposure for directors is correspondingly greater.

BTI 2014 LLC v Sequana SA [2022] UKSC 25

In its landmark judgment of October 2022, the Supreme Court, by a majority, confirmed the existence and scope of the creditor duty in English law. The principal holdings were:

When Does the Creditor Duty Arise?

The creditor duty does not arise at the mere possibility of insolvency. The Supreme Court identified a spectrum of circumstances:

• When insolvency is a real and not merely prospective risk , directors must begin to consider creditor interests, balancing them against shareholder interests
• When insolvency is probable , the balance tips more decisively toward creditors
• When insolvent liquidation or administration is inevitable , creditor interests become paramount and shareholder interests effectively cease to be a counterweight

The Sliding Scale

The court confirmed that the creditor duty operates as a sliding scale. The greater the company’s financial difficulties, the more directors should prioritise creditor interests. This is not a binary switch from “shareholders first” to “creditors first”, it is a progressive reweighting. The practical implication is that directors must reassess the balance continuously as the company’s financial position changes.

Ratification

The Supreme Court confirmed that where the creditor duty applies, shareholders cannot authorise or ratify a transaction that breaches that duty. This is an important limitation on the usual shareholder ratification mechanism.

Hunt v Singh [2023] EWHC 1784 (Ch)

In this subsequent Chancery Division decision, the court applied BTI v Sequana to a scenario where the company was technically insolvent due to a tax liability arising from an avoidance scheme that the directors believed would succeed. The court held that the creditor duty arose because there was “at least a real prospect of the challenge failing”, the directors could not defer the creditor duty on the basis that they genuinely (though incorrectly) believed the tax liability would be eliminated.

HMRC as Preferential Creditor Since 1 December 2020

Finance Act 2020 restored HMRC’s preferential creditor status (which had been removed by the Enterprise Act 2002) with effect from 1 December 2020. HMRC is now a secondary preferential creditor in respect of:

• PAYE income tax deducted from employees’ wages and salaries
• Employee National Insurance contributions
• VAT collected on behalf of HMRC
• Construction Industry Scheme deductions

As a secondary preferential creditor, HMRC ranks ahead of the holders of floating charges (and ordinary unsecured creditors) but behind fixed charge holders, insolvency expenses and primary preferential creditors (mainly employee claims for wages and holiday pay). HMRC’s own tax claims (e.g. corporation tax on the company’s own profits, employer NIC) remain unsecured.

The practical consequence of preferential status for directors is that assets subject to a floating charge that might previously have partially satisfied HMRC’s debt will no longer do so, HMRC takes priority. This has also changed the calculus for lenders holding floating charges, who now bear greater exposure in insolvency scenarios. From a director’s perspective, the combination of preferential status and the creditor duty means that directing company resources away from HMRC during the twilight zone is both a potential misfeasance and a matter of increasing regulatory significance.

Misfeasance: Section 212 Insolvency Act 1986

Section 212 of the Insolvency Act 1986 is the primary vehicle by which a liquidator pursues directors for breaches of duty occurring during the period prior to liquidation. Any person who has “misapplied or retained or become accountable for, any money or other property of the company or been guilty of any misfeasance or breach of any fiduciary or other duty in relation to the company” may be required by the court to repay, restore or account for the relevant money or property with interest.

For HMRC-related misfeasance claims, the liquidator must establish:

1. That the creditor duty had arisen (applying the BTI v Sequana sliding scale to the specific timeline)
2. That the director breached that duty (typically by authorising payments or distributions that preferred shareholder or director interests over HMRC’s claims)
3. That the breach caused loss to the company’s creditors (the “but for” causation test)
4. The quantum of that loss

A successful s212 claim results in the director being ordered to contribute to the assets of the insolvent estate. In cases where the HMRC debt is substantial and the director has personally benefited from the breach (for example, by drawing salary or dividends while HMRC debts accumulated), the exposure can be very significant.

Personal Liability Notices

Separately from the misfeasance route, HMRC has direct statutory powers to hold directors personally liable for certain unpaid company taxes. A Personal Liability Notice (PLN) can be issued to an officer of a company (or LLP) in respect of unpaid PAYE, employee NIC and VAT where HMRC can show that the failure to pay was attributable to the officer’s fraud or neglect. PLNs are an administrative determination, not a court order, they are issued by HMRC and can be appealed to the First-tier Tax Tribunal.

The PLN power and the s212 misfeasance route are not mutually exclusive. HMRC can issue a PLN and the liquidator can pursue s212 proceedings in respect of the same underlying conduct. Directors should take early legal advice before either route is formally engaged.

Director Disqualification

The liquidator is obliged under the Company Directors Disqualification Act 1986 and the Insolvent Companies (Reports on Conduct of Directors) Rules 2016 to report to the Insolvency Service on the conduct of directors. HMRC’s Fraud Investigation Service and the Insolvency Service share intelligence. Conduct that consistently features in disqualification proceedings includes:

• Non-payment of PAYE, NIC and VAT while the company trades at HMRC’s expense
• Deliberate use of HMRC as an interest-free lender by retaining collected taxes
• Schemes to transfer assets or income to other entities to avoid the accumulated tax debt falling within a formal insolvency

See the companion article in this series for a detailed analysis of director disqualification and HMRC debt.

Checklist for Directors in Financial Distress

1. Obtain independent legal advice immediately, not from the company’s solicitors but from a solicitor advising you personally, to avoid conflicts and privilege complications.
2. Apply the BTI v Sequana sliding scale: have you reached the point where insolvent liquidation is probable? If so, the creditor duty is in full operation.
3. Maintain contemporaneous written records of all board decisions and the reasoning behind them, demonstrating awareness of the financial position and proper consideration of creditor interests.
4. Do not make preferential payments to connected parties, family members or trade suppliers who are also directors, these are the highest-risk transactions in misfeasance and PLN proceedings.
5. Engage with HMRC proactively if tax liabilities are accumulating, a Time to Pay arrangement is far preferable to allowing debts to accumulate in a situation where the creditor duty may already have arisen.
6. Do not distribute dividends or draw increased salary during the twilight zone without specific legal advice on whether this breaches the creditor duty.
7. If formal insolvency proceedings become likely, consider seeking protection via administration rather than allowing the company to proceed to a compulsory liquidation triggered by HMRC.
8. Where HMRC has already issued a winding-up petition, take immediate urgent advice, the scope for resolution narrows rapidly once a petition has been presented and advertised.

Frequently Asked Questions