Zombie businesses and rent arrears: the legacy of the pandemic

There were 355 business failures or liquidations in the Irish economy last year, according to insolvency practitioner PKF. What’s unusual about this figure is that, under normal trading conditions – without the disruption of Covid – we typically see a lot more.

The 355 figure was the lowest level of insolvencies in 14 years – since the height of the Celtic Tiger – and a fraction of what we saw in the aftermath of the 2008 financial crisis. In 2011 there were more than 1,400.

And yet the economy, at least the consumer-facing one, has been hammered for the past two years, thwarted from trading normally by on-off restrictions and squeezed by increased levels of digitalisaton. So what’s going on?

The Government, through financial supports, and the Revenue Commissioners, through tax forbearance measures, have effectively shielded many businesses from the full force of the pandemic. These measures have propped up many so-called “zombie” businesses that would have gone to the wall with or without Covid.

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The big question is what happens next? Weaning the economy off pandemic-era supports, a fiscal imperative for the Government, is one of the key challenges. Move too fast and you may end up hurting otherwise viable businesses; move too slowly and you only delay the inevitable while running up more debt for the exchequer.

As of the end of February more than 95,000 businesses were availing of the Revenue’s debt warehousing scheme. Legislated for as part of the Government’s July 2020 stimulus package, the scheme has allowed businesses to effectively park their tax liabilities. To date €3.1 billion has been warehoused, roughly €30,000 per business. A breakdown of debt shows that €1.46 billion relates to VAT, while €1.48 billion relates to PAYE liabilities.

Debt recovery

A Revenue spokeswoman said the approach to retrieving the debt would be sensitive, flexible and tailored to each business based on its capacity to pay.

There would be no immediate removal of the support either, she said, as, under the terms of the scheme participating businesses can park the debt for another year – until 2023 – before interest starts to accrue. And even then that interest will be at a low rate of just 3 per cent.

Normally the Revenue charges interest on outstanding tax liabilities at 8-10 per cent. “Revenue is keen to stress that there is no immediate requirement to pay the debt currently in the debt warehousing scheme; this means businesses can focus on rebuilding trading levels throughout 2022 without having to worry about paying the debt,” she said.

She also noted that businesses which were unable to trade in any way during the strictest lockdowns and may have made the hard choice to temporarily lay off their staff will more than likely have incurred little or no VAT and PAYE employer liabilities during the period.

“Businesses experiencing tax difficulties is not new, and in many ways is part of natural economic cycles. Because of this Revenue has a strong track record of working with businesses to reach tax payment arrangements that are agreeable to both the business and Revenue,” she said.

But will we see a surge in insolvencies when this debt is called in?

According to restructuring expert Declan de Lacy, a partner with PKF, there are three types of businesses facing financial difficulty.

The first category weren’t viable even before the pandemic but got a reprieve with the Government supports and will fail once conditions normalise, he says. There was a perceptible uptick in insolvencies at the start of 2020 just prior to the pandemic, most probably relating to Brexit, but these firms were inadvertently saved by the crisis and the rollout of supports, de Lacy says.

“[Back then] anybody who was under pressure with Revenue, their landlord or their bank ... the pressure just evaporated,” he says, noting the Revenue effectively halted all enforcement procedures, allowing firms to effectively pocket the money and pay other costs.

He reckons there are about 200 companies that will be wound up immediately once supports stop.

Cashflow crunch

The second category are those facing a cashflow crunch as a result of tax and rent debt built up during the pandemic. If they don't work out a process to fund themselves going forward through examinership or Scarp (the Small Companies Administrative Rescue Process) or some other method, many of these otherwise viable entities may end up in liquidation, he says.

The third category of affected businesses face a changed consumer landscape in the wake of Covid, he says. De Lacy gives the example of a city centre business reliant on office footfall or on face-to-face custom, which is no longer there.

“They have overheads based on a level of turnover that may never return,” he says.

De Lacy believes we’ll see a gradual tick-up in insolvencies rather than a big bang. “Maybe we hit that number of about 1,000 again but it won’t be in 2022, it might not be 2023, because people will hang on for as long as they can,” he says.

The smarter businesses will work on solutions now while creditors understand where the debts came from and “still potentially sympathise”, he says.

The elephant in the room and the more lasting scar from Covid, however, is unpaid rent. While SMEs in Ireland have a lot less bank debt now than they had in the wake of the financial crisis, De Lacy says many firms have not paid rent for two years.

This is potentially a much bigger problem than the tax debt, he says.

“There’s a statutory mechanism for paying down the warehoused debt but with rent arrears there is no structure that they’re entitled to short of going into say a Scrap scheme or examinership.”

And if the turnover of the business has dropped because of increased digitalisation, many will face a difficult adjustment.

De Lacy has spoken to several high-profile retailers that are 18 months plus behind on rent with little or no chance of ever paying it off.

First lockdown

Kyle Kennedy, managing director of Kylemore Karting in west Dublin, Europe's largest indoor karting arena, says the business availed of a mortgage holiday during the first lockdown in 2020. However, it was advised by lenders that to do so again – during the second lockdown in 2021 – would potentially damage its credit rating, a key consideration for the business, which has availed of capital funding in the past.

Despite not trading it used cash reserves built up during better times to pay the mortgage during the period, says Kennedy. It was able to keep its full staff via the Government’s Employment Wage Subsidy Scheme (EWSS). As a consumer-facing business it was hit hard during the pandemic but Kennedy says it has weathered the storm and is in a good position to pick up where it left off prior to the pandemic.

Another business that availed of a mortgage holiday and the Revenue's debt warehousing scheme was cafe and boutique department store Fishers of Newtownmountkennedy, Co Wicklow.

Proprietor Rebecca Harrison says the business was forced to warehouse a significant chunk its 2020 VAT bill, equating to about 10 per cent of the business's annual turnover in normal times, but is confident the deficit can be made up in six months provided there are no further shocks.

“Having access to that working capital that we didn’t have to pay Revenue has allowed us not only to survive but to invest in the physical premises of the business,” she says, noting the company has added a wellness hub to the business, which includes a skin clinic, a hairdresser, a physiotherapist and an audiologist.

“We’ve gone from a department store to a retail and wellness hub,” Harrison says.

Elaine McParland, owner of the UpToMyEyes beauty salon in Greystones, Co Wicklow, didn’t avail of a mortgage holiday or the Revenue’s debt warehousing scheme, using cash reserves to stay afloat during lockdown. She also had business interruption insurance, which covered three months of lost turnover, when the insurer finally consented to pay out.

McPartland says she has had more problems since the business reopened, with people cancelling appointments and staff being out due to Covid. “The last four or five months have probably been more tricky,” she says.

Cost of support

We know, anecdotally, that some businesses are continuing to warehouse Revenue debt until interest kicks in next year while others are paying it down to remove current liability from the balance sheet.

The Government has spent close to €20 billion on the various schemes supporting the economy. The EWSS is due to end at the end of April, while the Pandemic Unemployment Payment (PUP) scheme is due to wind up at the end of this month.This level of support was never sustainable in the long term.

“We know that supports cannot extend indefinitely, and the Government must taper asap,” says Irish Small and Medium Enterprises (Isme) chief executive Neil McDonnell.

“Acknowledging that this money is due to the exchequer and must be paid, there are certain sectors where two years of trade to repay that liability cannot be made up retrospectively,” he says. “In effect this means that the Revenue will render some of these businesses insolvent by collecting the money unless the repayment is scheduled over a longer time,” he says.

The end of Covid-related restrictions was meant to trigger a return to normal trading conditions but the virus caseload is still high and that is frustrating many businesses.

The wider economic outlook is now also clouded by the Ukraine crisis and the current cost-of-living squeeze. How these forces will affect companies and their attempts to trade their way out of the last two years is difficult to say.