Will Government changes fix R&D tax credits?

Innovation in the UK lags other advanced economies. Will the overhaul of R&D tax credits fix the problem?

Chancellor Rishi Sunak announced plans during the Spring Statement to reform the way Research & Development (R&D) tax credits will work in the future.

The scheme, which offers financial incentives for businesses investing or developing new products, services or improving existing areas, currently entitles businesses to claim tax relief on R&D costs such as research funding, software costs and specialist staff.

To qualify for R&D tax credits, companies must:

• Be UK-limited and pay Corporation Tax.
• Have conducted research and development activities across the science or technology fields.
• Invested financially in these projects.

But the Chancellor wants to make the scheme more generous.

Part of this would be to expand the remit of R&D tax credits by including cloud computing, hosting, data costs and pure maths – proposals first announced during the 2021 Autumn Budget.

But there were strong hints that some aspects of R&D tax relief would be restricted to UK-only activity in the future. Currently, the tax credits can include overseas activity as long as the entity itself is UK-limited and subject to Corporation Tax.

Further details on potential reforms have yet to be made public, with more announcements expected during the 2022 Autumn budget later in the year.

So what do accountants think of these potential reforms and how would they go about improving the system? We spoke to several commentators for their views.

Limit payable credit only to non-UK sub-contractors

Toby Ryland, Partner, HW Fisher

There is one particular area that can operate very unfairly and that is the PAYE limitation on the payable R&D tax credit. Broadly, this limits the payable tax credit to a maximum of £20,000 plus three times the company’s PAYE liability. Although this is to encourage companies to take on employees and to establish substance in the UK, this is having a very negative effect on many start-ups, particularly in the tech industry. Typically, these businesses engage sub-contractors for their R&D work as they cannot justify taking on permanent employees until they have proven their business concept – and the payable tax credit has helped to fund the R&D work in these early stages in the companies’ growth. In time, these businesses have usually developed and become employers with material PAYE liabilities. The PAYE limit that has now been introduced is therefore cutting off essential funding for these young businesses.

We consider that a compromise could be to only limit the payable credit where the sub-contractors that are used are non-UK businesses or individuals. This would assist in the Government’s aim of ensuring that R&D is carried out in the UK, but without stifling the financial help available to young entrepreneurial companies undertaking R&D projects.

Verdict: Limit payable credit to non-UK sub-contractors.

Review definition of ‘qualifying R&D’ and simplify patent box to encourage more take-up.

Stuart Weekes, Corporate Tax Partner, Crowe

A key aspect of reform should be to review the definition of ‘qualifying R&D’. This has been around for nearly two decades, so there is a question over whether it remains appropriate in reflecting the innovation achieved by UK companies today and in the future.

In addition:

• As innovation plays a crucial role in the start-up community with many inventors and entrepreneurs having to invest their own time, it would be good to explore a mechanism to ensure time spent can be sufficiently incorporated into R&D claims.
• Companies in a scale-up and growth phase should be encouraged to invest further in R&D although this poses a degree of risk. The scheme should be further enhanced to encourage such companies to be bold, knowing that the UK government will share in the investment and help to reduce the risk.
• The patent box has had little take up over the years and needs a review. It is too complex and not wide enough in application. Consideration should be given to whether this can be extended to other forms of Intellectual Property and be simplified without taking away the intentions of the relief.

Verdict: Review definition of ‘qualifying R&D’ to ensure reflects modern working practices, explore mechanisms to adequately remunerate time into claims and simplify patent box to encourage more take-up.

Require professional body membership for any consultancies offering R&D tax relief advice

Steven Bone, Director, Gateley Capitus

I would like to see relevant professional body membership become a requirement for anyone offering paid-for R&D tax relief advice. This would rein in the activities of unregulated, misinformed or unscrupulous agents who fail to apply the required professional standards. It would also help target only qualifying activities to meet the Government’s policy objective of stimulating genuine scientific and technological innovation.

Modernising the software cost category to allow relief for data and cloud costs where these are necessary for R&D is a welcome change. As was the announcement in the Spring Statement that this would include the storage of data. The other category of cost that I would perhaps like to see added is the hire costs of R&D equipment, such as those used for testing.

The key change I would make to the scheme right now would be to provide greater clarity over subcontracting and subsidised expenditure. The SME scheme rules are intended to prevent double claims where two companies both believe they are eligible for relief and claim for their respective expenditure on the same R&D activity (e.g. both the principal and the contractor). But in practice the risk exists that both could do so, and this is an issue of concern to HMRC and advisers.

Verdict: Require professional body membership for companies providing R&D tax relief advice.

Introduce an exemption to UK-only subcontracting rules if overseas activity is a necessity

James Tetley, corporate tax Partner, RSM UK

Changes have been proposed to the tax relief for companies that subcontract R&D to a third party, or engage with external labour resource (externally provided workers, or ‘EPWs’), effective from April 2023.

In the initial draft, in the case of subcontracted activity, R&D relief for such spend will only be available where that third party performs the work in the UK, and in the case of EPWs, R&D relief will only be available where these workers are paid via a UK payroll.

Whilst the intention to ensure the relief is focused on ‘UK plc’ is understandable, it also assumes that businesses will have the commercial flexibility to move to UK-based providers. For many, this won’t be the case, it could simply result in UK companies claiming less R&D tax relief, therefore reducing the incentives for UK innovation.

More positively, the Chancellor’s Spring Statement suggests that he has taken on board the strong lobbying from us and other advisors and has made some important concessions. These include introducing an exemption to the rules when undertaking activity overseas is a necessity (for example, a clinical trial must be conducted in a particular country, or where there are material factors such as geography, population or environment that are not present in the UK).

Verdict: Introduce an exemption to UK-only subcontracting rules if overseas activity is a necessity

Make R&D schemes for SMEs more generous in recognition of smaller available budgets

Nigel Holmes, head of tax, Catax
HMRC could be about to make a series of changes that would seriously damage the ability of businesses to claim R&D tax relief. Proposals to restrict claims on overseas expenditure currently risk discouraging firms from using staff in the same group of companies if based abroad, which many businesses will think unfair and could lead to the removal of their R&D operation wholesale from the UK.

Plans to prevent firms from claiming for two prior periods from April 2023 will also harm those who were unaware of the scheme and are claiming for the first time. 

More broadly, the Government is considering rolling the relief scheme for SMEs into the less generous RDEC scheme for larger companies. However, SMEs are, by definition, less able to invest significant sums in innovation, so it should be expected that a scheme for SMEs is more generous. Altering this would be a backward step and disincentivise R&D for the vast majority of companies in the UK. 

Lastly, abuses and false claims continue to occur. HMRC would have more success with its compliance efforts if it focused its firepower on advisers rather than claimants, who are frequently misled about the veracity of their claims.

Verdict:  Make R&D tax credit schemes for SMEs more generous to recognise smaller budgets.

Annie Makoff is a freelance journalist and editor.