Bloomberg Tax
Jan. 10, 2023, 8:00 AM

Changes in the UK’s R&D Tax Relief and the Impact for Business

Jenny Tragner
Jenny Tragner

The UK Autumn Statement in November 2022 saw the Chancellor Jeremy Hunt unveil a priority for stability and growth. The majority of measures announced focused on lowering inflation and defining solutions intended to deal with unprecedented global economic headwinds.

As part of this, the chancellor designated innovation (along with energy and infrastructure) as one of his three key categories for growth—reaffirming the UK government’s commitment that research and development spending will increase to £20 billion ($23.9 billion) a year by 2024–25.

This equates to a cash increase of a third compared to 2021–22, which, according to HM Treasury, makes this the largest ever increase in R&D spend over the course of a Spending Review period.

As part of this spending commitment, in an effort to ensure that taxpayer support is deployed as effectively as possible, the chancellor announced significant adjustments to rates of R&D tax relief, which will see a “rebalancing” of the two schemes which make up the incentive—SME, for small and medium-sized enterprises, and RDEC, Research and Development Expenditure Credit, with the latter aimed at larger companies.

The RDEC rate will increase from 13% to 20%. This is a 42% increase in generosity (after tax) from 10.5% to 15%; these rates also account for the increase in corporation tax from 19% to 25%. 

Less positively, the chancellor paid for this generosity with a reduction in the enhancement rate for SMEs from 130% to 86% and the credit rate from 14.5% to 10%. A typical loss-making SME currently receives up to 33% payable credit on qualifying R&D expenditure. From April 1, the generosity of this credit will be reduced by 44% to 19%.

Will the Changes Improve Compliance and Reduce Fraudulent Claims?

The UK tax authority, HM Revenue & Customs, estimates the level of error and fraud within R&D tax relief to be at 4.9% of all claims made. This is estimated to have cost the taxpayer £469 million in 2021–22, comprising £430 million (7.3%) in the SME scheme and £39 million (1.1%) in the RDEC scheme. These projections are based on outcomes of compliance cases completed in 2020–21 and 2021–22 and assumptions on error and fraud within unreviewed cases.

It is important to note that HMRC is not yet able to split this estimate between cases of error and those resulting from fraudulent activity. This distinction is critical, since errors and fraud are clearly driven by different behaviors and therefore require different approaches to resolve. Without an understanding of the statistical split, it remains difficult to anticipate whether the actions proposed can or will improve compliance, and to what degree.

HMRC has agreed to provide a more accurate estimate of error and fraud to the Public Accounts Committee by this summer.

There have been reports in the media that the rebalancing of the rates of relief announced in the Autumn Statement is expected to reduce the overall level of error and fraud by 1.3% to 6%. However, this would appear to be simply a by-product of the changes to generosity, since the rate changes do not directly impact error and fraud. If less money is paid out overall, less will go to erroneous and fraudulent claims. Since the estimated rate of error and fraud is currently higher for SMEs, bringing the generosity of this scheme down could be presented as targeting the population of claims most susceptible to error and fraud. It falls far short of targeted action to prevent fraud and error.

The chancellor’s strategy to improve compliance and reduce the number of spurious claims also has potential to limit the efficacy of the relief. The Office for National Statistics has recently revised its estimate of the level of business expenditure on R&D, as a result of identifying that it had underrepresented for many years substantial amounts of R&D carried out by SMEs. These measures will reduce relief given to R&D intensive SMEs and could disincentivize legitimate claimants. In this sense, the policy carries the risk of being too blunt an instrument for the delicate surgery required.

Outside of measures announced in the Autumn Statement, HMRC is actively undertaking more compliance activity, with increases announced in the level of staffing dedicated to tackling error and fraud within the relief. The impact of HMRC’s renewed focus on compliance is already being felt, with organized crime efforts being successfully targeted.

Additionally, reforms announced by Rishi Sunak when chancellor in 2021 already sought to tackle abuse of R&D tax reliefs. While these changes are more targeted than the recent rate changes, they won’t come into force until April, with potential for unintended consequences for genuine claimants.

How Will the Changes Impact Multinational Companies?

The increase in the generosity of the RDEC rate—an equivalent of 42% after tax, from 10.5% to 15%—will be warmly received by large businesses, albeit with concerns cited over the impact of the “rebalancing” on SMEs in their supply chain. Increasing the generosity of RDEC should, in theory, translate to an increase in business investment in R&D, underpinning the government’s growth strategy for the UK.

This has the potential to go some way to mitigate the impact of the forthcoming restrictions to relief for overseas R&D, softening the blow on multinational companies impacted by domestic skills shortages.

From April, the legislation will introduce new conditions affecting subcontracted R&D expenditure and payments for externally provided workers. To include this type of expenditure within an RDEC or SME R&D tax relief claim, subcontracted R&D activity will need to be performed within the UK, and externally provided workers will need to be subject to the UK’s “pay as you earn” tax system.

Proposed changes to subcontracted R&D expenditure and payments for externally provided workers could result in a significant reduction in benefit for both RDEC and SME claimants.

There are some circumstances in which overseas activity will be permitted, where the expenditure meets the definition of “qualifying overseas expenditure.” Circumstances where it would be wholly unreasonable to undertake the R&D in the UK due to geographical, environmental, or social factors (e.g. deep ocean research), or where legal or regulatory requirements require activity to take place in specific territories (e.g. clinical trials) will be excluded from the new rules.

The draft legislation explicitly rules out “cost” or “workforce availability” as reasons for overseas expenditure to qualify for relief.

While new conditions for overseas R&D will likely be received negatively by multinational companies, potentially influencing R&D investment away from the UK, it remains to be seen how this impact will be offset by the increased generosity of the RDEC rate.

The econometric model published as part of HMRC’s Evaluation of RDEC in October 2020 calculated additionality for RDEC as having greater potential of the two schemes—which aligns with the chancellor’s recent decision-making. However, as welcome as the increase in rates may be for multinational companies and others accessing the RDEC scheme, many would prefer the reliability of a stable policy environment, to aid longer term planning and development cycles.

Investment Slowdown and Impact on SMEs

The reduction in generosity for the SME scheme paints a daunting picture for smaller innovative SMEs.

The reduction is stark and will hit loss makers and those with smaller profits the hardest because of the impact of the previously announced rise in corporation tax to 25% for businesses with profits over £250,000.

The changes mean that an SME making an R&D claim that includes £500,000 of qualifying expenditure will benefit from a payable credit of £93,000, compared to the previous amount of £166,750.

The chancellor has suggested that “Those with more should contribute more.” However, a likely outcome of the reduction in generosity for the SME scheme is that highly innovative pre-revenue start-ups will be disincentivised, forced to extend development timelines or to spend time looking for alternative financing. All of this risks hampering the UK’s international competitiveness in R&D intensive sectors and cutting-edge technologies.

R&D tax relief has been a reliable and stable form of funding for innovative SMEs. The funding is proactively factored into investment decision-making and informs the timing and extent of many planned development programs. The relief incentivizes businesses of all sizes, but importantly the SME scheme helps start-up and scale-up companies to move quickly and stay ahead of global competition.

The success of SMEs directly impacts the scalability and flexibility of larger, more complex companies, including multinational companies through supply chains.

Ultimately, a lack of SME investment in R&D stifles competition and decelerates development, reducing broader economic spill-over benefits.

Bridging the Gap between Policy and Implementation

The chancellor’s rebalancing of R&D tax relief represents a step towards a simplified, single RDEC-like scheme for all. This is something many have advocated for—albeit not at a lower rate of generosity for R&D-intensive SMEs.

And while tackling error and fraud will remain important, this should not detract from the transformational influence the incentive has for innovative businesses, or indeed the significance of incentivizing R&D to enable growth and prosperity for UK plc.

Piecemeal changes which risk adding complexity to the incentive and undermining confidence will not be welcomed in the long term by companies accessing either the SME or RDEC scheme. Measures that simply aim to diminish the overall cost of the incentive are not likely to help fuel the growth that a mature and resourceful innovation policy requires.

Planning Points

With the commencement date only three months away, the first step for a business planning for the changes will be to evaluate how they are likely to impact its R&D claim—including both the value and when these will apply. Note that the rate changes commence at a slightly different date to the new rules for overseas R&D, data, and cloud expenditure.

Reflect on how this impact may change the business’s innovation roadmap. Is there any action you can take now to mitigate any reduction in relief? Examples include onshoring external R&D activity or planning the timing of certain expenditure carefully.

With changes coming and HMRC stepping up compliance activity, now is the right time to consider whether the business’s R&D claim methodology is fit for purpose or in need of an update. Seek advice if needed, but make sure to work with a properly qualified and experienced tax adviser. The tax advice market is not formally regulated, so ask for evidence of professional body membership and check the terms of any agreements carefully.

Finally, the review of R&D tax reliefs is ongoing, and the government has invited feedback from industry on future reforms. If R&D is vital to your business, this is an opportunity to feed in your views, experience of R&D tax reliefs, and suggestions for how the UK can successfully foster and support a culture of innovation.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Jenny Tragner is Director and Head of Policy with ForrestBrown.

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