Keeping the U.K.'s R&D Environment Globally Competitive

In his Spring Statement and the “Tax Plan” published with it, the U.K. Chancellor Rishi Sunak focused on capital, people and ideas. Under the heading of “Ideas,” the plan promises to raise public investment in research and development (R&D) to 20 billion pounds ($26 billion) a year by 2024–25 and to continue the ongoing process to “reform and improve the R&D tax reliefs at the next Budget.”

Here it is important to understand what the Chancellor means by “improve”: the Spring Statement document refers to “steps to ensure the UK’s R&D tax reliefs are as effective as possible and, importantly, deliver the best possible value for taxpayers.”

In terms of maintaining the existing incentive that R&D relief provides, just keeping the U.K. R&D regime competitive with other jurisdictions is going to be a difficult task, as the Chancellor has already announced tax changes that will make U.K. R&D relief in 2023–24 significantly less beneficial than it is now.

Tax Relief Declining

Currently the 13% research and development expenditure credit (RDEC) is actually worth 10.53% of their costs to large companies, because it is implemented as an “above the line credit” in tax calculations. This effective rate of relief will fall to 9.75% from April 2023 when the U.K.’s corporation tax rate increases to 25%. An increase in the headline rate of RDEC relief of around 1% will be required so as not to erode RDEC’s current value.

Conversely, the value of R&D relief for small and medium-sized enterprises (SMEs) will increase in value for those large enough to pay corporation tax at 25% from April 2023. However, statistics from the Office for Budget Responsibility suggest that the government does not get a good return on its investment—for every one pound of tax relief claimed it stimulates 0.60–1.28 pounds in additional private R&D expenditure. The Chancellor has referenced this research several times and the inference is that SME relief may well be pruned back or modified as part of the wider reforms.

There have even been suggestions that the SME relief will be combined with the RDEC into one simplified relief. I believe this is unlikely as it would be hugely damaging for start-up companies: To illustrate the scale of difference in the reliefs, a combined RDEC would have to give relief at around 33% to give start-ups the same financial support as they currently enjoy under the SME scheme.

Overseas Costs Issue

At the last budget, the Chancellor announced his wish to ensure that R&D relief is only given where R&D work is carried out in the U.K. and cited government statistics showing that in 2019 only 25.9 billion of the 47.5 billion pounds of R&D costs on which R&D relief was claimed related to R&D work actually carried out in the U.K.

Reforms to be introduced from April 2023 will mean that companies will be prohibited from claiming the costs of overseas activities and workers as part of their R&D relief claim under either scheme, with only a few narrow exceptions to this new rule.

There is clearly logic in ensuring that R&D relief delivers the wider benefits that having the activity and workers in the U.K. brings to the economy. However, this change will have a huge impact on the costs, profitability and perhaps even viability of many U.K. businesses. While some R&D work can be “onshored” and support for “high skilled immigration” is helpful, in many cases this has cost implications that could outweigh the benefit of claiming U.K. R&D relief (especially under the current RDEC regime).

Put simply, many start-up company business models depend on being able to outsource their R&D work to lower-cost locations. As U.K. R&D relief will no longer be available in most cases, U.K. start-ups may well migrate to other jurisdictions: not quite what the Chancellor wants, I suspect.

Larger U.K. companies will lose the competitive advantage of being able to cut their R&D costs by offshoring and claiming tax relief on those lower costs. In many cases it seems unlikely that onshoring R&D activities will be the immediate response of these companies—it may not be practical and, at the current rate of relief, RDEC is unlikely to be sufficiently financially attractive to cover the cost of onshoring. Worst of all, if they are going to carry out some of their R&D overseas, businesses may seek to reduce their U.K. footprint and centralize their R&D functions in low-cost locations, regardless of the tax relief available in the U.K..

Cost Cutting

Finance Act 2023 will include some initial measures to deter the “abuse” of R&D tax relief that the government perceives is taking place. Alongside new powers and enforcement action against rogue R&D advisers, this includes new compliance procedures to deter speculative R&D claims. How much these changes alone will save the taxpayer remains to be seen: I suspect that they will be dwarfed by the “savings” related to overseas costs.

The Case for a Higher Rate of Tax Relief

Against this background it is hard to see how the U.K. will remain a competitive place to carry out R&D work without a considerable increase in the headline rate of RDEC relief—but how much of an increase would be enough?

Using BDO’s proprietary R&D data of past claims across a range of industry sectors we have assessed the potential impact on different sectors based on the average amount of overseas costs claimed. We have used the data to try to determine the level the RDEC rate would need to be increased to in order for large companies to match the tax relief they can claim under the current rules.

• IT sector—RDEC rise to 140% from 13%

Due to extreme skills shortages in the U.K., companies must often pay high salaries to attract and retain highly qualified software developers and data engineers. It is not uncommon, therefore, for IT and software development companies to use personnel employed by overseas group companies to provide highly specialized individuals at a lower cost. This results in a large percentage of their qualifying expenditure being composed of overseas costs which will no longer be eligible from April 2023.

• Financial services sector—RDEC rise to 55%

As most of the large companies within the financial services sector are institutions such as banks, asset managers, and insurance companies with an international presence, a substantial amount of their qualifying expenditure currently arises from the cost of externally provided workers overseas (either within their group or fully outsourced). As they are often regulated businesses, the key functions and a significant proportion of personnel have to be located in the U.K., so the impact is not as extreme as for pure IT/software businesses.

While the inclusion of costs for “pure maths” work and cloud computing costs from April 2023 will be beneficial for many financial services businesses, this is unlikely to balance the loss of relief on costs on software development costs arising overseas.

• Engineering sector—RDEC rise to 19%

While large engineering groups outsource some R&D work overseas, most of their qualifying expenditure relates to personnel costs comprised of highly specialized engineers and scientists who are based in the U.K. However, they do tend to use overseas workers within their group when having to deal with large workload fluctuations—this means that a reasonable proportion of their qualifying R&D expenditure currently comprises overseas costs.

We would expect the exclusion of overseas costs to impact the large engineering companies the most, particularly those groups with high levels of international presence and global operations. It is also important to remember that the narrow exemptions for overseas costs within the new rules may apply in some instances, for example where it is not possible to carry out trials of products in the U.K. for geographical (e.g. Arctic testing) or regulatory reasons.

• Construction sector—RDEC rise to 14%

Due to the site-specific nature of the construction sector, it comes as no surprise that construction companies across the whole supply chain have the lowest overseas costs in R&D claims. The U.K. has some of the highest construction costs worldwide, where the inability to use overseas labor (along with the off-payroll labour/IR35 rules) makes it difficult to drive labor costs down, regardless of the fact that the sector has a large reliance on external workers. In conclusion, only an increase to take into account the corporation tax rise would seem essential.

• Overall—RDEC increase to 70%

Across the thousands of R&D claims in our database, our modeling shows that an RDEC rate of circa 70% would be needed in order for most companies to be able to receive a similar level of financial support after April 2023 as they currently receive.

This may seem like an improbably large figure, and it would certainly be world leading if introduced, but it does clearly illustrate how beneficial the current rules on costs have been to U.K. companies: the U.K. currently has an R&D regime that is highly globally competitive (at least in terms of encouraging start-up companies to be headquartered in the U.K.).

Other Levers

On the assumption that any headline increase in the rate of RDEC relief from April 2023 will not be anywhere near as dramatic as our comparisons illustrate is necessary to maintain equivalent levels of support, it is clear that the Chancellor will have to introduce a much wider package of measures to increase private sector R&D in the U.K.

The 2021 consultation on R&D reform considered the issue of R&D carried out in different regions of the U.K., noting that most R&D is carried out in South East England. The government has yet to comment further on this, but in a recent survey of mid-market companies carried out by BDO, only 16% of respondents supported the idea of using differential rates of R&D relief to help with “leveling up” the economy. However, differential rates of RDEC for CO2-reducing or energy-generating/saving R&D projects have clear attractions amid the current energy and environmental crises.

I also think there is scope to expand the types of cost that qualify for R&D relief—for example accounting depreciation on capital assets used in the R&D and the legal costs associated with patent applications to protect their innovations. Both of these costs are eligible in other international R&D regimes.

The U.K. already offers 100% capital allowances relief for qualifying capital expenditure on R&D. I hope this is improved as part of the capital allowances overhaul being considered, as the government looks to replace the uncapped capital allowances super-deduction when it expires in April 2023. A deduction of 130% for qualifying capital expenditure on R&D capped at, say, 5 million pounds, would be helpful.

Maintaining the current rate of relief for the patent box, making it more valuable as the corporation tax rate rises, is essential, as is broadening its scope—for example, to allow U.S. patents to qualify for the scheme would be extremely helpful. Changing U.K. patent rules so that more types of software could be patented (and therefore qualify for patent box) would be helpful and forward-looking, as software plays an increasingly important role in all areas of the U.K.’s economy.

Whether or not the SME R&D scheme is scaled back, a wholesale overhaul of the grants landscape in the U.K. is required to support early-stage businesses: I believe that a significant increase in funding would yield strong payback for the taxpayer in terms of economic growth and jobs.

More “Bang for Your Buck”

It is easy for a government to cut back on tax reliefs but much harder to persuade companies to invest in R&D projects in the U.K. when there are much cheaper alternatives overseas. The bottom-line issues for businesses mean that the Chancellor’s aim of bringing more R&D work to the U.K. is likely to be undermined by the April 2023 changes as currently proposed.

A full package of measures will be needed to support future innovation in the U.K., but if a significant increase in the RDEC cash incentive for doing R&D work in the U.K. is not part of that, there may well be even less R&D “bang” in the U.K. in future.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Carrie Rutland is innovation and technology partner at accountancy and business advisory firm BDO.

The author can be contacted at: carrie.rutland@bdo.co.uk