Bloomberg Tax
March 8, 2023, 8:00 AM

The Innovation Funding Gap—Four Tax Reforms for the UK Treasury

Benjamin  Craig
Benjamin Craig
Ayming UK

The UK government is talking a big game when it comes to innovation. Only a few weeks ago, Chancellor Jeremy Hunt reaffirmed the government’s ambitions to become a science superpower and made a direct appeal for businesses to innovate in the UK. In his speech, he said, “If you do, we will put at your service, not just British ingenuity, but British universities to fuel your innovation, Britain’s financial sector to fund it, and a British Government that will back you to the hilt.”

So the will is there, but is the policy?

It’s true the government is listening to feedback from experts, implementing some sensible reforms, and taking positive action to stimulate UK innovation, such as creating a dedicated Department for Science, Innovation and Technology. And no doubt, innovation will be a prominent theme in the upcoming budget on March 15.

But the reality doesn’t match the rhetoric. Despite the government’s efforts, the evidence is mounting that innovation in the UK is on a downward trajectory. The findings of Ayming’s recent UK Innovation Barometer 2023 revealed that almost three-quarters of firms have either offshored research and development activity across 2022 and 2023, or plan to do so.

To stimulate R&D activity across the UK, the treasury should consider the following four reforms to the R&D tax credit scheme. These could dramatically improve the UK’s R&D funding landscape.

Use Technology to Solve the Fraud Problem

A recent fraudulent claims scandal has sent ripples through UK R&D, leading to a clampdown from the tax authority, HM Revenue & Customs. It is undeniably a problem, with estimates suggesting fraud and error cost around £469 million ($564 million) in 2021–22.

However, the government’s reaction has been misguided. Our research revealed that HMRC’s clampdown has resulted in widespread delays to funding and is preventing legitimate innovation. This directly contradicts the treasury’s intentions to stimulate innovation: so instead of delaying payments and leaning on its staff to scrutinize claims, there must be a more long-term solution.

To tackle this, HMRC should overhaul the R&D application process and develop a simple, intelligent portal for applications, in combination with its form for “advance notification” and standard information required. This is an overdue change that would improve HMRC’s ability to detect fraud and streamline application processes for businesses.

Reverse Cuts to the SME Scheme

Partly in reaction to fraud, the chancellor announced a cut to the small and medium-sized entity scheme in November. The SME relief is due to be reduced from 130% to 86% in April, and the payable tax credit rate will be reduced from 14.5% to only 10%. The effect will be to reduce the cash benefit for many SMEs to barely half the current amount. This will be disastrous for the UK’s innovation.

Research from the Federation of Small Businesses found that tens of thousands of businesses plan to scale back investment if the government continues with the reduction. And considering the UK Innovation Barometer found that tax credits were the second most popular reason for R&D offshoring, the UK government risks accelerating the R&D exodus among SMEs.

The chancellor himself has said that becoming the world’s next Silicon Valley relies on the innovation of small businesses. It therefore seems extremely counterintuitive to cut the SME scheme. These credits provide thousands of SMEs with funding without which they wouldn’t be able to innovate. As such, the treasury must reverse this cut.

Expand the Scope of the Credits

Beyond financial generosity, the cost criteria deserve further attention. The treasury has already added pure mathematics to the definition of R&D and the data and cloud computing to the types of costs that can be included. These changes were universally welcomed, but other important costs are still omitted.

For example, costs relating to the rental of plants or premises aren’t currently eligible. These are both types of cost which are necessary for many R&D projects and their omission is therefore a source of frustration to many claimants. The treasury should therefore review the criteria to ensure all costs associated with R&D are included.

Abolish the Capital/Revenue Divide

One of the most complex areas of the current R&D tax landscape is the treatment of capitalized costs; that is, costs accounted for on a claimant’s balance sheet. Costs are currently treated differently for a few reasons, such as for tangible and intangible fixed assets, and the nature of costs as capital or revenue. This latter point is a complex and sometimes controversial area.

Given that this depends on a business’s accounting policies in terms of how the company recognizes costs, rather than whether they are R&D, it is disappointing that it can significantly affect the value that a company can receive. It can also bring additional complexity to the process of qualifying and quantifying an R&D claim.

The distinction should be abolished. In other words, costs should be eligible for R&D tax reliefs regardless of their treatment in the company’s accounts. This would mean that decisions about investments in R&D can be made purely on the merits of the innovation itself, without the need to also consider complex questions of accountancy and legislation.

Consistency is Key

As we approach the budget, the government must consider its next steps carefully. We know that the government is now considering replacing the two separate R&D expenditure credit and SME schemes with a single, simplified tax credit scheme, which could be a positive move.

While reform is positive and long overdue, stability is fundamental to encouraging investment in R&D. Countries such as France and Canada have successful schemes because the consistency in the process, eligibility, and benefits allows companies to make long-term investment decisions with certainty of the tax implications.

Therefore, in an ideal situation, the government should endeavor to make all reforms in one sweep, and with appropriate warning so that plans can be made in anticipation of the changes. But at the very least, any further reforms must be positive extensions of the existing scheme that will encourage further uptake, rather than taking steps backward that will reduce investment.

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

Benjamin Craig is associate director of R&D tax credits at Ayming UK.

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