The UK government is conducting a wide-ranging review into the tax credits system for qualifying expenditure on research and development (R&D) activity.
However, introducing effective reform to the UK's R&D tax relief system will be a careful balancing act between ensuring changes improve efficiency, whilst also maintaining accessibility to R&D intensive businesses that are often heavily reliant on tax reliefs.
- Wide ranging review considers expanding R&D definition and merging SME and large company schemes
- Relief could be restricted for overseas R&D
- Likely outcome of review unclear
The government has set itself the target of raising total investment in research and development (R&D) to 2.4% of UK GDP by 2027. At the Spring Budget 2021, chancellor Sunak announced an extensive review of the R&D tax relief system “with the objective of ensuring the UK remains a competitive location for cutting edge research, that the reliefs continue to be fit for purpose and that taxpayer money is effectively targeted”.
The review is wide-ranging and broadly will consider whether the definition of qualifying R&D should be expanded and whether the existing two separate systems of reliefs for larger and smaller businesses should continue. It will also consider whether changes should be made to how the system is administered and whether territoriality requirements should be introduced.
Given that the consultation document (26-page / 242KB PDF) reads more like a call for evidence, at this stage it is difficult to draw any conclusions as to what the consultation may ultimately mean for R&D intensive businesses. There is currently no clear indication of the route any future reforms may take. However, if evidence obtained through the consultation indicates that changes to the regime could translate into increased investment in innovation, and particularly if it supports the UK's post Covid-19 recovery, it is likely that the government will be keen to act swiftly and introduce reforms at pace.
Affected businesses and interested stakeholders are encouraged to respond to the consultation which closes on 2 June 2021.
The current system
Two forms of tax reliefs are currently available to companies for certain R&D qualifying expenditure.
- Relief is available for small and medium size enterprises (SMEs) in the form of an effective deduction of 230% on qualifying R&D costs where certain conditions are met; and
- A research and development expenditure credit (RDEC) at 13% of qualifying expenditure is also available. The RDEC is primarily targeted at larger companies, although it may be used and can indeed prove valuable to SMEs in certain circumstances.
Capital allowances providing a 100% deduction may also be available for qualifying capital expenditure on R&D.
The meaning of R&D
Both SME relief and RDEC adopt the same definition of R&D and qualifying activities. The meaning of R&D for tax purposes is defined by reference to activities that are treated as R&D under UK generally accepted accounting practice (GAAP).
Further direction on qualifying R&D is then provided by guidance from the Department for Business, Energy and Industry Strategy (BEIS) that was first published in 2004. Broadly, the guidance specifies that the R&D activity must take place within a project that seeks to achieve an advancement in science or technology. The activities may be seeking a resolution of scientific or technological uncertainty and certain qualifying indirect activities related to the project may also qualify as R&D.
SME relief
Under SME relief, SMEs can deduct an additional percentage of 130% of qualifying expenditure when calculating their taxable profits or losses. This provides for an effective deduction of 230%, since 100% deduction for revenue expenditure is already allowed under normal corporation tax rules. Ultimately, the relief will reduce taxable profits or increase taxable losses.
Beyond there being qualifying expenditure on a qualifying R&D activity, there are several other conditions that need to be satisfied for SME relief to be available. For example, the relief is broadly only available to SMEs and is restricted if the SME has already obtained a grant/subsidy in relation to the R&D expenditure. There is also a cap on the total level of relief that can be claimed for each R&D project.
Penny Simmons
Legal Director
If evidence obtained through the consultation indicates that changes to the regime could translate into increased investment in innovation, it is likely that the government will be keen to act swiftly.
Where an SME is loss-making, it may have the option of surrendering all or part of its losses relating to the R&D to HMRC, in exchange for receiving a repayment of the tax credit as cash. Any repayment is capped at 14.5% of the losses available for surrender. Therefore, with a corporation tax rate of 19% (rising to 25% from April 2023), the repayment will be less than the tax saving if the losses are carried forward to set against future taxable profits. However, a repayment may be favourable to SMEs that are loss-making, have cash-flow constraints and therefore, need to raise cash in the short-term.
For accounting periods beginning on or after 1 April 2021, the repayment is also subject to an annual cap of £20,000 plus three times the company's total PAYE and national insurance contributions' liability.
The RDEC
Broadly, the same conditions for qualifying R&D activities and expenditure apply in relation to the RDEC as with SME relief. However, the RDEC is only available where R&D is subcontracted in limited circumstances. Although, targeted at larger companies, the RDEC is available to SMEs and may be utilised where SME relief is not available: for example, where the cap has been reached, or where a grant/subsidy has been awarded and therefore SME relief is restricted.
In contrast to SME relief, the RDEC uses a different method of calculating corporation tax relief on R&D expenditure. The R&D expenditure credit is often referred to as an 'above the line' credit because it is brought into account as a receipt of trade, consequently increasing taxable profits (or conversely reducing losses) (CTA 2009 s 104A). A credit of 13% of the qualifying expenditure is then credited to the company. In certain limited circumstances, a repayment may also be available.
The consultation and scope of the review
Although labelled a 'consultation', the document published jointly by HM Treasury and HMRC is more akin to a call for evidence, since it does not detail any broad proposals. Rather, it outlines aspects of the relief system that are the subject of the review and seeks input on whether, rather than how, changes should be made.
Structure and administration of the reliefs
The first part of the consultation considers whether the two relief systems should be consolidated. Consolidation may simplify the regime, which may be beneficial to many businesses trying to navigate an increasingly complex corporate tax system. However, this may not be a straightforward exercise. There are significant differences between the two systems and as outlined above, one relief may be available where the other is not. For example, SME relief rather than the RDEC may be available where an SME has subcontracted the R&D to another entity. The ability to subcontract R&D activities can be vital to SMEs that may not have the resources and sufficient finance to conduct the R&D itself.
Whereas in contrast, the RDEC may be claimed where SME relief is unavailable because the company has already obtained a grant/subsidy in relation to the R&D. Therefore, the pursuit of simplification should be welcomed, but it will be a fine balancing act to ensure that SMEs and companies at the margins do not find themselves disadvantaged by any form of consolidation.
The question as to whether to change the process for claiming reliefs raises similar issues. Administering the tax reliefs through the corporation tax system (as is currently the case) creates simplicity. However, this may also lead to delays in obtaining relief and result in the relief not being received until many months after the R&D activity has been undertaken, negatively impacting cash flows.
Qualifying expenditure and R&D definition
The consultation also considers the definition of R&D and the nature of activities that should qualify for relief. The current definition is based on BEIS guidelines that have been in place for over 15 years, so it is unsurprising that its review would fall within the scope of the consultation. This is especially so, given the dramatic developments in science and technology over the past 15 years, which are reflected in the government's recent decision to include data and cloud computing costs within the scope of eligible expenditure. Any further changes to the definition of R&D would need to be broad enough to allow for further rapid and anticipated changes within the sphere of science and technology.
The government will also need to be mindful that the definition is well understood by many businesses that are reliant on R&D reliefs to succeed. Therefore, again the government faces a balancing act of introducing improvements and efficiencies, whilst ensuring that the reliefs remain accessible and do not become overcomplicated.
Territoriality
To qualify for R&D tax relief, there is currently no requirement that the R&D activity must be undertaken in the UK. Consequently, UK companies that incur R&D outside the UK may still be eligible for full tax relief. The government wants to maintain the UK's position as “a global leader in science and innovation” and ensure that the reliefs incentivise UK innovation and are appropriately targeted in a way that best benefits UK industry.
However, any territoriality restrictions may introduce further unwelcome complexity to the regime. Restrictions may be particularly concerning to the life sciences sector where overseas research, most notably in relation to medicines and vaccines may be vital to the eventual development and approval of a new drug or vaccine. One strategy to overcome this might be to introduce some form of carve-out for overseas R&D which is integral to the development of the innovation.
Other developments affecting R&D relief
The possible changes to the R&D tax reliefs should be considered alongside other developments affecting R&D intensive businesses. At the Budget, the government also announced a review into the enterprise management incentive (EMI) scheme, a tax-advantaged employee share scheme, to consider its effectiveness in supporting SMEs “to recruit and retain the key talent they may need to grow and scale up”. The scheme is a valuable tool for many R&D intensive SMEs and therefore, its review is likely to be of interest.
The chancellor also used the Budget as an opportunity to confirm the creation of a new government-led funding programme called ‘future fund: breakthrough’, which will be overseen by the British Business Bank and will provide £375m 'to support the scale up of the most innovative, R&D intensive businesses'. Again, this will be another development being followed by those R&D intensive start-ups reliant on external capital to progress and innovate.
This update is based on an article by Penny Simmons, a tax expert at Pinsent Masons, the law firm behind Out-Law, which was published in Tax Journal on 14 May 2021.
