Streamlining R&D tax relief: how will merging the incentive affect UK businesses?

HM Revenue and Customs statistics from September this year showed a welcome increase in R&D expenditure in the UK in 2021-22, totalling £44.1 billion ($53.8 billion), following a dip thought to be caused by the pandemic. But this does not tell the whole story, with plans afoot to change the face of the long-established incentive, seen by some as the government’s flagship innovation tax policy.

For many years since its inception back in 2000, R&D tax relief remained relatively stable, but recent years have seen a series of piecemeal changes add complexity for companies making claims. And with the chancellor’s Autumn Statement on the horizon, innovative businesses in the UK are looking ahead to further significant reforms, with the potential merger of the two existing schemes into one tax relief.

Currently, the relief operates through an SME scheme for smaller businesses and a separate scheme for larger businesses, known as the research and development expenditure credit (RDEC). The government recently consulted on the merger of the two, having already adjusted R&D tax relief rates in last year’s Autumn Statement to bring them closer together. This ‘rebalancing’ was seen as a stepping stone towards the now-proposed single scheme.

Draft legislation published in July brings such a merged scheme closer and proposes an implementation date as early as April 1 2024. This timescale raises questions about the ability of businesses to prepare and the impact this could have on their R&D investment plans.

Currently, the SME and RDEC schemes have different rules, with notable differences in their approaches to contracting out of R&D. Therefore, whatever approach is adopted will result in changes for many businesses currently claiming relief. While the intention is to adopt an RDEC-style credit, the proposals would mean changes to the existing RDEC rule base to accommodate the merger. For example, some companies will gain the ability to claim for relief for R&D carried out by their subcontractors, while R&D subcontractors who can currently claim under RDEC in certain circumstances will lose their eligibility – with potential implications for supply chain relationships.

While there will be winners and losers in the short term, the single scheme proposals provide an opportunity to bring certainty to what is currently a contentious area. By ensuring that relief is targeted to the companies driving decision-making on R&D, the government can reconnect the incentive with its original aim of encouraging and increasing private sector investment in innovation. However, understanding exactly how this will play out for supply chain partners should be explored further before the single scheme gets the green light.

While the current twin-track system has its advantages, it can be challenging for businesses to navigate it successfully. The first step in claiming is to confirm which scheme a business is eligible for, but this process isn’t as simple as it may seem.

Aggregation rules on capital, as well as restrictions for subsidised expenditure and subcontracted R&D can affect firms that may operate as SMEs but fall into RDEC when considering R&D relief. The merger of the two schemes would theoretically make things simpler by removing a number of these complexities.

However, the additional rate introduced in the spring to enhance relief to ‘R&D-intensive’ SMEs (companies whose investment in R&D accounts for 40% or more of total business expenditure) is scheduled to run alongside the newly merged RDEC scheme. The aim of achieving simplicity by replacing two separate schemes with one does not sit well with the prospect of continuing with two schemes, albeit with a smaller number of businesses accessing the R&D-intensive SME scheme.

Because eligibility for the R&D-intensive rate is based on figures included in a company’s tax return, it will always be confirmed retrospectively, meaning some businesses will be unable to forecast the relief they will be due, which may hamper the scheme’s ability to influence decision-making. Some companies face moving between the R&D-intensive scheme and the merged RDEC scheme from year to year, making long-term planning even more difficult.

Moving R&D-intensive SMEs onto the single scheme is one possible solution to this issue, aligning the rules to achieve a simpler framework but preserving a higher credit rate for those businesses. The SME scheme has historically offered a more generous rate of relief because of the challenges SMEs face in accessing finance for risky endeavours such as R&D. To recognise this, the government should commit to reviewing this (somewhat hastily designed) measure after 12 months, and reduce the eligibility threshold to bring more companies into scope of the higher rate, which compares much more favourably globally to the RDEC rate.

While businesses will welcome simplification of the scheme, there remain very real costs for companies adapting to such significant change. Many will have established systems for identifying R&D projects and expenditure and these proposals come alongside a tumultuous period of change for R&D tax relief. It is important that businesses are given time to review their processes and to adapt before a single scheme comes into play. Broader questions remain about the direction of travel in this policy area, particularly after the rebalancing of the rates last autumn signalled a potential declining enthusiasm for supporting SME R&D.

Previously announced limitations on the availability of tax relief for overseas R&D expenses are locked into the latest proposals. That means expenditure associated with externally provided workers and subcontractors will generally no longer qualify for R&D tax relief. Narrow exceptions apply in cases where it is impracticable for the company to replicate the circumstances within the UK. These exceptions are limited in scope, and do not include cost or availability of skills, which are often cited as drivers for businesses to look overseas for input into their R&D. Businesses recruiting from a global talent pool are likely to be impacted, with knock-on effects for decision-making on the location of R&D projects.

R&D investment requires significant resources and strategic planning, meaning the decision to invest is often made with long-term considerations. The flow of piecemeal changes announced since an initial consultation launched back in March 2021 has created considerable uncertainty that has an impact on the effectiveness of R&D tax relief as a tool to encourage investment in innovation.

Continued limited reforms would be challenging for businesses to navigate, necessitating constant changes to their internal strategies to adjust. More importantly, a lack of a clearly communicated end goal, timetable or clear strategy undermines confidence in the UK’s ability to support the next generation of technology businesses. Clearly, the R&D tax relief scheme needs a longer period of stability following the significant proposed overhaul.

Equally, getting the design of the single scheme right first time will be essential to ensure success and avoid the need for future tinkering – which is why taking the time to consider all the implications first is so important. Tax consultations are not always easy for businesses to engage with, so proper outreach from policymakers to consult businesses on what positive change looks like gives the scheme the best possible chance of success. A well-functioning R&D tax incentive drives increased business investment in R&D, resulting in spillover benefits from an innovation culture.

‘R&D’ and ‘innovation’ are often terms that are used interchangeably, but one of the key challenges facing R&D tax relief is what we really mean by research and development. Taking the opportunity to modernise the definition of R&D would help the UK to futureproof its science and technology investment by establishing a much clearer framework with which to target government funding. This would also help to improve business understanding of what does and does not qualify as R&D, reduce errors and enable HMRC to focus its resources on tackling fraud.

R&D tax relief is vitally important to innovative UK companies as they face economic headwinds and global competition. As the country strives to achieve its ambition to be a scientific and technological superpower, an incentive that works for innovative businesses of all sizes is imperative. The single scheme proposals provide the opportunity to deliver this – if the government takes the time to listen to the voice of those innovative businesses.