Legislation Day 2023—The Proposed Future of R&D Tax Relief in the UK

Background:

Legislation Day—A Merged R&D Regime:

On 18 July 2023, HMRC published a policy paper and draft legislation setting out the design of a potential merged R&D tax incentives regime. This would apply a R&D Expenditure Credit (RDEC) mechanism for all claimant companies (except for those claiming under a separate regime for R&D-intensive loss-making SMEs - see below). If taken forward, the regime is expected to apply to qualifying expenditure incurred on or after 1 April 2024. The government will announce its decision on whether to proceed with the merged regime, and clarify the final policy design, at the next fiscal event.

This follows a consultation launched by HMRC in January 2023 into the design of a single, simplified R&D tax relief scheme to merge the existing RDEC and SME regimes, as part of an ongoing review of the R&D tax reliefs in the UK. The consultation ran until 13 March 2023 and invited opinions from stakeholders on the possible benefits, costs, and impacts of a single R&D tax credit scheme, as well as key design features and transitional arrangements.

It was made clear that the principle aims of a single regime are to: (i) minimize administrative burdens for HMRC, as well as for claimant companies; (ii) provide a greater degree of clarity to SMEs, and in particular, to those with complex funding arrangements or corporate structures; and lastly, (iii) to support the government’s ambition to increase national R&D investment to 2.4 percent of GDP by the 2027. The government’s response to the consultation, also published on 18 July 2023, sets out how the proposed merged regime is intended to meet these policy aims.

We have set out below key details of the announcements, the potential impact for businesses, and the wider context of these proposals.

Above-the-Line Credit:

Under the merged regime, tax relief would be delivered by means of a taxable above-the-line expenditure credit at a gross rate of 20 percent (15 percent cash credit net of corporate tax). The relief mechanism is in line with the existing RDEC regime, and as such it represents a significant change for businesses currently claiming under the SME scheme, which presently provides tax relief to SMEs via an enhanced expenditure deduction applied when calculating taxable profits (with, for loss making SMEs, an option to surrender losses for a payable tax credit).

PAYE/NICs Cap:

The draft legislation proposes to maintain a PAYE/NIC cap in the new unified R&D regime, using the existing SME design, which is slightly more complex than that under the large company RDEC regime - R&D payable tax credits under the new regime would be capped at £20,000 plus 300% of the company’s overall PAYE and NIC contributions for the relevant accounting period in which the R&D claim is being made.

Claiming Subcontracted Expenditure:

One significant change is that the new regime, as presently drafted, will follow the treatment of subcontracted expenditure currently applied under the SME regime, such that entitlement to claim tax relief on subcontracted R&D activity sits with the payor, rather than the business actually undertaking the R&D activity. The new regime seeks to prevent the ‘double claiming’ of tax relief on R&D activities by restricting companies from claiming for expenditure incurred on R&D activities contracted out to them, on the basis that this expenditure will be captured in the R&D claims prepared by the subcontractor of the R&D.

The government will ‘work with industry to further develop its approach to this issue’, which would be significant for a range of businesses across all sectors but particularly those who operate with consultancy-style business models. The largest impact may be for businesses who currently subcontract out their R&D (and may now gain entitlement to make an R&D tax relief claim), and businesses who carry out R&D activities subcontracted to them (who may lose their entitlement to make an R&D claim). This aspect remains under consideration and, like the remainder of the policy design, is subject to change before a new regime is finalised.

Claiming Subsidised Expenditure:

A notable aspect of the policy design that is ‘still under consideration’ is a potential restriction from businesses claiming expenditure on projects that have been ‘subsidised’ which would restrict the availability of R&D tax relief for companies that undertake projects through customer contracts or, potentially, where they have been funded by other companies in the same corporate group. This is an area that businesses will be monitoring closely, as the treatment of subsidised expenditure could significantly widen, or narrow, businesses’ entitlement to claim R&D tax relief depending on the final policy design.

Other factors

A potential ‘Minimum Expenditure Threshold’ and rules on Qualifying Indirect Activities will be kept ‘under consideration’. There is also a commitment to review HMRC’s technical guidance on the reliefs, and consult on a new draft ‘Guidelines for Compliance’ to assist R&D claimants.

Broader Context

On 17 July 2023, HMRC published a document titled ‘HMRC’s approach to Research and Development tax reliefs’. This set out HMRC’s latest analysis of non-compliance in the R&D tax relief sector, as well as HMRC’s compliance approach to supporting businesses and taking action in respect of non-compliant claims and perceived abuse of the regimes. This provides an interesting context to the proposals for an RDEC-style merged scheme, given HMRC’s analysis demonstrated that the ‘vast majority of non-compliance’ related to the SME customer group.

On a broader level, the government’s response to the consultation on R&D reliefs reports that respondents believed that a ‘stable and tax efficient’ R&D regime would ‘encourage greater investment in UK R&D including from internationally mobile investors’. This aligns with comments made by the Chancellor in his 2023 Spring Budget speech regarding ‘the importance of a competitive tax regime’. Full costing of the merged regime is expected to be presented by the government at the next fiscal event, which will reveal interesting insights around the balance to be struck between promoting innovation in the UK while retaining focus on value for money.

The impact of the merged regime on the UK’s competitiveness will only become clear with time, but businesses will be keen for certainty and stability following a period of rapid and complex change to the R&D tax regimes (including the current proposals, as well as recent changes to the headline rates of relief, extensions to qualifying expenditure and activities, restrictions on overseas R&D expenditure, and claim notification and Additional Information Form requirements).

In particular, the significant changes to entitlement in respect of subcontracted R&D will see some businesses benefit from the changes but others negatively impacted, with the overall impact on UK competitiveness a complex picture. The government notes that the merger of the regimes ‘would present significant opportunities for simplification’, and there would be streamlining of the mechanism for relief as well as reduced differences in the calculation and approach between SMEs and Large businesses. However, there is inherently an increase in complexity in the short term while businesses get to grips with the new regime – and the ongoing existence of a separate regime for certain SMEs means that challenges around assessing SME/Large company status will remain for a number of businesses.

There is also a short lead-in time for the potential new regime, meaning that businesses trying to forecast their R&D tax credits for 2024 onwards may currently be unable to do so with sufficient certainty. Businesses with year ends other than 31 March would also have to prepare two separate R&D claims for the period straddling 1 April 2024.

Other Considerations from L-Day 2023:

R&D Intensive SME Regime:

As announced at the Spring Budget 2023, additional tax relief will be made available to ‘R&D-intensive’ loss-making SMEs. Under this regime, with effect for expenditure incurred on or after 1 April 2023, eligible claimants can claim the SME payable credit at an increased rate of 14.5 percent of the enhanced R&D expenditure identified (being qualifying R&D costs multiplied by 186 percent), giving rise to a net cash credit of 27%. Although lower than the net cash credit of 33.35% available before the reduction in the rate of enhancement from 130% to 86%, this is higher than the 18.6% net cash credit available to non-R&D intensive SMEs.

In order to qualify, 40 percent or more of a claimant’s total expenditure for a period (i.e., those used to calculate profits subject to Corporation Tax) must be qualifying R&D expenditure. This regime would operate separately and alongside any future merged R&D scheme.

Qualifying R&D Costs—Restrictions to Overseas Expenditure:

The draft legislation has also addressed the proposed reforms to overseas R&D expenditure, first announced in the Autumn Budget 2022, to be effective for accounting periods beginning on or after 1 April 2024.

Broadly in line with the Autumn Budget 2022 announcements, the draft legislation states that where a company incurs costs on either subcontracted R&D and/or Externally Provided Workers (EPWs), in order to claim these costs as part of an R&D claim, the activities of the said EPWs or subcontracted work must have taken place within the UK. The criterion for UK-based activities is to be focused on geography, namely, that the activities taking place fall within UK borders, but also that, in the case of EPWs, the relevant individuals are subject to UK PAYE.

It is noteworthy that the draft legislation does, however, retain the exemption for ‘qualifying overseas expenditure’, which provides that where it is ‘wholly unreasonable’ to carry out the R&D activities in the UK, or where legal or regulatory requirements require that activities must take place in specific locations, such costs can still be included within the UK R&D claims in respect of accounting periods beginning on or after 1 April 2024.

Looking Towards the Future of R&D:

The government has not yet taken a decision on whether to merge the RDEC and SME regimes into a single scheme, with a decision to be made and final policy design announced at the next fiscal event.

A consultation on the draft legislation in respect of the merged R&D regime, and the additional tax relief for R&D-intensive loss-making SMEs, is open until 12 September 2023.