The UK’s merged R&D regime – what do you need to know?

Following extensive consultation, the UK’s new merged R&D tax relief regime is now in operation for accounting periods beginning on or after 1 April 2024. The previous R&D expenditure credit (‘RDEC’) and SME regimes have been replaced by a new merged RDEC regime, which applies to all R&D claimants, with the exception of loss-making, R&D intensive small and medium-sized enterprises ('SME’s) claiming relief under a new enhanced R&D intensive support (‘ERIS’) regime.¹

The merged R&D regime should be viewed alongside other recent changes that have significant implications for R&D claimants. This article provides an overview of the key changes taking place in the R&D tax relief landscape, with key dates summarised in the timeline below.

Key takeaways

Previous RDEC claimants will be familiar with the mechanism of the new merged relief but will need to understand some new concepts, including rules for contracted out R&D and overseas restrictions, which could have a significant impact on the economics of R&D projects. Previous SME claimants that don’t qualify for ERIS will experience a significant transition – both in terms of the mechanism of relief and the reduction in rate.

It is important for claimants to prepare for the new rules as RDEC claims can have a material impact on a company’s EBITDA. The implications for existing contractual arrangements should be reviewed, as well considering eligibility for and value of the credits when negotiating new contracts.

Deloitte’s Gi3 (Global investment and innovation incentives) and Legal practices are well-placed to help companies navigate the changes, combining tax and legal expertise to deliver subject matter advice in a practical context. Our experts can help you understand the implications of the changes for your business, including identifying opportunities to claim relief where it wasn’t previously available, mitigating risks in existing contractual arrangements and meeting the new compliance obligations.

Effective benefit of the relief

In addition to wider reform of the R&D tax relief regimes, the government has also made changes to the rates of relief; reducing the differential between large companies and SMEs, and focussing enhanced support on R&D intensive SMEs. The table below shows the effective net benefit of R&D tax relief under the old and new regimes for different sizes of company.

*As RDEC is delivered above-the-line and is therefore taxable, the net benefit will depend on the taxable profits of the company and whether the main rate of tax (25%) or the small profits rate (19%) applies. 

**Under the old regimes, RDEC also applied to expenditure by SMEs which doesn’t qualify under the SME regime, e.g. subcontracted or subsidised expenditure.

Key features of the merged RDEC regime

Mechanism and rate:

• As with the previous RDEC regime, claimants receive relief for R&D expenditure by means of a taxable, above-the-line credit at a rate of 20% of qualifying R&D spend.
• As RDEC is delivered above-the-line and is therefore taxable, the net benefit will depend on the taxable profits of the company and whether the main rate of tax (25%) or the small profits rate (19%) applies. Loss-making companies are subject to a notional tax deduction at the small profits rate, delivering a net benefit of 16.2% compared to 15% for companies taxed at the main rate.
• A seven step calculation applies to deliver the benefit of the credit; using it to discharge tax liabilities before paying the balance as a cash credit.
• The payable credit is capped at £20,000 plus three times the amount paid in respect of PAYE and Employee Class 1 NIC liabilities. A company is exempt from the cap if its employees are creating, preparing to create or actively managing intellectual property, and qualifying R&D expenditure does not include more than 15% of spend relating to connected party subcontractors or connected party externally provided workers (EPWs).

Definition of R&D and qualifying expenditure:

• The meaning of R&D for tax purposes is set out in updated government guidelines issued on 7 March 2023. This version of the guidelines was updated to include pure mathematics within the definition of R&D for tax purposes for accounting periods beginning on or after 1 April 2023.
• For accounting periods beginning on or after 1 April 2023 the categories of qualifying expenditure were expanded to include data and cloud computing costs, in addition to the existing categories of staffing costs, software, consumable items and relevant payments to subjects of a clinical trial.
• For contracted out R&D and EPWs, relief is available on 65% of the qualifying cost for payments to unconnected parties.
• Under the merged regime, subsidised expenditure qualifies for relief, but contributions to independent R&D no longer qualify.

Contracted out R&D:

• Under the merged regime, relief for contracted out R&D is claimed by the customer where it is reasonable to assume that the customer intended or contemplated that R&D of that sort would be done, except in certain circumstances where the customer is not entitled to relief (e.g. charity or overseas company). This is explored in more detail below.

Overseas restriction:

• Restrictions apply to limit qualifying expenditure on contracted out R&D and EPWs in relation to R&D undertaken overseas. Relief will only be available for R&D carried out overseas where there are necessary conditions that are present in the overseas location but not in the UK and that it would be wholly unreasonable to replicate in the UK. This is explored in more detail below.

Contracted out R&D

One of the major changes in the new merged regime is the treatment of contracted out R&D. To incentivise increased R&D activity, the government’s intention is that the party who makes the decision to undertake or initiate R&D should be able to claim relief. Determining whether a project meets the definition of ‘contracted out R&D’ and which party is entitled to claim tax relief will inevitably pose a significant challenge for claimants on both sides of the relationship. It is important for claimants to review the terms and circumstances of existing contracts, as well as taking eligibility for R&D relief into account when negotiating future contracts.

General rule – customer claims

Where R&D activities are carried out under a contract, they are treated as contracted out R&D to the extent that it is reasonable to assume that the customer intended or contemplated that R&D of that sort would be undertaken when entering into the contract. Regard must be given to both the terms of the contract and any surrounding circumstances.

The general rule for contracted out R&D is that eligibility to claim relief will rest with the customer rather than the party carrying out the R&D.

The legislation also allows for scenarios where there are more than two parties in a relationship (‘subcontracting chains’). The effect of the legislation is that, broadly, the highest UK company in the chain is eligible to claim relief.

Scenarios where the contractor may be able to claim

In contrast to the general rule, there are several scenarios where the contractor rather than the customer may be eligible to claim relief.

Definition of contracted out R&D not met: Where it is not reasonable to assume that the customer intended or contemplated that R&D of that sort would be undertaken, the expenditure will not meet the definition of contracted out R&D. In this situation, the contractor would be able to claim relief (subject to the usual qualifying criteria) where it initiates and carries out R&D in order to fulfil its obligations to the customer.

Irrelievable clients: There is an exception to the general rule where the customer is an ‘irrelievable client’ (i.e., one that cannot make a UK R&D claim). In this case, relief can instead be claimed by the contractor (subject to the usual qualifying criteria). An irrelievable client is either an ‘ineligible company’ (including a charity, an institution of higher education, a scientific research association or a health service body), or ‘a company not acting in the course of trade, profession or vocation within the charge to tax’ (e.g. a customer based overseas or a government body).

Group provisions: Where a group company subcontracts R&D to another group company, the companies can make a revocable joint election to enable the company carrying out the R&D to claim relief. The election must be made in writing either before or at the same time as any claim that depends on it, and remains in place until revoked by either company or the companies are no longer in the same group.

Transitional provisions

Where two companies are in a contractual relationship, and one moves into the new R&D regime ahead of the other, transitional provisions apply to prevent relief being available twice or not at all.

Overseas expenditure

Another major change in the new regime is the overseas restriction for contractor payments and payments for EPWs. Only UK expenditure and overseas expenditure meeting certain conditions will be eligible for relief. For contractor payments, UK expenditure is defined as expenditure incurred on R&D that is undertaken in the UK. Expenditure on EPWs is treated as UK expenditure where the earnings are wholly or partly subject to UK PAYE and NIC.

R&D activity carried out overseas will be eligible for relief where there are necessary conditions that are present in the overseas location but not in the UK and it would be wholly unreasonable to replicate the conditions in the UK. Conditions may include geographical, environmental or social conditions and legal or regulatory requirements, but cost and availability of workers are specifically excluded.

There is no territorial restriction on the company’s own staffing costs, consumables, software, data and cloud computing costs, or payments to clinical trial participants.

Changes to claim procedures

As part of the government’s drive to tackle fraud and error in relation R&D claims, changes to claim procedures have been implemented alongside the introduction of the new regime. In particular, claimants should be aware of the additional compliance requirements and the early deadline for the claim notification requirement.

Claim notification requirement

For accounting periods beginning on or after 1 April 2023, claimants may be required to submit a claim notification to inform HMRC of the intention to claim R&D tax relief and provide some basic information on the company and planned R&D activities. The notification must be submitted between the start of the period of account and six months after the end of the period of account. Claim notifications are generally required for new claimants and those who have not submitted R&D claims in the three years prior to the claim notification deadline. However, the rules are not straightforward so there are circumstances where a company with a history of regular R&D claims may be required to make a claim notification. In particular, R&D claims for accounting periods beginning before 1 April 2023 made by virtue of an amendment made on or after 1 April 2023 will be ignored when determining whether a claim was made in the three-year period. The position should be reviewed annually.

Additional Information Form

An Additional Information Form (AIF) containing detailed information supporting the R&D claim is required for all new R&D tax relief claims submitted on or after 1 August 2023. The AIF must be submitted before or at the same time the claim is submitted.

HMRC power to correct a return

HMRC has the power to correct a company’s tax return by removing any R&D claim where the claim notification or AIF requirements are not met.

What should I do now?

The introduction of the new merged RDEC may have a significant effect on the economics of R&D contracts so it is important that key stakeholders understand the impact of the changes. In addition to tax teams, this may include finance, legal, procurement and commercial teams.

The implications for existing contractual arrangements should be reviewed and remediated where necessary to provide clarity on whether the customer or contractor has the right to claim R&D relief. The eligibility and value of the credits should be considered when negotiating new contracts.

Claimants should start to gather the data and documentation required to complete the AIF and to support their claims under the new regime. This is particularly important where third party information is required (e.g. PAYE references for EPWs) and where intentions at the planning stage are relevant (e.g. to demonstrate the customer’s intentions for contracted out R&D or to explain why it was necessary to undertake R&D overseas).

Given the potentially costly consequences of missing the claim notification deadline and the potential pitfalls within the rules, claimants should review their circumstances to confirm whether or not a claim notification is required.

For more information, please contact our specialists using the details below or your usual Deloitte adviser.

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References

¹ If you are a loss-making R&D intensive small-medium sized enterprise, please also see our dedicated article here.