I’ve been saying for some time that the R&D tax credit relief system isn’t working as it should. The Chancellor now appears to agree. So I think it’s likely that we will see a major overhaul to the system some time in the next 12 months. There may even be something in the Spring Statement on Wednesday.
The Chancellor has already announced some changes in Budget 2021 (last Autumn). The Budget announced plans to limit relief for expenditure where the physical R&D activity is happening outside of the UK. In addition, there was a further suite of measures aimed at trying to mitigate the risk of incorrect or even fraudulent returns.
The Chancellor has already provided some insight as to his thinking during the 2022 Mais lecture. In this, he argued that despite the UK having one of the most generous tax regimes for R&D investment anywhere in the world, it is not working as well as it should. Rishi Sunak indicated that UK spending on R&D amounts to just four times the value of the R&D tax relief, compared to the OECD average of 15 times.
I’ve thought for some time that most SMEs see R&D tax credits as a welcome boost to cashflow, but I am not convinced that this has necessarily influenced their spending decisions on R&D. It may have pushed back the need for external funding for a few months or so, but that is all. I see very few companies which, if R&D tax relief was withdrawn in its entirety, would significantly cut back on their R&D spend. If my theory is correct, then the R&D tax incentive isn’t doing what it’s been designed to do.
And what is it intended to do? Is it meant to support existing, planned R&D, and maybe permit it to happen at a faster pace that would otherwise be the case? Is it intended to encourage R&D that otherwise wouldn’t have taken place at all? Is it intended to encourage entrepreneurship and innovation and encourage more people to take that entrepreneurial risk?
In my view it should act as an incentive to undertake more R&D, not be a subsidy for existing, planned R&D. It should make the difference between a company deciding to do something or not. That is what innovation and entrepreneurship is.
The University of Cambridge has published a report entitled “Is the UK’s flagship industrial policy a costly failure?”. The report mentions HMRC’s internal analysis which indicates that the RDEC (large company R&D) scheme is more efficient than its small company counterpart, generating £2.40 to £2.70 of additional R&D expenditure for each £1 of tax relief claimed, compared to the SME scheme which generated only £0.60 to £1.28.
Now, the reason for the above is, to me, pretty clear. A large company has significantly more resources, and therefore the R%D tax credit benefit is probably channelled completely into additional R&D. A small company, however, is probably using a significant amount of the R&D tax credit benefit to fund other activities such as sale and marketing, and general admin costs.
So, if the current system is to be overhauled, what would I like to see? Writing as a PhD research scientist (in a former life), I can say with some authority that some of what companies try and claim as R&D is fanciful in the extreme. But equally, a lot of potentially qualifying R&D is not claimed. So, changes that are needed are:
- Tighten the definition of qualifying R&D and ensure that spurious claims are challenged and where appropriate, disallowed.
- Clarify the existing R&D qualifying criteria to remove grey areas and ambiguity.
- Fully modernise the system: the inclusion of cloud-computing costs from next year is welcome, but why wasn’t it introduced immediately? Modern methods of carrying out R&D needs to be recognised and embraced.
- Re-direct the cash saved from spurious claims into greater relief for genuine claims.
- Increase current R&D uplift from 130% to 200% of qualifying expenditure. Make it a very attractive incentive but ensure that companies submit technically robust claims prepared by real experts.
- Re-focus the PAYE cap so that companies which rely on sub-contracted R&D staff are not penalised.
- Introduce R&D tax credit repayments on account (quarterly throughout the year based on anticipated total R&D spend) to help companies with cashflow to fund R&D.
Will it happen? Without something along these lines I fear that R&D tax credits will continue not to significantly enhance the UK’s commitment to risk-taking and innovation. We cannot afford to fall behind many other countries. As shown with the development of Covid-19 vaccines and pcr testing, we can be world-leaders. We need to learn from this and ensure that UK companies remain at the leading edge of innovation.
