Legislation Day: Changes to the R&D scheme

Legislation Day was a much-anticipated occasion for those who work with the R&D tax credit incentives. Innovative businesses, professional bodies, accountants, and specialist R&D agencies alike had expected that this would be the day when legislation regarding the additional tax relief for R&D-intensive SMEs would be published. As it happens, we got rather more than we had bargained for.

Changes to the incentives

To start with, though, let’s discuss the predicted additional tax relief. At 2022’s autumn budget, Jeremy Hunt announced a raft of changes that decreased the generosity of the SME scheme. Enhanced deduction dropped from 130% of qualifying expenditure to 86%, and the tax credit rate dropped to 10%. This led to widespread complaints that the changes would negatively impact some of the companies who the policy is most supposed to support. That is, loss-making SMEs who invest greatly into R&D. As a result, the government backtracked and announced plans for these companies to be protected from the change.

A policy paper has formalised what the government had already announced: loss-making, R&D intensive SMEs will be eligible for a higher rate of R&D tax credit than other companies in the UK. What this means is if you are a company who invests 40% of all expenditure into R&D-related activities, then you will be able to claim at a higher credit rate of 14.5%. Overall, this should mean that the benefit will be about 27% of your qualifying expenditure – a much smaller difference from the current rate of 33% than had originally been feared.

Now for the surprise element: HMRC also released draft legislation for the merging of the RDEC (R&D relief aimed at large business) and SME schemes, starting 1 April 2024. In many ways, this was not out of the blue. The chancellor made clear that it was looking to align, and possibly merge, the SME and RDEC schemes with the rate changes announced last October. The advantages are evident. Having only one scheme would simplify the R&D tax system; and the benefit would work as an above-the-line credit, meaning that companies will be able to better estimate the impact of the incentive into their cashflow planning. To release the draft legislation was, though, unexpected.

There are some encouraging signs for R&D intensive SMEs, but my concern lies with the single scheme designed for all UK businesses, which may be too broad. This could potentially lead to inequitable rewards and fail to attract companies that have contributed to the UK’s reputation as a centre for technological and scientific advancement.

Joe McGurk, Managing Director

It is important to remember that the government has not yet made a decision on this. However, it is looking likely that they will soon push forward with the merger, and agents like Kene can help businesses remain prepared for this significant change.

HMRC’s public consultation

In January of this year, the HMRC launched a public consultation into the merits of merging the SME and RDEC schemes – a consultation that Kene responded to. Today, a summary of responses has been published. A large number of the 149 respondents (a mixture of agents, individuals, professional bodies, businesses, and industry groups) seemed to agree that merging the schemes could have many benefits. There were, however, reservations. Firstly, the speed of the proposed changes was a concern, especially when combined with the already announced reforms at the last Autumn Budget. Secondly, there was the caveat that any merging of the scheme would lead to a lower benefit rate for SMEs – a worry that the introduction of the additional relief for R&D intensive SMEs has partially alleviated. The promise of simplifying the scheme and the benefit calculation, though, has proven enticing.

The consultation also featured several questions on more technical elements of the scheme. Most important were those on the meaning and position of subcontracted R&D. As it stands, companies that claim under the RDEC scheme cannot include any costs that they sub-contract out. SMEs can, but HMRC’s understanding of who ‘owns’ the R&D and what ‘subcontracted R&D’ means has meant that they, too, have faced challenges. The aim of the policy is that only one company should be able to claim for a particular R&D project and merging the schemes could complicate this. Most respondents agreed that the incentive is supposed to encourage financial risk of R&D, and therefore that should continue to be an important indicator of who should be able to claim relief for a specific project. To add to this were questions on PAYE/NIC caps, Qualifying Indirect Activities, and the possibility of a minimum threshold.

The draft legislation provides some clarity and shows that parts of the consultation have been taken on board. The potential rate of tax credit has been settled at 20% of qualifying expenditure – the same rate that the RDEC scheme was set at following the Autumn Budget changes. Moreover, overseas externally provided worker costs will be excluded; expenditure on domestic externally provided workers is included only if those workers are subject to PAYE; and the more generous PAYE/NIC cap that is currently seen in the SME scheme will be applied. Moreover, expenditure on sub-contractors will be included – an important difference to the current RDEC scheme, which could allow for larger companies to claim a much greater tax credit.

Residual uncertainty

Not all questions, though, have been addressed. While payments to subcontractors involved in R&D will be included, the issue of how a merged scheme will approach ‘subcontracted R&D’ and R&D performed in service of a standard contract remains unclear. The government has not decided, moreover, whether a clause excluding ‘subsidised expenditure’ will remain. These two elements have been a long-standing problem for SMEs claiming R&D relief: confusion has even led to companies taking claims to first-tier tax tribunals (and, indeed, succeeding). The draft legislation also makes no mention of qualifying indirect activities or a minimum threshold for expenditure – questions which it had raised during the consultation. Perhaps this means a decision is pending, or that the government is no longer interested in changing those parts of the incentive.

The policy paper goes on to announce that ‘the government now invites views through a technical consultation on the proposed merged scheme design to ensure that the draft legislation captures the policy as intended’. Kene will look to let its thoughts be known and continue to support companies’ claims through a tumultuous and technically challenging period.

‍