R&D tax credit changes - Proposal for a merged R&D tax relief scheme

Highlights of the proposed merge schemes: 

Expenditure Treatment 

The merged R&D relief scheme will resemble the existing RDEC scheme whereby the credit will be treated as an above the line expenditure credit, calculated as a percentage of total R&D expenditure. This means the credit will be recognised as income within the P&L and can positively impact KPIs such as Earnings before Interest and Taxes (EBIT). The tax benefit calculation is far more straightforward, with taxpayers and tax-loss businesses receiving the same benefit. The only issue large SMEs might have to watch out for is that this new credit will not form part of calculating quarterly instalment payments, as it sits outside the tax computation. 

Enhanced SME Scheme 

According to the draft legislation, the SME scheme is expected to be preserved for eligible loss-making, high-intensity SMEs, which can claim additional relief. However, this may be a topic of further deliberation as it will result in two schemes, not a single merged scheme. The additional deduction remains at 86%, with the rate of payable credit for surrendered losses being 14.5%. But companies need to be careful as there will be no tapering of relief as they approach the 40% R&D intensity cut-off, so non-R&D expenditure decisions must be carefully considered. 

Subcontracted Costs

Under the RDEC scheme, companies can only reclaim costs for subcontracted R&D under specific services. However, in the proposed merged scheme, all claimants, including large companies, can claim for expenditure incurred on contracted-out R&D activities. Therefore, a company subcontracted to undertake R&D on behalf of another UK company will be excluded from the merged R&D scheme. HMRC is proposing to allow companies to claim for work subcontracted by an overseas company, but this waiver is still up for debate. 

As expected, the previously announced restrictions on overseas costs will be introduced from 1 April 2024. Any expenditure on R&D activities undertaken outside of the UK will no longer be claimable unless the expenditure falls within the boundaries of ‘qualifying overseas expenditure’. 

This change alters the UK scheme from one that rewards the company doing the R&D to one where the payer is rewarded. HMRC believe this will improve the trickle-down of R&D benefits, but it will put extra financial pressure on businesses employing engineering and technical staff as they may find they’re excluded from the R&D scheme. Given that the UK is struggling to train sufficient technical staff to support businesses, this change must be monitored to ensure it doesn’t force consultancy businesses to relocate overseas. 

Subsidised activities 

The proposed legislation also seeks to prevent ‘double claims’ on the same R&D activity. Currently, HMRC is proposing to prevent grant recipients from claiming R&D tax credits. Given that one of the main advantages of Brexit is that the UK is now outside of EU state aid rules, it seems odd to bring in a rule in relation to the R&D scheme that is even more restrictive than companies faced under EU regulations. Hopefully, HMRC will remove this restriction and retain the existing RDEC rules for the merged scheme. 

NIC/PAYE cap 

The PAYE/NIC payable credit cap was brought in as an anti-abuse measure to prevent fraud. It has been advised that the single scheme will adopt the more generous SME aspect of the cap, where the R&D credit will be subject to a cap of £20,000, plus 300% of the SME’s overall liability for PAYE and NIC in the claim period.

Our thoughts

We’ve reflected on the proposed changes to the scheme. The government has noted that it has published the draft legislation “in order to keep the option of implementing a merged scheme”. However, although a final decision will need to be made at a future fiscal event, the new merged scheme could come into effect as early as 1 April 2024. Under this scheme, all companies would get a headline rate of relief at 20% and their net benefit at 15%.

Although we find it encouraging that HMRC is trying to address fraud and abuse within the scheme, we’re concerned about the extent to which these reforms will affect claimant’s R&D claims if enacted as drafted, given the restrictions on overseas R&D expenditure and subsidised R&D activities. There have been significant amounts of tax changes that SMEs have had to respond to in recent years, and this is no different. The merged scheme will not only be an entirely new method of claiming R&D tax relief for SMEs but also appears to penalise SMEs that are far more likely to undertake subcontracted R&D on behalf of another company than a large company. This, combined with the substantial reduction in rate when compared to prior claims, may have significant impacts on smaller companies. We are concerned that SMEs will become fed up with the constant changes and may show their annoyance by moving R&D activities to countries with more stable, potentially more generous, R&D incentives. 

With so many changes to the scheme, claimant companies will need to spend significant resources and time to avoid potential pitfalls within the new scheme. We would encourage claimant companies that will be negatively affected by the proposed legislation to respond to the technical consultation of the draft legislation, which is open until 12 September 2023. Here, the proposed legislation is a step towards a simpler R&D tax relief scheme that is in line with the government’s policy intent to reduce fraud within the scheme. Until the future fiscal event, the changes can’t be confirmed, and companies may need to play the waiting game until further legislation is announced.

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