The UK’s review of R&D tax reliefs: where are we now?

An expanded definition of R&D to include pure mathematics and the widening of qualifying activities to cover cloud computing and data costs is welcome and will likely prove beneficial to a broad range of R&D intensive businesses looking to developing new UK innovations. A new territoriality restriction will limit the availability of R&D tax reliefs, although a proposed exemption for certain overseas R&D activity should ensure that relief continues to be available where overseas R&D activity is necessary to the development of UK-based innovations and is reassuring to business across the life sciences sector and other R&D intensive businesses.

The changes are being introduced as part of a government led review into the R&D tax relief system, first announced at the UK Budget in March 2021. The stated objective of the review was to ensure that the “UK remains a competitive location for cutting edge research, that the reliefs continue to be fit for purpose and that taxpayer money is effectively targeted.”

The UK government views boosting innovation and increasing investment in R&D is an important driver of economic growth and has set itself the target of raising total investment in R&D to 2.4% of UK GDP by 2027. R&D tax reliefs are considered a significant incentive to encourage R&D investment and therefore ensuring they are effective forms an important part of the UK government’s R&D investment strategy.

Draft legislation detailing the changes was published in July 2022 and will be included in the UK’s Finance Bill 2023.

Current UK R&D tax reliefs

Currently, two reliefs are available on certain qualifying R&D related expenditure.  Both reliefs adopt the same definition of R&D and qualifying activities. R&D for tax purposes is defined by reference to activities that are treated as R&D under UK generally accepted accounting practice (GAAP) and fall within Department for Business, Energy and Industry Strategy (BEIS) guidance. Broadly, the guidance specifies that the R&D activity must take place within a project that seeks to achieve an advancement in science or technology.

SME relief

Where certain conditions are met, relief is available for small or medium sized companies (SMEs) in the form of an effective deduction of 230% on qualifying R&D costs. Loss-making SMEs may have the option of receiving a cash repayment of the tax credit in return for surrendering R&D related losses. Any repayment is capped at 14.5% of the losses available for surrender. For accounting periods beginning on or after 1 April 2021, any repayment is also subject to an annual cap of £20,000 plus three times the company’s total Pay As you Earn (PAYE) and National Insurance contributions’ liability.

Research and Development Expenditure Credit

Although primarily targeted at larger companies, Research and Development Expenditure Credit (RDEC) may be used and can prove valuable to SMEs in certain circumstances. The RDEC uses a different method of calculating corporation tax relief on R&D expenditure. The “above the line” RDEC is brought into account as a trade receipt, increasing taxable profits (or reducing losses). A credit of 13% of the qualifying R&D expenditure is then credited to the company. A repayment may also be available in certain limited circumstances.

Proposed reforms from April 2023

Broadly, there are three aspects of the relief system to which changes are being introduced.

New territoriality restriction

A territoriality restriction will be introduced, meaning that a business will only be able to claim tax relief for qualifying expenditure on R&D activities undertaken in the UK. However, there will be an exemption where it is necessary for R&D to be undertaken overseas due to geographical, environmental or social conditions not present or replicable in the UK, or where there are regulatory or other legal requirements for the R&D to be undertaken outside the UK. The cost of the R&D and availability of workers to carry out the R&D are specifically excluded and will not be considered necessary for R&D to be undertaken overseas.

Currently, there is no requirement that R&D activity must be undertaken in the UK for companies to be eligible for R&D tax relief. UK companies that incur R&D expenses overseas may still be eligible for full tax relief.

The new territoriality restriction is being introduced as part of the UK government’s objective of ensuring that the reliefs are targeted and refocused on UK innovation. When the restriction was first announced there was widespread concern across R&D-intensive industries that many UK businesses would be denied tax relief for R&D undertaken overseas, despite the R&D being integral to the development of the UK innovation and being required to be undertaken overseas. For example, in the context of life sciences, when developing new drugs or vaccines, clinical trials may need to be undertaken outside the UK to gain licensing approvals.

Industry representatives have been engaging with the UK Treasury extensively since the restriction was first announced. It is very positive and constructive that the Treasury has listened to concerns and introduced this exemption. R&D tax reliefs often provide an important source of funding to R&D intensive start-ups. Without access to tax relief, R&D costs may be prohibitive, preventing the development and progression of UK-based innovation. The new restriction could have posed a potentially insurmountable stumbling block to the development of R&D and the exemption has been welcomed by businesses.

There are still areas of uncertainty regarding when the exemption will be available, for example, what will be included as “geographical, environmental or social conditions”. Hopefully, any uncertainty or ambiguity in the exemption can be resolved before the draft legislation is enacted.

Expanded definition of R&D and qualifying expenditure

The categories of R&D expenditure that will qualify for tax relief will be expanded to include data licences and cloud computing. Qualifying expenditure should extend to all cloud computing costs associated with the R&D, including storage, according to the draft legislation. These changes are being introduced to “better reflect developments in technology” and the different ways that cutting edge R&D is now undertaken.

The government announced that it intends to amend the definition of R&D to cover pure mathematics at the Spring Statement in March 2022. This change will be introduced in secondary legislation and is also expected to take effect from April 2023.

The expansion of activities qualifying for relief to reflect modern research practices and the inclusion of pure mathematics in the definition of R&D is hugely welcome. The importance of data and data processing when developing new technologies has become increasingly evident, and these changes will therefore be beneficial to many R&D-intensive businesses. The changes also support the UK government’s drive to ensure that the reliefs remain fit for purpose and act as an effective incentive to encourage UK-based innovation.

Combatting abuse

New measures to combat abuse of the R&D tax reliefs system are also being introduced. These include a requirement for all claims to be made digitally with endorsement by a named senior officer of the company; and requiring advance notice to HMRC before making a claim – unless the company has made a claim in one of the previous three accounting periods – with details of any agent who advised the company making the claim.

Safeguarding the R&D tax reliefs system against abuse and fraud is vital. However, the changes are complex and increase the admin involved when making claims - something that HMRC has acknowledged in a recent policy paper detailing the reforms. It is important to ensure that the reliefs remain accessible to small businesses and start-ups that are driving forward UK innovation and which may be reliant on tax reliefs as a source of financing.

Next steps

The government-led review into R&D tax reliefs is still ongoing.

To date, the review has been silent regarding how R&D tax reliefs can be better used to support the UK’s net zero transition and global efforts to combat climate change. It is widely understood that developing new “green” technologies is paramount in driving forward global decarbonisation, from carbon capture and storage solutions to the development of new technologies to reduce our reliance on fossil fuels. Given the unprecedented heatwaves and resulting fires and droughts that the UK and Europe have experienced this summer, the issue of climate change must not be ignored. It is hoped that UK government will now refocus its review into R&D tax reliefs to address how R&D tax reliefs can better incentivise UK investment in green technologies and support global decarbonisation.   

A version of this article was first published in the International Law Office (ILO) corporate tax newsletter.