R&D tax incentives have been a vital tool in driving business R&D spending. In part thanks to the incentives regime, the UK has reached its target for R&D spending (2.4% of GDP by 2027) eight years early. And research suggests the productivity spillovers from business R&D are likely to materialise in the near future.
Business investment in R&D is essential if the country is to pull itself out of its current economic slump. But recent investigations into R&D tax incentives schemes highlight the rising costs of the schemes, bloated by fraudulent claims. Out-of-date mechanisms, poorly supported capital expenditure and a lack of transparency are hampering the effectiveness of the schemes in a global environment that is increasingly competitive in attracting business investment.
In this research note we outline where the current R&D incentives regime is failing, and how it can be reformed in order to more effectively incentivise R&D investment, while reducing the fraud and inefficiencies that currently plague the schemes.
R&D tax credits allow firms to claim their spending on R&D against their corporation tax bill, or if they don’t have any corporation tax to pay they can claim a cash credit. This is particularly useful for growing, innovative firms that are investing in research before they are making a profit.
The current SME scheme’s design means the effective rate of relief is different depending on if it is applied against corporation tax, claimed as a cash credit, or a mixture of the two. If firms are loss-making, the rate will be up to 33% but if they are liable for corporation tax then the rate of relief will be up to 25%. This complexity makes it difficult for firms to effectively budget their R&D investments.
The newer RDEC scheme for large firms (introduced in 2013) improved on the earlier Large Company and SME schemes (introduced in 2002 and 2000 respectively). These improvements, made in consultation with firms, included giving a fixed rate regardless of the company’s tax position and applying the relief before tax, making it more visible in company accounts. The fixed rate of relief, regardless of tax position, gives much greater predictability when it comes to cash flow forecasting.
Recommendation 1: The SME scheme should be updated to match the more modern RDEC scheme, with a fixed relief rate regardless of a company’s tax position. This would increase the predictability and visibility of the relief, increasing its impact on company spending decisions.
R&D capital expenses on plant, machinery and buildings are not covered by the tax credits. Instead they are eligible for full first year tax deductions called the Research and Development Allowances (RDA).
Capital spending is particularly important because it locks R&D activity in the UK for the long-term, and the spillover benefits such as high-quality jobs. All our neighbouring countries offer incentives for loss-making firms investing in R&D capital, the UK does not. The current regime risks our neighbours attracting business investments in long-term capital assets while we lose out on the benefits.
Recommendation 2: Research and Development Allowances (RDAs) should provide a cash credit for loss-making firms. This would support growing firms to make long-term commitments to R&D in the UK in a time when the cost of funding capital expenditure is increasing.
Although the Frascati Manual was foundational in the definition HMRC developed in the year 2000, there was a decision to depart from this internationally recognised standard and to instead use a bespoke definition developed by the Department for Trade and Industry.
The Frascati Manual has since been updated (in 2015), with consideration of modern R&D practices – for example in computer science – and detailed worked examples across different fields to clarify where the boundary of R&D is. Meanwhile the definition used for the UK’s R&D tax reliefs has stayed broad, with an absence of worked examples of how companies should apply the definition to business activities in different research-intensive sectors.
The result is that it is not clear what exactly counts as ‘R&D’ for tax purposes, making it difficult for HMRC to challenge claims of dubious R&D activity. And to cause some businesses to fail to realise when some of their investment should count as R&D.
Recommendation 3: HMRC should update guidance with industry-specific examples of what activities are eligible, and ineligible, for R&D tax credits. This would reduce the need for R&D tax consultants and help HMRC enforce compliance.
The proliferation of R&D tax consultants, many of whom operate on a ‘no win, no fee’ basis taking their commission from the amount of tax relief secured, is a worrying sign of leakage in the system. The consultants are taking a cut from the tax relief intended for the innovating firms – immediately reducing the efficiency of the scheme. There’s also concern within the tax industry that some consultants, with their fees based entirely on the amount of tax reliefs companies earn, are inflating the eligible R&D activities of small firms, and profiting at HMRC’s expense.
Recommendation 4: Tax agents named on R&D tax credit claims must be members of a regulatory body and adhere to a code of practice to reduce abuse of the schemes.
HMRC is currently proposing a discontinuation of the supplementary tables in the R&D tax credits statistical publication – this would remove the already limited geographical and sectoral data in R&D tax credit claims. Instead, the Government should provide statistics to a level of detail used in other R&D support schemes such as InnovateUK grants.
Recommendation 5: HMRC should provide more detailed data on the types of R&D businesses are doing, and which R&D costs make up the claims, to give a more detailed picture of the UK’s R&D landscape.
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