In his Spring Statement, and the Tax PlanThe U.K. Chancellor Rishi Sungak, published alongside it, focused on capital, people, and ideas. The plan is called Ideas and promises to increase public research and development (R&D), investment to 20 billion pounds ($26billion annually) by 202425.
It is important to know what the Chancellor means when he says “improve”. The Spring Statement document refers specifically to steps taken to ensure that UK’s R&D tax exemptions are as effective and as valuable as possible for taxpayers.
Maintaining the incentive R&D Relief provides is difficult. The Chancellor has already announced tax changes that will make U.K. R&D relief significantly less attractive in 202324.
Declining Tax Relief
Currently, the 13% research-and-development expenditure credit (RDEC), is worth 10.53% of large companies’ costs. This is because it is used as an above the line credit in tax calculations. This effective rate will fall to 9.75% when the U.K. corporation tax rate rises from 25% to 25% in April 2023. To maintain RDECs value, an increase of the headline rate of RDEC exemption of approximately 1% will be required.
In contrast, the value R&D relief for small- and medium-sized companies (SMEs), will increase for those large enough that they can pay 25% corporation tax beginning in April 2023. However, StatisticsAccording to the Office for Budget Responsibility, the government does not receive a good return for its investment. Every pound of tax relief claimed stimulates 0.601.28 dollars in additional private R&D. This research has been cited by the Chancellor several times. It suggests that SME relief could be reduced or modified as part the wider reforms.
Some have suggested that the SME relief and the RDEC will be combined into one simplified relief. This would be extremely detrimental for start-ups and I think it unlikely. To show the difference in reliefs, a combined RDEC would need to provide relief at 33% to give start ups the same financial support they receive under the SME scheme.
Issues relating to Overseas Travel Costs
The Chancellor stated at the last budget that he would ensure that R&D assistance is only granted to R&D work carried out in the U.K. Government statisticsIt was shown that only 25.9 Billion of the 47.5 Billion pounds of R&D expenses on which R&D relief was claimed in 2019 were related to R&D work actually performed in the U.K.
The April 2023 reforms will make it impossible for companies to claim the costs of overseas workers and activities as part their R&D relief claim under either program. There are a few exceptions to this rule.
It is logical to ensure that R&D relief provides the wider benefits that having activity and workers in the U.K. has for the economy. This will have a major impact on the cost, profitability, and even viability for many U.K. businesses. Although some R&D work may be done offshore and support for highly skilled immigration can be helpful, it could have cost-repercussions that exceed the benefits of claiming U.K. R&D Relief (especially under the current RDEC system).
Simply put, many start-up business models rely on the ability to outsource R&D work to lower cost locations. U.K. R&D relief won’t be available in most cases so start-ups could well migrate to other countries. This is not what the Chancellor wants.
Larger U.K. companies may lose the competitive advantage that offshoring can bring to their R&D cost reductions and allow them to claim tax relief on these lower costs. Many companies won’t be able to offshoring R&D activities immediately. The current rate relief means that RDEC is unlikely be enough financially attractive to pay for the cost of onshoring. Worst of all is that businesses may look to reduce the U.K. presence and consolidate their R&D functions in low cost locations, regardless if there is tax relief.
Cost cutting
Finance Act 2023 will include some preliminary measures to prevent the abuse of R&D Tax Relief that the government suspects is taking place. In addition to new powers and enforcement actions against rogue R&D advisors, the Finance Act 2023 will include new compliance procedures that deter speculative R&D. It is not clear how much these changes will cost the taxpayer, but I suspect that they will be offset by the savings related overseas.
The Case for Higher Tax Relief
It is difficult to see how the U.K. can remain a competitive place for R&D work against this backdrop. But how much would that increase be sufficient?
We have used BDO’s R&D data from past claims across a variety of industry sectors to assess the potential impact on different sector based on the average overseas cost claimed. We used the data to determine what the RDEC Rate would need to be to make large companies eligible for the tax relief under the current rules.
- The IT sectorRDEC rose to 140% from 13%
Companies must pay high salaries to retain and attract highly skilled software developers and data engineers due to the UK’s severe skills shortage. IT and software developers often employ staff from overseas companies to provide highly-skilled individuals at a reduced cost. This means that a large portion of their qualifying expenses is made up of overseas costs, which will be no longer eligible starting April 2023.
- Financial services sectorRDEC rises up to 55%
The majority of large financial services companies are banks, asset managers and insurance companies with international presences. Therefore, a significant portion of their qualifying spending is currently caused by the cost of foreign workers (either fully or partially outsourced). Because they are often regulated businesses the key functions and a significant portion of staff must be located in the U.K. so the impact isn’t as severe as for pure IT/software businesses.
Financial services companies will see a benefit from including costs for pure maths work as well as cloud computing costs beginning in April 2023. However, this is unlikely the offset to the loss of relief on overseas software development costs.
- RDC in the Engineering Sector Rises to 19%
While large engineering companies may outsource some R&D work to overseas, the majority of their qualifying expenditures are for personnel costs. This includes highly skilled engineers and scientists who are based here. They do however, tend to use overseas workers in their group when they have to deal with large workload fluctuations. This means that a reasonable portion of their qualifying R&D spending currently includes overseas costs.
We would expect that the exclusion from overseas costs will most impact large engineering companies, particularly those with high international presence and global operations. It is important to note that the strict exemptions for overseas cost in the new rules may be applicable in certain instances. For example, where it is impossible to test products in the U.K. because of geographical (e.g. Arctic testing) and regulatory reasons.
- Construction sectorRDEC rises to 14%
Because of the site-specific nature and importance of the construction industry, it is not surprising that overseas R&D costs are the lowest for all supply chains. The U.K. has one of the highest construction prices in the world. The inability of using overseas labor, along with the off-payroll labor/IR35 rules, makes it difficult for the sector to drive down labor costs. It would be necessary to increase the corporation tax rise.
- OverallRDEC rises to 70%
Our modeling shows that a RDEC of approximately 70% would be required for most companies to receive financial support after 2023, based on the thousands of R&D claims we have in our database.
Although it may seem like an inordinately large figure, it would be world-leading if it were. However, it clearly shows how beneficial the current rules regarding costs have been to U.K. businesses: The U.K. currently has a R&D regime which is highly competitive globally (at least in terms encouraging start-ups to be headquartered in the U.K.).
Other Levers
Assuming that any headline increase of RDEC relief starting April 2023 won’t be nearly as dramatic as our comparisons show, it is clear the Chancellor will need to introduce a wider array of measures to increase private sector R&D within the U.K.
The 2021 Consultation on R&D ReformConsidered the issue of R&D being carried out in different parts of the U.K., pointing out that most R&D is done in South East England. While the government has yet to comment on this, a recent survey by BDO of mid-market businesses found that only 16% of respondents supported the idea for differential rates in R&D relief to help level the economy. However, differential rates of RDEC for CO2-reducing or energy-generating/saving R&D projects have clear attractions amid the current energy and environmental crises.
I believe there is scope for expanding the types of costs that are eligible for R&D relief. For example, accounting depreciation on capital assets used to R&D and legal costs associated to patent applications to protect their inventions. Both of these expenses are eligible under international R&D regimes.
The U.K. offers 100% capital allowances relief for qualified capital expenditure on R&D. This is something I hope will be enhanced as part of the capital allowances overhaul. The government is looking to replace the uncapped total capital allowances. super-deductionWhen it expires, in April 2023. It would be beneficial to take a deduction of 130% on qualifying capital expenditure on R&D that is not less than 5 million pounds.
It is crucial to keep the current rate of relief on the patent box, making the patent box more valuable as the corporation rate rises. Additionally, it is important to expand its scope. For example, to allow U.S. Patents to be eligible for the scheme. It would be beneficial and forward-looking to change the U.K. patent rules in order to allow more types of software to be patented (and thus qualify for patent box). Software plays an increasing role in all areas within the U.K.’s economy.
Whether or no SME R&D scheme is reduced, a major overhaul of the grants landscape is required in the U.K. to support early stage businesses. I believe that a significant increase would yield strong returns for the taxpayer in terms economic growth and job creation.
More bang for your buck
It is easy for a government not to cut tax reliefs. But it is difficult for companies to invest in R&D projects within the U.K., when there are better alternatives overseas. The April 2023 changes, which are currently being proposed, will likely undermine the Chancellor’s plan to bring more R&D work to Britain.
A complete package of measures will be required to support future innovation within the U.K. But if a substantial increase in the RDEC Cash incentive for R&D work is not part of that, it could well mean that there will be less R&D bang at the U.K. in the future.
This article does NOT necessarily reflect the opinions of The Bureau of National Affairs, Inc., publisher of Bloomberg Law, Bloomberg Tax, or its owners.
Carrie Rutland serves as innovation and technology partner at BDO, an accounting and business advisory firm.
The author can be contacted at: [email protected]
