“For a long time, economists thought the dominant factors driving economic growth were capital and people. Economic research shows us there’s now a third: innovation. For me, if we want to drive up future growth and productivity, then the highest of the three priorities should be to ensure the UK economy is the most innovative in the world…
…So what should we do to support greater private sector investment in R&D? One obvious answer is to look at our tax regime.”
The above are the words of Chancellor Rishi Sunak during his 2022 Mais Lecture. When he says “innovation”, he is indeed making reference to research and development (R&D). He makes it clear during his lecture that he sees R&D as a tool vital for furthering economic success in the UK. He also made it clear that he believes the current tax regime for R&D is not doing enough to spur investment from UK private companies into R&D.
Further references were made to innovation in Sunak’s Spring Statement on 23 March 2022. It seems obvious that changes to R&D tax relief are in the works and it is expected that more will be revealed in the Autumn Budget later this year. Until then, this article seeks to explain how things work right now.
What is R&D?
Companies that incur expenses developing or enhancing existing products, processes or services may be eligible for research and development tax relief. R&D can exist in every market and can often be overlooked or difficult to identify.
The definition of R&D, as per tax legislation, is taken to be that which is also accepted as R&D in generally accepted accounting principles. The principle we look to would be that under FRS 102.
It defines ‘research’ as the original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding.
‘Development’ is the application of research and findings or other knowledge to a plan, or design for the production of new or substantially improved material, devices, products, processes, systems or services before the start of commercial productions or use.
It has been deemed that the above is not precise enough for tax purposes and so HMRC have stated that, when relief is sought, the claimant should identify how a project:
- looked for an advance in science or technology
- had to overcome uncertainty
- tried to overcome this uncertainty
- could not be easily worked out by a professional in the field
For example, a project which seeks to create a process, product or service which is an increase in the overall knowledge in a field of science or technology would contain qualifying R&D.
In addition, all R&D expenditure must be relevant to the trade in which the entity engages or to the future trade it wishes to engage in following the R&D project.
HMRC make it clear that the project must look to make an overall advance in the field that would be of benefit not just to the entity making steps towards the innovation. Qualifying R&D can sometimes be difficult to identify and businesses should be careful not to make incorrect claims. If a claim is found to be incorrect, HMRC will look for a refund of the credits issued, and in some cases issue penalties. A business that relies on relief might not be in a position to pay this back and will be in serious trouble.
Relief is available under two schemes and will depend on the size of the company. The expenditure must be allowable as a deduction in computing profits of a company and the typical rules surrounding capital expenditure are relaxed.
Small and medium sized enterprises (SMEs) can claim SME R&D relief. This allows the company to deduct an extra 130% of the cost on top of the normal 100% deduction – this equates to a total deduction worth 230% of the costs incurred. If they are loss making, they can surrender that loss for a tax credit of 14.5%.
Large companies can claim a Research and Development Expenditure Credit (RDEC) for their qualifying projects. This credit is calculated at 13% of the qualifying R&D expenditure. The credit can be received as a cash payment (which is taxable) or as a discharge to corporation tax.
Qualifying R&D categories
Expenditure that can be claimed must fall within certain categories:
- staff costs
- consumable or transformable items
- relevant payments to the subjects or clinical trials
- subcontracted out R&D costs
- costs of R&D work subcontracted to the company
- externally provided workers
- for larger companies only, contributions to independent research.
The government has confirmed that costs on data and cloud computing will also be brought into the scope of R&D relief in April 2023.
Despite the tax reliefs available, investment in innovation from UK business remains low. Capital investment from the UK private sector averages just 10% of GDP – the OECD average is 14%. The Chancellor has made it abundantly clear that he believes the way to ‘level up’ the UK is through innovation. It is anticipated that R&D reform is coming. A tax specialist that understands current legislation and the subsequent changes could save a company a significant amount in tax.