The Evolution of UK R&D Tax reliefs – Part 1

The UK R&D reliefs have now been in place for over twenty years so it seems timely to review their history as many themes recur over time and some of the missteps show the practical difficulties of using tax policy to drive commercial behaviour.

It is obviously unfeasible to cover every change over more than two decades, and more recent developments will already be familiar to readers, so this 3-part series is not comprehensive but focuses on some specific areas of interest.

SME R&D Relief - origins and policy

The SME relief dates from 2000. It is worth looking at the background as it is then possible to consider to what extent the aims of the relief have been achieved.

The “New Labour” government wanted to encourage commercial growth and a modernisation of the economy. It saw the future in terms of moving to a more knowledge-based economy to secure international competitive advantage.

The UK was seen at the time as lagging in commercial R&D spend behind its OECD peer group and the government wanted to boost this as they thought it would feed into productivity gains.

An example of a technological failure that was important to official thinking was the development of the Sony Walkman. Much of the necessary technological development in miniaturisation had been carried out in British Universities but the commercial development into a viable product had been left to the Japanese who, as a result, had built a world leading industry in the area.

Therefore, a key part of government thinking was that the relief should be focused on moving beyond pure and applied science to technological development of commercial products.

At the same time, the government’s ability to directly address the development issue was constrained by membership of the European Community (EC). The State Aid rules blocked or restricted national subsidies to industries except where there was a demonstrable market failure.

It was accepted by the EC that SMEs were unable to fully exploit the benefits of their investment in R&D because of their lack of capital, expertise or industrial reach, so generous R&D incentives were permitted for SMEs.

The R&D that could be subsidised was broadly defined by what were known as Frascati principles and the SME companies that could benefit were as defined in an EC SME definition.

An examination of the way in which SME status would be tested under this EC definition suggests that the relief was seen in European terms as a “prospective” relief – probably to be delivered by grants in advance of the R&D being carried out.?

However, in the UK the likely grant giving body would have been the Department of Trade and Industry (DTI) but when the relief was being developed, the UK Treasury had a very negative view of the competence of the DTI in operating such a relief.

The perception was that the DTI had over the years encouraged numerous piecemeal R&D initiatives that often overlapped, or clashed, in confusing ways and so their capability to run a clear and comprehensible regime was doubted.

For that reason, and also to keep the regime and costs under close Treasury control, it was decided that the relief should be delivered through the tax system by the Inland Revenue (IR).

A problem with providing R&D relief through the corporation tax collection system is that you can only reduce the tax payable and can only do so after the year end. So, for start-up companies that were not yet making profits, a pure tax relief provided no immediate assistance. To counter this, the SME relief was designed so that loss making R&D companies could also surrender their tax losses for government cash. This would help them in funding their early development work when the need for assistance was greatest.

Previous UK attempts to incentivise particular industries, or areas of work, through the tax system had operated by giving tax relief to wealthy individuals for investing in desired areas, such as film production, but such efforts had frequently been reduced in their effects by tax avoidance, which aimed to secure the tax relief for the investors without the required, new, economic investment taking place.

To minimise the avoidance opportunities for the R&D relief, and channel it directly to those carrying out the work, the new credit system was designed whereby some avoidance protections were built in, and the credit would be paid direct to the company carrying out the R&D.

This was an innovative step for the UK tax system and has generally been considered a success – resulting in its adoption in other areas such as film production and video games.

But R&D was the test bed where the mechanics of the credit system were developed and refined.

There was still a problem with delivering the relief through the tax system in that it depended on a claim being made after the end of year, and then the claims would still have to be reviewed so there might be a time delay and uncertainty for companies accessing the relief.

If the relief was to provide an incentive to cash strapped companies carrying out the R&D, this delay and uncertainty had to be minimised. Various targets were set whereby a claim for credit would be paid within a short period of making the claim, with any enquiry to be carried out subsequently.

(Over time it is possible that HMRC became too focused on this payment metric, as it was measurable, and paid less attention to the quality of compliance work).

At the outset, a definition of qualifying R&D was published. This was to be identified by the claimant company’s own competent R&D professionals, and tax relief would apply on a self-assessment basis. Any claims for cash were to be paid as quickly as practicable, before any? more detailed scrutiny of the claims took place under the enquiry regime.

The Treasury was concerned that the Inland Revenue, with its function of trying to get money into the public purse whilst resisting its outflow, might be unreasonably obstructive of legitimate claims, or would make companies work too hard to get the relief.? So, although this was not made public, there was a strong early steer given to the IR that there should be no “technical blocking” of claims and that enquiries should only be raised sparingly in the early years.

A decision was also made that the IR would not employ any competent R&D professionals able to challenge the technological merits of claims.

The rationale here was supposedly that this was a self-assessment regime, that no IR specialist would be able to cover the whole of their field adequately and also that any? government employed technologists would not then be working in productive industry – creating a bigger skills gap for UK industry.

However, one suspects that the real reason was principally a reluctance to have more staff on the civil service payroll and what actually happened was that the technologists were instead? recruited by claim preparing agents, thereby still rendering them unavailable to industry and leaving HMRC with an expertise deficit in examining claims.

In practice, the agency technologists proved well able to apply themselves to adjacent areas of expertise as technology development is easy for a professional technologist to identify.

Large Company Relief and RDEC

The initial R&D relief was only targeted at SMEs however, most economically effective R&D was actually being carried out by larger companies, and the UK was uncompetitive in this area, as other countries gave reliefs to large companies and the UK didn’t.

These larger company reliefs were permitted by the EC, but only within certain limits, so in 2002 a UK large company relief was introduced which was set at a less generous level than the SME relief in order to comply with EC restrictions.

The large company relief originally only applied as a deduction from taxable profits. There was much lobbying from industry to the effect that, at the lower level of the relief it was not incentivising additional R&D because the benefit was often hidden in a much larger tax? calculation and might not be agreed until some considerable time after the R&D had been carried out.

For this reason, the R&D benefit was largely hidden from the decision makers actually commissioning R&D and they had difficulty getting this taken account of in their R&D? budget.

The concern was that these problems meant that the large company relief was not having the desired incentive effect to carry out additional R&D.

As a result, a slightly more generous RDEC credit was introduced in 2013 which gave a cash amount “above the line” in the accounts that was therefore more visible and provided a cash sum directly linked to the R&D, thereby enabling the R&D budget holders to pitch for this to spend on additional R&D.

Generally, this has been seen as a successful mechanism and it is now being adopted for SMEs as well.

Available now... click here for part 2 of my Evolution of UK R&D Tax reliefs series where I examine how a combination of inconsistent R&D definitions, inadequate checks, HMRC cost-cutting and compliance failures led to the growth of poor claims and organisational turmoil.

Note: this article series is based on exclusive interviews with a senior ex-HMRC inspector who was instrumental in the initial set-up and oversight of the R&D regime.

Interviews conducted by Rufus Meakin

Rufus Meakin helps companies prepare complex R&D Tax Credit claims where robust HMRC compliance is essential.

If you would like to discuss any aspect of your R&D Tax Credit claim then please feel free to call me on 0794 110 3285.