The Evolution of UK R&D Tax reliefs – Part 3

Since their introduction in 2000, UK R&D tax reliefs have undergone numerous changes aimed at enhancing their effectiveness.

In recent years, insufficient oversight from HMRC has allowed the widespread submission of fraudulent and incorrect R&D claims, prompting the Treasury to scale back the scheme for SMEs.

Based on exclusive interviews with a former senior HMRC inspector who was instrumental in the creation of the scheme, the final part of my Evolution of UK R&D Tax relief series examines the factors leading to the recent issues and assesses whether the initial objectives of the scheme have been met.

Avoidance and compliance problems in a cash-generating regime

When first designed, the SME regime incorporated a number of anti-avoidance provisions, or measures designed to stop abuse. One of the most useful ones was a PAYE cap which limited the amount of credit to the amount of PAYE/NIC paid by the company.

A prime aim of the tax avoidance industry is to get money out without having to put money in, so a requirement that they have to pay out for staff before getting any credit made pure avoidance in this area unattractive.

Over time various protections like the PAYE cap that had been built into the original SME scheme were abandoned in the interest of simplification. Then the rates of relief were increased, and the pressure to cut staff resources meant that HMRC adopted an informal risk filter.

This meant that smaller R&D claims generally went unexamined except for basic checks like correct categories of qualifying expenditure. The result was that actual fraud was back on the agenda.?

HMRC did at least notice some of the large scale attempts at fraud, and took counteraction, but seemed to think that by doing so they had tackled the general problems of compliance.?

They either didn’t appreciate, or didn’t seem to care, how many incorrect claims were being made and accepted, as long as they weren’t fabricated.

An additional factor compounding the problems was that the previous de minimis size limit for claims had been abandoned which meant that HMRC were getting swamped by large numbers of very small and questionable claims that they lacked the resources to police.

The developing problems had been drawn to HMRC’s attention by reputable claims practitioners over a number of years but HMRC failed to take any adequate counteraction. In turn, this encouraged cowboy firms to submit more and more unjustifiable claims, most of which were being paid.

The position was only taken seriously when the amount of R&D expenditure being claimed as eligible for relief was outstripping the total expenditure on R&D thought to be taking place in the economy, leading the National Audit Office to conclude that HMRC had lost control of the regime and resulting in the HMRC accounts being qualified.

The panicked reaction to this has led to arbitrary claim refusals and further distrust of HMRC amongst the reputable advisor community.

Has the R&D relief scheme achieved its objectives?

In terms of R&D being encouraged, it is arguable that the SME scheme has failed to achieve its objectives in a cost efficient way. A recent HMRC consultation document (January 2023)?suggested that additionality in the SME scheme is lower than the RDEC, incentivising as little as 60p to ￡1.28 of additional R&D for each ￡1 spent.

This does not compare favourably with the additionality shown in the RDEC scheme of as much as ￡2.40 to ￡2.70 additional R&D per ￡1 of RDEC. At the same time, the SME scheme cost more than RDEC and grew at a faster rate.

It is also arguable that the underlying aims of increasing technological product development in SMEs has not met with particular success.

The original plan was that this would lead to growth in size of knowledge intensive SMEs, to become large companies, with a corresponding growth in higher value employment. It is unclear that this has taken place.

By 2008, the Treasury had noted that the larger SMEs were not appearing to grow as anticipated so it intensified its efforts by doubling the SME size thresholds for obtaining the SME relief. However it is not clear that this produced any major company growth effect, except for increasing the cost of the relief.

In 2010 the very survival of the R&D reliefs was in question. There were strong voices in the Conservative party that called for its abolition in favour of generally lower corporation tax rates. However these did not ultimately prove persuasive for two reasons.

One was that it was perceived that the R&D relief might help rebalance the economy towards development of manufacturing systems and away from the finance industry which had caused such damage with the 2007/8 crash.

Another was that it was just not considered feasible to try running a pure market-led low tax economy when other countries were subsidising their own R&D. The potential loss of international competitiveness in key industries of the future was considered too big a risk.

What we now see in the new relief from 2024 is an abandonment of the favourable rates for most SMEs, and an improvement of the RDEC rates, suggesting that knowledge rich SMEs are no longer seen as special engines of economic growth and employment. Instead, there is a simpler regime for all companies, and a bigger incentive for non-SMEs.

Another point to note is that over time the focus of technological innovation has moved towards software businesses using data in innovative ways.

Under the old SME relief regime it was relatively easy to outsource these companies’ software?development work overseas by subcontracting, or the use of foreign agency workers, and once they became viable businesses they had a low staff need because the systems that were being developed aimed to be automated.

That meant that the benefit to the UK of giving these companies such a generous SME relief was not particularly clear.

Indeed, in the latest iteration of the relief we can see efforts being made to require the development work to be done in the UK to be eligible for the relief, suggesting that the overseas development problem has been noticed.

Going forward we must hope that the newly reshaped R&D regime proves effective and that HMRC compliance efforts will stabilise at an appropriate level.

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.

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