The positive case for pre-notification of R&D Tax Credit claims

One of the latest measures announced by HMRC to tackle R&D Tax Credit fraud is that first-time R&D claimants must notify HMRC of their intention to file an R&D claim within six months of the end of an accounting period.

Currently, any company can make an R&D claim for the previous two accounting periods without notifying HMRC, so this change will effectively shorten the deadline for companies to decide to make an R&D claim by 18 months (for first time claimants).

Now that the dust has settled, the implications for many firms in the R&D advisory sector are becoming apparent. For some R&D advisors, this will significantly impact their business model.

Contrary to many sceptics in the R&D advisory field, I welcome this move.?

A number of R&D advisors have suggested that this measure will "stifle innovation" and disproportionately affect start-ups who may miss the opportunity to claim R&D Tax Credits because they weren’t aware of the scheme.

I'm always wary of R&D advisors who complain about changes to the R&D regime because it doesn't suit them. ?There is a tendency for some advisors to resist changes under the pretence of “sticking up for hard-pressed innovators” when in reality it is their own revenues they are more concerned about.

For readers who are new to R&D Tax Credits, I thought it would be interesting to look at the origins of the R&D scheme and see how decisions taken nearly a quarter of a century ago led directly to these changes now being introduced by HMRC.

How did we get here?

When R&D Tax Credits were first proposed by the New Labour Government in the late 1990s, there was a heated debate within the Treasury about how the scheme would operate.

At the time, two fundamental issues had to be resolved:

1. Should the incentive only be available for “incremental” R&D (over-and-above what companies would do anyway without the incentive), in which case the relief rates could be higher, or would it apply to “volume” R&D (all R&D undertaken by companies), in which case the relief rates would be lower.
2. Who would take charge of the scheme - HMRC or the DTI (Department of Trade & Industry). The case for the DTI was that it already operated a myriad of business R&D grant schemes so it had the relevant operational experience. In HMRC’s favour was the simplicity with which the scheme could be operated within the existing tax system.?

The first question was resolved by the requirement to make it simple for SMEs, which were originally intended to be the beneficiaries of the R&D scheme, so it had to be easy for them to make a claim. ?

Having looked in detail at what other countries were doing, the Treasury concluded (sensibly in my opinion) that it would be too complicated to calculate what R&D might be additional to what SMEs would do anyway without any R&D relief, so a uniform system was agreed that applied to all a company’s R&D expenditure.

The second question was also considered from the viewpoint of simplicity. In many ways, the DTI was the natural body to administer an R&D incentive scheme, however there was a general feeling within the Treasury that the DTI was making a hash of its multiple R&D grant programmes, which were seen as incoherent and difficult for SMEs to access, so a decision was made to let HMRC rather than the DTI run the new R&D incentive.

With HMRC now in charge, R&D reliefs would be managed through the tax system and be “retrospective” in nature, meaning that companies could claim for R&D costs they had already incurred in previous years. The DTI on the other hand ran grant programmes that were “prospective”, where companies would put forward ideas for R&D projects that hadn’t yet started (rather like Innovate UK does today).

(Whereas a prospective system operated by the DTI was more likely to be a true R&D incentive, government ministers feared being accused of “picking winners”, ie. funding companies that might subsequently fail and embarrass them personally, hence why it was believed that a simple retrospective system untainted by political interference would be preferable).

These policy decisions - taken over 20 years ago - have had profound consequences and have largely caused the problems that plague the R&D regime today.

Where we are today

In the 22 years since the inception of the SME scheme, mistakes have been made, most of which derive from the original aim of simplicity for SME claimants.

Perhaps the biggest error was the long-term failure of HMRC to employ technologists to police the R&D regime. This led directly to the current situation where some R&D claimants, advisors and accountancy firms effectively game the system by pushing project boundaries, inflating costs and submitting claims for R&D that isn’t R&D.

(This is highlighted by the well-known mismatch between the value of R&D claimed under the R&D reliefs and the estimated total business R&D taking place in the UK economy).

The recently announced anti-fraud measures appear to be a belated attempt to stem some of the losses, estimated at ￡469m in 2021-22, but almost certainly an underestimate.

Given the size of these losses, it is highly probable that the lax oversight of the R&D regime by HMRC has ultimately led to far more tax being lost to fraud and error than would have been saved had more effective monitoring been in place.?

However, I would go a step further than fraud and error and suggest that some money has been poorly allocated, partly by allowing loss-making companies to claim cash credits for R&D they have already done in the distant past.

In economics, this is called a “deadweight” and was neatly described in the 2021 Cambridge Judge Business School report into R&D Tax Credits:

?“R&D tax credits tend to be regarded by entrepreneurs as a bonus. The most common comment from CEOs is how the arrival of the HMRC [R&D] cheque provided their company with a lifeline during periods of crisis, rather like the unexpected legacy from the great aunt in Australia.?As a result, R&D tax credits are greatly valued by this part of the business community, even though the economic impact may be low”

I am going against the conventional wisdom of the R&D advisory sector, but I believe that is perfectly reasonable to say that companies shouldn’t be able to go back to claim for R&D expenditure incurred up to 3 years ago.?Whilst it is possible that the monies may be used to fund future R&D, it is not really an incentive. It is rewarding past behaviour.

Given their defence of the status quo, I suspect that many R&D advisors and accountants have not faced up to economic reality. This is evident in the marketing material of many advisors who persist in saying that R&D Tax Credits are a “reward for your innovation” and which proudly promote case studies of their clients who had no idea they had been doing R&D until an R&D Tax Credit salesman came along and told them they had.

Given the enormous sums handed out under the R&D scheme, it was inevitable that the Treasury would get wise to the situation that historical R&D claims are largely driven by aggressive R&D advisors and contribute virtually nothing to the aim of raising UK R&D levels to 2.4% of GDP by 2027.

An ￡8 billion scheme that is delivering questionable value is unsustainable. For the government, “rewarding” companies for R&D they did up to 3 years ago makes little sense. ?It would be far more effective to reconfigure the regime more towards incentivising companies to do future R&D.

Many, if not most, R&D advisors will disagree with me. Their position tends to be that by limiting the historical R&D claim position, many start-ups will miss out on “valuable funding” which they can then use to fund future R&D projects (or not). However, I suspect their main concern is more that their own R&D advisory businesses will miss out on valuable fee income from new claimants which they can charge much higher contingency rates than companies already making claims!?

In reality, if these innovative start-up companies are doing genuine R&D (as opposed to non-R&D activity that has been “dressed up ” by a wily R&D advisor) then it is not unreasonable to expect them to be aware of the R&D scheme within 6 months of their year-end. ?If they notify HMRC accordingly, then no cash credits are lost.

R&D Tax Credits are over two decades old, widely publicised, and aggressively marketed by R&D advisers and accountants so there is little excuse for companies not being aware.

Things have moved on from the inception of R&D reliefs, since when there have been regular downgrades in terms of the benefit delivered to the economy. It is estimated that the SME scheme only stimulates between ￡0.60 and ￡1.28 of additional R&D spend for every pound put in.

When companies can claim a cash credit for R&D they have already done then this results in no extra R&D being stimulated because it has already taken place.

Due to significant “over-fishing” by a number of aggressive R&D advisors submitting questionable back-dated claims, it is clear we are now in damage limitation territory for the R&D scheme.

All reputable R&D advisers should accept that there will probably be further restrictions introduced so that the core fundamentals of the scheme can be justified and retained. ?This will involve advisors having to compete on the quality of their service rather than the belief that the R&D scheme will keep expanding indefinitely.

That's why I'm supporting this particular measure.

Rufus Meakin is a long-standing business development expert for R&D Tax Credits and a firm believer in raising standards across the UK R&D claims industry.