R&D Tax Credits unlikely to face changes in Budget

Since the Chancellor announced that the budget would take place on 30 October, there has been widespread speculation about possible tax measures needed to address a ￡22 billion shortfall in the nation's finances.

Among the concerns of the UK tech community is the possibility of further changes to R&D Tax Credits – a key incentive that supports innovation and economic growth.

As Daniel Tenner argued in a newsletter article a fortnight ago, scaling back R&D Tax Credits for SMEs in particular would be disastrous for economic growth.

His perspective resonated with many in the R&D field and led me to wonder whether Rachel Reeves would risk dampening activity in sectors that are central to economic growth.

I looked at the case for maintaining R&D Tax Credits as they are – at least for the time being – and my findings indicate it is highly unlikely that Reeves will feel compelled to make further adjustments.

These are my 5 reasons why I don’t believe there will be any further changes to the R&D regime in the budget.

1.???? Recent comprehensive review

The Treasury has recently completed a thorough, root-and-branch review of R&D Tax Credits which scrutinised the effectiveness, efficiency and integrity of the scheme. This led to the announcement in 2022’s Autumn Statement that the RDEC scheme for large companies and the SME scheme would be merged, a measure that only came into effect for accounting periods beginning on or after 1 April 2024.

If there had been significant pressure within the Treasury to abolish or drastically alter the scheme, this review would have been the ideal opportunity to do so. But they didn't. Instead, the conclusion was quite the opposite.

The review found that the RDEC scheme for large companies is functioning effectively. In fact, so much so that the Treasury actually increased the rate of relief.

While the R&D scheme for SMEs has faced challenges related to abuse and fraudulent claims, the government implemented a series of measures to combat these issues. These included tightening eligibility criteria, enhancing scrutiny of claims and reducing the rate of relief to deter opportunistic applications.

Given that the latest estimated losses to fraud and error have more than halved in two years (from ￡1.34 billion in 2021-22 to around ￡600 million in 2023-24) the measures put in place do seem to be paying off, meaning the Treasury is more likely to wait and see before making any further changes.

2.???? Limited HMRC capacity

Implementing more changes to R&D Tax Credits would require substantial resources from HMRC.

The policy and technical teams are already grappling with managing existing initiatives, including the recent measures introduced to combat abuse of the SME scheme.

Developing, drafting, and implementing new legislation is a complex and time-consuming process. Given HMRC's current capacity constraints, it's unlikely they would want to undertake a significant overhaul of the scheme right now.

Untangling newly implemented legislation could also lead to unintended consequences. Companies might attempt to change accounting periods, restructure operations or engage in other strategic behaviours to mitigate the impact of changes, thereby complicating HMRC's enforcement efforts.

Given these challenges, it would seem more pragmatic for the government to allow the recent changes to settle and assess their effectiveness before considering further adjustments.

3.???? Labour's historical support aligned with economic growth

Historically, the Labour Party has been a strong advocate of R&D Tax Credits. Indeed, it was the last Labour government that introduced the R&D scheme in the first place.

Labour's philosophy often emphasises the role of government in facilitating economic development through strategic investments and incentives, and Rachel Reeves has publicly stated that her overriding concern is to stimulate economic growth.

A fundamental principle in economics is that investment in research and development fuels innovation, productivity, and ultimately, economic expansion. The government is keen to position the UK as a global leader in high-growth sectors such as biosciences, renewable energy and advanced manufacturing.

Attracting overseas investment is a critical component of this strategy. Large multinational companies often decide where to allocate resources based on the attractiveness of a country's tax incentives and support for R&D.

Eliminating or reducing R&D Tax Credits would send a negative signal to these potential investors, possibly driving them to more welcoming jurisdictions.

The recent merger of the RDEC with the SME scheme creates a unified framework that benefits companies of all sizes. Any changes to the R&D scheme would impact both large corporations and SMEs alike. Given that large companies are highly mobile in their investment decisions, the government is unlikely to introduce measures that could deter them from investing in the UK.

Maintaining the current R&D Tax Credit scheme aligns with Labour's historical support for such incentives and the broader economic goal of fostering growth through innovation.

4.???? Political and economic risks of changing the R&D scheme

Politically, targeting the R&D Tax Credit scheme with further cuts, or even abolition, is not an attractive proposition and would lead to a significant backlash from the wider business community.

SMEs in particular could find themselves suddenly deprived of critical support, leading to a wave of negative stories and public outcry.

In an environment where the media is often critical of government actions, such a move could provide ammunition for opponents as well as detracting from other policy initiatives.

The government might prefer to focus on areas where changes are less controversial and where the potential for public resistance is lower. Measures affecting less sympathetic groups or areas with perceived inefficiencies might present fewer political risks.

Crucially, making substantial changes to the R&D scheme could be portrayed as undermining the UK's commitment to fostering innovation. This could harm the government's reputation both domestically and internationally, at a time when attracting investment is crucial.

With the upcoming budget being closely watched, the government is likely to avoid any actions that could be perceived negatively by key stakeholders.

5.???? Challenges of implementing sector-specific incentives

Some commentators have suggested that the government could refine R&D Tax Credits to focus on specific sectors deemed strategically important.

While this idea has merit in theory, in practice, it presents significant challenges.

The UK's system for classifying company trades is not sufficiently nuanced to accurately target specific sectors without causing collateral effects.

For example, a furniture company that invests heavily in software development might contribute to technological advancement but might not fit neatly into a preferred category.

Similarly, distinguishing between sectors such as biotechnology and cosmetics can be problematic, as both involve substantial R&D activities with potential economic benefits.

Companies might also attempt to reclassify their activities in order to fall within favoured sectors, leading to administrative burdens and potential loopholes.

During the pandemic, we saw how research projects were quickly rebranded to align with Covid-19 priorities, illustrating how swiftly companies can adapt to shifting incentives.

If the government wishes to support specific industries, direct grants and targeted funding programs are more effective tools. These methods allow for greater control and oversight, ensuring that resources are allocated to projects that align with strategic objectives.

R&D Tax Credits are designed to be market-led, encouraging innovation across the economy without governmental micromanagement.

Implementing sector-specific incentives within the R&D framework could also lead to unintended consequences, such as stifling innovation in non-favoured sectors or creating distortions in the market.

The complexity of defining and regulating eligible activities could well outweigh the potential benefits, making such an approach impractical.

Conclusion

In light of these five considerations, it seems highly unlikely that Reeves will pursue further changes to R&D Tax Credits in the budget.

Keeping the current R&D scheme in place helps both large and small companies and fits with the broader goal of driving innovation and sustainable growth in the UK.

Should concerns about abuse or inefficiencies persist, Reeves can always attribute them to previous mismanagement by the Conservatives, thereby deflecting criticism while still maintaining the integrity of the scheme.

By giving the recent anti-abuse measures time to work, the government will be in a better position to evaluate and refine the scheme if needed down the line.

Keeping the R&D scheme as it is makes sense and strikes the right balance between being responsible with public funds and encouraging innovation and growth.

It also reassures businesses and investors that the UK is serious about supporting R&D, which is exactly the kind of stability needed in today’s uncertain economic climate.

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Article written by Rufus Meakin

Rufus Meakin works with tech companies to help ensure their R&D Tax Credit claims are accurate and defendable.

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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