Why cutting R&D Tax Credits would undermine UK innovation

Guest article written by Daniel Tenner , Founder of GrantTree

With every new government, there is a chance to turn the page and write a new story. And this government has stated that they want to “kickstart economic growth”, “unleash investment” ,?and “respect business” .

But could they be about to do the opposite?

It is practically a cliché to state that small businesses are the backbone of the economy. In the UK, SMEs form 99.9% of businesses and employ 61% of the private sector workforce, contributing 52% of the UK’s total turnover.

And of all the activities any business does, science and technology R&D is one of the most productive and lucrative, when done right.

Anyone who has been alive for the last few decades has seen technology transform our world: the internet, social media, electric cars, solar power, smart phones, and now, of course, artificial intelligence… the list goes on.

It’s no surprise that the US still dominates the world, given that, thanks to Silicon Valley and its VC ecosystem, it is a powerhouse of global innovation without equal.

“Among our portfolio companies, R&D Tax Credits funding has all been re-invested into further R&D activities. Without R&D Tax Credits, this would not be possible without external funding and would possibly lead to having to sell the company’s IP to overseas purchasers” – VC.

For two decades, the government has understood this, and through efforts like Tech City, Innovate UK’s grant schemes, SEIS, and R&D Tax Credits, has tried to support the UK’s tech industry to flourish. And these have worked!

The UK is punching well above its weight, in third position after the US and China ?in terms of the size and value of its tech sector. And it moves quickly - in the nascent field of AI, the UK is host to 20 AI unicorns and 1,800 VC-backed AI startups .

But this could all come to an end, at the stroke of a pen.

A frayed history

“We spend around 10% of revenues on R&D activities. This allows us to compete effectively with competition from overseas. Margins in our industry tend to be low, so R&D Tax Credits reduce our risk and enable this investment” - Food industry SME

One of the core forms of support that the UK has provided to innovative SMEs has been the R&D Tax Credits scheme. Put in place by the previous Labour government in 2000 , it has since provided billions of pounds of support to the UK’s tech companies, and been a critical incentive to help our companies remain competitive in a global market - which all markets are, nowadays.

Anyone who has any contact with the UK SME tech sector knows that R&D Tax Credits are seen as critical. Some companies (yes, even SMEs) do decide to start in the UK and stay here because of the scheme’s benefits.

It seems like a no-brainer: if you want to “unleash investment” and “kickstart economic growth”, why wouldn’t you carry on with this powerful tax incentive.

Unfortunately, two interrelated factors have muddied the picture substantially and put SME R&D Tax Credits in doubt: fraud, and a more obscure concept called “additionality”.

A circular argument

“The R&D scheme has allowed us to tender for contracts against listed US businesses. Without it, we would be less able to continuously develop our products, would be less viable, and would not win those overseas contracts” - Online Platform SME.

In 2020, an HMRC evaluation of its own R&D Tax Relief schemes ?found that the “additionality” of SME R&D Tax Credits was lower than it would have liked.

“Additionality” is a synonym for “how much bang for the buck is this thing?” - and in that, the SME scheme was found wanting - the average pound of benefit for one pound of cost to the taxpayer was found to be between ￡0.60 and ￡1 (though HMRC itself admits this is an underestimate).

By contrast, its evaluation of the RDEC tax credit ?for large companies suggested between ￡2.40 and ￡2.70 of benefit for each pound spent.

Not to get too technical about this, but this “additionality” is largely derived from estimates of the “cost elasticity” of R&D in small and large firms. A higher cost elasticity means that a decrease in the cost of R&D translates into a greater increase in the investment in R&D.

Now SMEs typically have higher cost elasticity (1 ?2 ), for a number of reasons: they usually spend any extra money they get directly on R&D. And they have fewer easily available sources of funding, compared to large companies.

Large companies may be influenced to move their R&D to the UK by R&D incentives, and so it is worth supporting them - after all, other countries do so too . But SMEs, especially tech startups, are always starving for funds, so they are very good places to put money if you want it to be spent on R&D.

So, how come HMRC’s evaluation found SMEs to be less “bang for the buck”? If the accepted wisdom across the OECD is that cost elasticity is higher in SMEs, why is HMRC using a lower figure?

Well, they won’t say, but most industry analysts believe that the reason is a combination of fraud and the complexity of the scheme.

“Frauditionality”

“We used the funding from R&D Tax Credits to expand our team and diversify our product portfolio” - Software SME.

HMRC’s issues with fraud in the R&D Tax Credits scheme have been well documented ?for a few years now. From 2019 onwards, under pressure from the Government, HMRC greatly reduced its qualified staff, and many unsavoury “R&D advisors” started filing spurious claims for companies that were not engaged in any R&D worthy of the name.

If, as is likely, they are included in the cost elasticity calculations, what it really means is that the belief that the SME scheme is less “bang for the buck” is wrong. Or rather, it’s right, but it points the current Government towards the wrong solution to this problem.

SMEs that get R&D Tax Credits make great use of them - better than the large companies - but if the scheme is mismanaged, as has been the case until the last 2 years, then fraudulent players will abuse it.

Moreover, one can assume that the “cost elasticity” of fraudulent advisors is fairly low.

Whether the scheme returns 15% or 25% makes no difference to them, as they are putting no effort into claim preparation, and fabricating R&D costs. It’s free money as far as they’re concerned! They will even continue to abuse the scheme once it is merged into RDEC next year, as the previous Government eventually decided to do, as if that would make a difference to dishonest advisors!

Continuing as things are is not viable - and in fact, that is already off the table. The previous Government already severely hamstrung the SME scheme, and, belatedly, HMRC has made substantial (if occasionally ham-fisted) efforts to reduce fraud through waves of random enquiries that have already taken down at least two large-scale?advisors ?that were busy defrauding the taxpayer for hundreds of millions of pounds.

But punishing SMEs by reducing the R&D incentives is unproductive, when the problem is fraud. The best solution to improve the return of the SME R&D Scheme is for HMRC to be given the resources to do a better job of operating the scheme - whatever it is called, and whatever percentages are allocated to it.

The worst option: “subtractionality”

Unfortunately, there is one more option, which I alluded to earlier, and which the present Government, under serious pressure to fix public finances, may be considering: getting rid of SME R&D Tax Credits entirely. After all, that would free a few billion pounds a year, and who’s going to defend the tech sector nowadays, when everyone is busy being afraid of what AI is going to do to their job?

This would be the worst possible move: to take the headline figure of additionality, which is based on HMRC’s own mismanagement of a valuable scheme, and “solve” this problem by punishing every single SME that relies on the scheme to remain competitive globally.

I said earlier that the UK punches well above its weight in terms of R&D. A recent Business Enterprise Research and Development Survey ?suggested it might be doing even better than the OECD figures suggest.

As in all parts of the economy, SMEs are the backbone of this performance, whether they are innovative tech startups leveraging the latest AI technology, or manufacturers competing against overseas suppliers.

Instead of eliminating the SME R&D scheme, if the Labour Government truly is committed to kickstarting economic growth, it might even pair that with an increase?in the SME rates, rather than a decrease.

This has only recently become possible as a side-effect of leaving the EU and escaping its Notified State Aid rules.

For some reason, the previous Government ignored this opportunity and went the other way.

It seems like an easy win for any government wishing to encourage more economic growth.

Here’s to hoping that the Labour Government recognises the reality of SME R&D in the UK and solves the right problem.

Guest article written by Daniel Tenner

Daniel Tenner is a serial entrepreneur and the founder GrantTree, an innovation funding consultancy specialising in R&D Tax Relief and grants.

?