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UK Research and Development Funding Reform—What Comes Next?

July 1, 2022, 7:00 AM

At long last … after 20 years and multiple consultations, the government is finally reforming the UK’s research and development (R&D) tax credit scheme. The importance of these reforms cannot be overstated.

The government already announced in the Spring Statement that it will add cloud computing, data and pure maths to the cost criteria, providing an overdue boost in funding for technological R&D. However, there is concern that reforms could take an alarming turn, with the Treasury hinting it intends to reduce the benefits for small and medium-sized enterprises (SMEs) in order to pivot the scheme in favor of larger companies.

There are significant flaws in this plan. The UK’s R&D scheme stands to take a significant hit, and with it, so does our ability to meet R&D expenditure targets.

Part One: Don’t Throw the R&D Baby out with the Bathwater

Looking at the potential reduction in the SME scheme, this move is above all being driven by reports of fraudulent claims. The government is convinced the SME scheme is being abused and that it is little more than a costly waste of resources. But the it could not be more wrong—cutting SME funding is a misguided reaction akin to throwing the baby out with the bathwater.

  • Small, but mighty

Why should the government care about SME R&D?

The UK is an SME-dominated economy and much of its economic growth comes from disruptive start-ups, as opposed to big business. The UK’s start-up and scale-up culture is an impressive force to be reckoned with, attracting 29.4 billion pounds ($36 billion) in 2021, more than twice the year-before level. These companies create jobs, provide new and competitive products and services, and stimulate growth.

Successful R&D plays a vital role here. Many start-ups are founded on a specific bit of IP, but subsequent innovation also helps businesses to take their product further and build growth. In this way, SME innovation truly is the next generation of enterprise, and must be nurtured.

While the SME scheme needs reform, a significant reduction in funding would cripple innovation. The government should make no mistake: These credits provide thousands of businesses across the country with vital R&D funding, without which many SMEs would not be able to innovate. The 50,000 pounds they receive can make the difference between hiring that extra developer or lab technician, or not. Without it, they might not be able to invest in R&D at all, especially considering the cost of doing business has just risen considerably.

Taking away that funding would damage the UK’s thriving start-up scene and inhibit its goal to become a “science superpower.”

  • Small claim fraudsters

In an attempt to stimulate start-up culture, the government has tried to increase uptake of the scheme in recent years, so why backtrack now that people are finally using it?

The core argument is that the R&D scheme is not providing value for money. Despite the government spending a vast and growing amount on R&D tax credits, the UK is not seeing a parallel growth in innovation, and overall spending remains less than half the Organization for Economic Cooperation and Development (OECD) average.

In search of an explanation, the government has had its eyes drawn to the mounting evidence that the scheme is being exploited by inaccurate or exaggerated claims, as identified in the annual report of the UK tax authority, HM Revenue & Customs (HMRC).

The scheme, like many others, is certainly open to abuse. Anyone can make a claim, regardless of whether they are actually carrying out legitimate R&D.

HMRC does not have the ability to scrutinize all claims, which means some of the smaller-value applications are approved without review. This problem has worsened, and, as of May 17, HMRC has suspended payments on some of its R&D tax credits.

However, while the problem of fraud absolutely needs to be resolved, the solution does not lie in cutting SME R&D funding altogether.

  • Don’t throw away the R&D baby!

It seems that the logic behind the government’s position is that clamping down and reducing funding for small claims (where the fraud usually takes place) will reduce the cost of the scheme and see it add more value. But that misses the bigger picture and the catastrophic impact on businesses that are innovating legitimately.

Fraudulent claims make up a small minority of submissions—about 5.5% according to the latest data. The vast majority are for genuine innovation, which needs to be retained. It would be disproportionate to change the scheme at the expense of those using the scheme legitimately because of a few “bad apples.”

I suspect HMRC is exerting its influence on policy here, leading the government to the conclusion they are throwing money away and not producing anything useful. But this is a drastic miscalculation.

First, the research used to justify that the scheme is not generating enough investment is supported by data from 2017, and the value of R&D has since drastically changed. There were 76,225 SME claims in 2020, compared to 34,060 in 2017 —more than double the number in three years.

Unlike HMRC, SMEs do not have enough of a voice here. Virtually no small businesses would have contributed to the recent consultations and, as a result, they are not visible to policymakers.

Combine the fact that smaller businesses are more dependent on R&D funding and that the UK economy is more SME-heavy than most OECD countries, and the government’s conclusions quickly fall apart. The reality is that a reduction in SME funding would ultimately have a greater impact here than in other countries.

  • Nurture, not neglect

Contrary to what the government might think, SMEs are finally engaging with the scheme in a really positive way, which is stimulating innovation that the government cannot yet see.

Granted, fraud is a problem and there needs to be more effective review of the small claims to catch those that are abusing the system, for which extra resource for HMRC will be necessary.

People have long argued for extra manpower in HMRC’s ranks, but this resource could take another form.

To give HMRC what it needs, the government should seriously consider an overhaul of the current application process. The future of tax is digital, so the digitalization of the application and review process is the way forward.

If this is done right and the resulting digital platform has, for example, intelligent capabilities that would enable it to spot potentially fraudulent claims, the return on investment would be significant. The technology already exists, the government just needs to implement it.

To get to the heart of the government’s concerns, they must develop a simple and intelligent portal for applications. That would both eliminate fraud and encourage greater uptake of the funding among the right participants, which would be beneficial for all parties—the Treasury, SMEs, HMRC, and the UK as a whole.

Part Two: The Flaw in the Government’s RDEC Plans

Any large businesses would be encouraged by UK Chancellor Rishi Sunak’s recent words on R&D. It certainly sounds like the Treasury has every intention of increasing the UK’s R&D tax credits for big businesses in the Budget this autumn.

But all is not at it seems. The reality is that large companies are currently on track to lose R&D funding—which the government has not made clear.

  • A net reduction in funding

In the Spring Statement, Sunak declared that the government would consider making the R&D incentive scheme more generous in autumn as part of a review to give it a greater impact: And judging by recent comments, he intends specifically to increase the relief for large businesses.

Good news then for big businesses? Well, potentially not.

The UK’s R&D expenditure credit for large businesses—known as the RDEC scheme—is calculated based on a company’s total amount of eligible R&D expenditure, of which business can then claim 13% back from HMRC. However, this is a taxable benefit, and businesses pay corporation tax on the credit they receive.

This raises a significant problem. Corporation tax is due to increase from 19% to 25% in April next year, which means that businesses will receive fewer credits than before. The government has hinted it will introduce some tax breaks to support businesses with the rising cost of doing business: But currently we are on track for a corporation tax increase.

So, unless the scheme becomes more generous, businesses will see reduced R&D funding, which will almost certainly mean less invested in innovation, considering the vital role R&D tax credits play in financing innovation.

The big question is: What will the government do?

  • Solution or spin?

It seems unlikely that the government has not noticed this problem, and the Treasury will be aware of the implications of its corporation tax increase on R&D funding.

So, there is implicit recognition that companies will lose part of their R&D cash, and potentially reduce investment, as a consequence of the rise. But will the government accept that, or will there be corresponding changes to RDEC to solve the issue?

There are hints that plans are afoot to mitigate the change—and perhaps even to increase the benefit. Strategically increasing the RDEC rate from 13% to 14% would almost exactly cancel out the effect of the corporation tax increase.

The government may have realized this and may be positioning its RDEC rise as greater investment, when it is not. Only a further increase to 15% would give an increase in R&D investment in real terms.

That would certainly contribute to the third part of the Chancellor’s “Capital, People, Ideas” pillars. It would indirectly support the first two elements as well, given that HMRC’s report shows that every one pound invested in RDEC generates 2.35 pounds in additional corporate investment—"Capital”—and that a substantial proportion of the funding is used to create jobs and hire more “People.”

However, no rise has been confirmed.

The undesirable alternative is that the government decides not to increase the RDEC rate, accepting that this would mean a reduction in the cash benefit and hence a probable reduction in innovation investment.

I am hopeful this is not the case. How would the government reconcile this with the drive to boost R&D spending as a mechanism for driving the economy? The pressure on the public finances is doubtless there, particularly given the expenditure on Covid measures in the last few years; however, that should not be allowed to constrain worthwhile investments.

  • Putting pressure on the government

We may have to wait until November 2022 to find out if the potential increase to the RDEC scheme will provide that real-terms increase in R&D funding. But the cut that lies ahead goes directly against the government’s long-held ambitions.

This, paired with the potential cut to the SME scheme, means the UK cannot possibly expect to hit its R&D spending targets.

It is now vital that those in the R&D community put pressure on the government. At a minimum, the government needs to increase the RDEC scheme to cancel out the rise in corporation tax. But if it truly wants to boost the amount of R&D funding available to big corporations, as Sunak suggests, the rise will need to exceed the impact of the new level of corporation tax.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Benjamin Craig is Associate Director of R&D Tax Incentives at Ayming UK.

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