Understanding the differences in UK & US R&D tax incentives

Taxpayers with multinational operations can be entitled to innovation tax incentives in multiple jurisdictions. Despite the common principles that underlie many countries’ research and development (R&D) tax reliefs, the technical requirements and the practical operation in each country can vary significantly.

In this article, we look at a few of the key differences between the UK and US regimes to help you navigate these intricate regulations. R&D tax incentives are a highly nuanced and complex area of tax regulation, so links to further technical detail are included where applicable.

How do the definitions differ?

The underlying definition of R&D differs between the UK and US regimes:

• the UK focuses on the underlying advance sought in science or technology in developing a particular product, process, service or device; whereas
• the US regime focuses on the product, process, software, technique, invention or formula under development itself.

For example, a project utilising existing scientific or technological know-how to create a new product would be unlikely to qualify for relief in the UK, as there is no underlying advance in science or technology sought. In contrast, the same project undertaken in the US could qualify as the taxpayer is developing a new product. Taxpayers in manufacturing industries such as industrial products manufacturing, commercial products manufacturing and food and beverage may therefore have more scope to include activities as qualifying for relief in the US than in the UK.

With digital transformation top of mind for middle market taxpayers (58% consider digital transformation among their most important areas of investment), it is also worth noting that the US regime has additional requirements to qualify software intended for internal use (for example, back-office software that supports human resource functions). The software must not be commercially available, must be unique or novel and must require substantial economic resources to develop. Activities such as implementing third-party software and creating software already available off-the-shelf are unlikely to qualify in the US. In contrast, the UK applies the same underlying qualification requirements to all types of projects, including software (albeit supported by supplementary guidance giving more detail).

The US regime has always included a territorial requirement that the qualifying activities occur physically within the US. From 1 April 2023, the rules will change such that the UK regime will have a similar requirement, necessitating any third party R&D support to be carried out within the UK, subject only to very narrowly drafted exemptions.

Are there differences in eligible costs?

Both the UK and US recognise eligible costs of internal staff, consumables, third parties and software. For accounting periods beginning on or after 1 April 2023, the UK will also recognise costs of data sets and cloud computing. Both regimes also require the costs included in a claim to be incurred by an entity within the respective jurisdiction.

The key difference is how each regime defines the acceptable boundaries of R&D and how strong the link between activity and eligible cost must be. Under the UK regime, costs attributable to qualifying indirect activities, such as finance and human resources, are currently permitted as they are seen to indirectly enable R&D to occur. The US regime is more restrictive, and general and administrative services, or other services only indirectly of benefit to research activities, are not considered eligible.

The link between R&D activity and eligible cost must be more apparent in a US claim, with clear nexus between expenditure and activity. In the UK it is reasonable to claim a proportion of utility costs, relevant software licenses and consumables where a reasonable basis for allocating these costs to eligible activities can be identified. This type of cost apportionment would likely be challenged in a US claim as the regulatory authorities prefer a clear and direct link between the cost claimed and the qualifying activity. In practice, this means that US claims are likely to include a narrower scope of costs.

How are the calculations and benefits different?

The mathematical calculation of R&D claims is complex in both the UK and US. However, the cause of complexity differs between the two jurisdictions.

Taxpayers in the UK must determine whether they fall in the small or medium-sized enterprise (SME) regulations or the research and development expenditure credit (RDEC) regulations. This affects the cost categories eligible for inclusion and the form and magnitude of the benefit received. For SMEs, the benefit is an enhanced expenditure deduction resulting in a payable tax credit, reduction in tax liability or increase in tax losses (depending on taxpayer circumstances). For RDEC claimants, the benefit is a payable credit or reduction in tax liability. Rate changes in effect from 1 April 2023 mean the SME benefit ranges from 18.6% to 21.5% of qualifying spend and the RDEC benefit is 15% of qualifying spend. This being said, the days of two schemes in the UK may be numbered, as HMRC recently announced a consultation on combining these into a single scheme, potentially as soon as 2024.

The US regime is based on incremental expenditure over a ‘base period’ rather than absolute expenditure in the tax year (see final paragraph of this article). In practice, this means that first-time US claimants must assess R&D activity not only in the claim year but in the applicable historical periods as well. The benefit is a non-refundable credit that can be carried forward up to twenty years if the claimant does not have a tax liability in the claim period. In some situations, qualified small businesses are eligible to utilise the credit to offset the employer share of payroll taxes, allowing them to monetise the credit before they are profitable. As there are two credit methodologies available to US claimants, both of which are incremental in nature, there is no fixed percentage to define the credit benefit. In typical cases, the resulting credit is approximately 7% to 10% of total qualified spend.

How are the claims processes different?

In the UK, claims are made within the corporation tax return. The R&D incentive must be claimed within two years of the end of the accounting period of the expenditure. This can be done in the original corporation tax return or by amendment to the return within the time limits. Recent changes made by HMRC to tackle perceived abuse include requirements to inform HMRC in advance of the intention to make a claim and provide brief details of the R&D activities.

There is no advance notification or registration requirement in the US. The R&D credit is claimed within the taxpayer’s annual income tax return and timely filed claims face no accompanying documentation requirements. Taxpayers generally have three years from the due date of the return or the date on which it was filed, whichever is later, to submit a claim via amendment. Additional detail and documentation may be required alongside claims made via amended return.

Why this should be front of mind

Taxpayers with, or planning to undertake, multinational operations are undoubtedly already considering tax implications when making global investment decisions. R&D tax incentives are a highly nuanced and complex area of tax regulation in both the UK and US. In order to optimise the outcome of their decisions, it is essential for taxpayers to be aware of the technical requirements and the practical operation in each country.

For further information on UK and US R&D incentives, contact James Tetley.