How much is an R&D tax relief claim actually worth for small and medium sized businesses (‘SMEs’)?

There have been several changes in R&D tax incentives over the past two years. However, the most significant change for SME claims made by SMEs is the reduction in the rate of benefit available from R&D tax relief claims.

In this article, we explore the announced changes to the R&D claims regime. We delve deeper into the details of the real benefits of R&D tax incentives. In particular, when considering the surrendering of losses, we uncover the true value that companies receive when they make their claim. It’s important to remember that tax losses are a potentially valuable asset for companies, and surrendering these comes with a potential future cost that SMEs must bear in mind.

Background

The rate of benefit for R&D tax relief claims has been reduced for SMEs as the Treasury believes that this type of claim has seen the highest level of fraud and error. 

The reduction in benefit will ultimately be made in two steps. 

• From 1 April 2023, the amount of SME R&D additional deduction fell from 130 per cent to 86 per cent of qualifying expenditure. The rate at which losses could be surrendered in return for a cash R&D tax credit reduced from 14.5 per cent to 10 per cent.
  
  Alongside these R&D rate changes, and offsetting them to an extent, is the change in the main rate of corporation tax, which increased from 19 per cent to 25 per cent on the same date. This means that a smaller amount of tax relief is required to generate the same level of corporation tax saving.
  
  

• For periods starting on or after 1 April 2024, the SME R&D tax relief scheme will no longer be available for SMEs unless they are ‘R&D intensive’. Instead, all companies will be claiming under the new merged regime. This is an R&D Expenditure Credit (‘RDEC’) regime, which until now had been the large company route and is broadly less generous.
  
  Headline rates, often quoted in commentary, suggest a decrease in the ‘benefit’ of R&D claims. The benefit, as a percentage of qualifying R&D expenditure, was in the range of 24.7-33.4 per cent in March 2023. It dropped to 21.5-18.6 per cent in April 2023, and is projected to fall further to 15-16.2 per cent from April 2024.
  
  At first glance, the benefit for loss-making companies appears to have been largely halved. But do these headline percentages paint the true picture of the tax benefit? As our analysis below suggests, not always.

Benefits available

The table below presents the tax saving or cash benefit in each case as a percentage of qualifying R&D expenditure. The latest R&D tax relief rates can be found at gov.uk.

Impact on profitable companies

The implications of the benefit situation are most evident for profit-making SMEs, who could leverage these incentives to immediately reduce their corporation tax liability. The effective corporation tax saving as a percentage of R&D expenditure will have fallen from 24.7 per cent in March 2023 to 15 per cent for periods starting on or after 1 April 2024. This is clearly not good news for SMEs.

There is a slight positive that can soften the blow. The benefit is transitioning to the RDEC mechanism, which means that a credit is recognisable in the profit and loss (P&L) statement, boosting reported profits and visibility of the R&D. 

For businesses that are profitable in a given period but have losses brought forward, there were cases where the SME R&D regime failed to deliver any short-term cash benefit. In contrast, under the RDEC mechanism, there is always an in-year cash benefit of at least 15 per cent.

Impact on loss-making companies

The SME R&D tax credit offers a cash benefit to loss-making companies that submit R&D claims. The R&D claim itself results in an additional deduction from taxable profits. This often leads to an increase in the size of a company’s trading loss for corporation tax purposes. 

In such scenarios, the R&D tax credit can be received in cash if the company chooses to surrender losses in return. The conversion rate of losses into a cash payment was 14.5 per cent prior to April 2023, which has since decreased to 10 per cent.

The amount that can be surrendered in return for the R&D tax credit is the sum of qualifying expenditure itself plus the additional R&D tax relief deduction (130 per cent up to April 2023, then 86 per cent thereafter). For instance, for £100k of qualifying R&D expenditure claimed in 2022, the maximum amount of losses that could be surrendered for an R&D tax credit was £230k. At 14.5 per cent of the loss, the R&D tax credit would amount to £33.35k. Relative to the R&D expenditure claimed, this cash amount is therefore 33.35 per cent.

Don’t forget about the value of tax losses

While the R&D tax credit of 33.35 per cent seems generous, what would the tax benefit be for a company incurring the same R&D expenditure but choosing not to claim R&D tax relief? 

The £100k of R&D expenditure would form part of the company’s trading loss, which could be carried forward to offset future trading profits. Assuming a corporation tax of 25 per cent applies, this £100k could lead to £25k of future tax savings. 

There is of course a timing benefit in receiving cash now rather than a potential tax saving in the future. If we assume future profitability, the R&D tax credit is only worth 8.35 per cent prior to April 2023. From April 2023 onwards, when the rate of R&D tax relief has reduced, the actual claim benefit turns negative at -0.3 per cent if the company surrenders losses that could have reduced a corporation tax liability. 

The company might be better off not claiming the R&D tax credit at all unless the short-term cash is important for its financing and growth plans. Without the need for cash, the time, cost and HMRC enquiry risk associated with the R&D tax credit should be carefully considered. 

It isn’t however essential to claim the R&D tax credit when the option is available. The R&D tax relief can be claimed (for now), increasing the company’s trading loss, which can be carried forward to use against future taxable profits. In this scenario, the company will still have the £25k of tax saving associated with the underlying R&D expenditure. It will also carry forward an additional potential tax saving of £21.5k related to the R&D tax relief. 

Carrying forward losses related to R&D claims is therefore arguably much more valuable for a company expecting to become profitable in the next few years. Be wary of R&D claim advisers who encourage claiming the cash R&D tax credit without considering losses. This is likely an approach used to justify their fees. 

How will this change under the new merged regime?

The upcoming merger of the R&D tax relief and R&D expenditure credit schemes has been described as detrimental to SMEs. Specifically, the rate of benefit for a loss-making, non ‘R&D intensive’ SME is frequently cited as dropping from 33.4 per cent to 16.2 per cent. However, once we consider the value of losses, we find that the rate of absolute benefit prior to 1 April 2023 was in fact 8.4 per cent. This makes the merged regime benefit look more attractive than initially thought. 

Under the RDEC mechanism, the company retains the value of any loss associated with the underlying R&D expenditure. Thus, any R&D claim adds value on top of this carry forward. A loss-making company will receive an additional 16.2 per cent as an immediate cash payment from HMRC, while also retaining carried forward losses. 

Although the cash receivable by the loss-making company when making a claim is reduced, the merged RDEC scheme still delivers a much higher absolute benefit overall. This is particularly true for loss-making SMEs if we assume that they will be able to use losses in the near future. 

What about ‘R&D intensive’ SMEs?

There have been special rules written for companies who incur over 30 per cent of their total expenditure on qualifying R&D. The aim of these rules is to maintain their rate of R&D tax credit at the 14.5 per cent level that applied before April 2023. The rate of R&D tax relief is still reduced to 86 per cent, meaning that the payable R&D tax credit will equal 27 per cent of the amount spent on qualifying R&D. 

After deducting the 25 per cent future tax saving that is surrendered when claiming this credit, the theoretical overall benefit is reduced to just 2 per cent. This indicates that the new RDEC remains a much higher overall value if the company intends to request the cash R&D tax credit.

Conclusion

Evaluating the overall benefit of R&D claims clearly requires some number crunching. So, what does this all mean? Take the time to understand the real benefit of an R&D claim based on your company’s tax position before feeling too disappointed with the headline rates of relief you may have seen. The real benefit may not be as obvious as these headlines suggest.

If you would like to further understand the impact of the R&D tax regime changes, please contact Will Rainford and Graham Steele or a member of the RSM Innovation Reliefs team.