The new merged R&D expenditure credit regime – who are the winners and losers?

Who are the potential winners and losers from the new merged R&D tax relief regime? In the first of a series of articles exploring the new regime, we look at who might benefit the most and who stands to lose out.

Introduction

The merger of the current research and development (R&D) tax relief regime for small or medium sized entities (SMEs) and the R&D expenditure credit (RDEC) regime for large companies was confirmed in the chancellor’s Autumn Statement 2023. The merged regime takes effect for accounting periods beginning on or after 1 April 2024. For many claimants this could significantly impact their future R&D tax relief claims.

We take a look at the key changes of the new merged R&D tax relief regime and explore who might be the potential winners and losers going forward.

Key changes

• Under the new merged regime, relief will be given in the form of an ‘above-the-line’ expenditure credit of 20%.
• The RDEC is itself taxable. As a result, the net benefit after applying the 25% main rate of corporation tax will be 15%. However, for claimants in a tax loss position, a 19% corporation tax rate is applied, meaning a slightly more generous net benefit of 16.2%.
• There is a separate regime for loss-making SMEs that are ‘R&D intensive’, which applies for expenditure incurred after 31 March 2023. This regime retains the same mechanics as the existing SME R&D tax relief regime. This includes: an enhanced deduction of 86%; and the ability to surrender a current year tax loss for a payable credit equal to 14.5% of the lower of the current year tax loss or 186% of qualifying R&D expenditure. To be ‘R&D intensive’, an SME’s qualifying R&D expenditure must be 40% or more of its total expenditure (this lowers to 30% for periods beginning on or after 1 April 2024).
• The subcontracted expenditure rules have been significantly changed. Broadly, relief is now available to the company that takes the decision to initiate the R&D and bears the risk.
• The existing subsidised expenditure rules for SMEs will be removed entirely.
• Overseas expenditure restrictions mean that where companies subcontract R&D activity to a third-party, they will only be able to claim relief if that activity is performed in the UK. Where companies incur expenditure on payments for externally provided workers (EPWs), they will only be able to claim relief where those workers are paid through a UK payroll. Exceptions exist for situations where it is wholly unreasonable to undertake the activities in the UK.
• A PAYE/National Insurance contributions cap on claims will continue to apply, but the more generous rules from the existing SME R&D tax relief regime will be adopted.
• For claims submitted after 31 March 2024, only claimant companies will be able to receive payable R&D credits from HMRC. The nomination of a third-party recipient, a practice used by some advisers, will be eliminated.

Whilst there are additional changes under the new merged regime, the above are likely to have the most impact.

Winners

Large companies are the most obvious group of winners.

• The incremental increases to the RDEC rate in recent years, combined with the ability to claim subcontracted expenditure in certain situations, will mean large companies are the main beneficiaries of the new regime.
• The new subcontracting rules will also favour large companies and those at the top of their supply chain. This is because a case-by-case analysis is required to determine which party can make a claim, and crucially, which party made the decision to undertake R&D. Where contracts are for the provision of goods or services, it may be difficult to ascertain whether the party engaging the subcontractor (the ‘subcontracting party’) intended or was aware that R&D would be required to fulfil the contractual requirements. If a consultative approach is taken between the two parties, it would seem likely that the subcontracting party would use its size and bargaining power to argue it had in fact been aware that R&D was required (and may even begin to note this in contractual terms). Many large companies may find they are now able to claim for more R&D activities whilst SMEs, whom the rules favoured previously in such situations, may now often be left with less.
• Companies receiving grant funding in respect of their activities had previously been prevented from claiming tax relief under the SME scheme. Going forward, SMEs will be able to receive grant funding and claim relief. This will particularly benefit innovative start-up SMEs and those in industries where grant funding is more prevalent, such as the life sciences and environmental sectors.
• Loss-making companies will be able to benefit from R&D claims to a greater extent than profitable companies. This may seem reasonable; however, the difference between 15% and 16.2% will hardly shift the dial. The additional relief will, in absolute terms, be more substantial for larger claims, so again larger companies stand to gain the most here.
• Loss-making R&D intensive SMEs may seem like big winners, but this may not be the case at all. The added complexity of this new regime creates significant downsides. Potentially eligible companies will need to navigate the SME size-testing rules, the R&D intensity rules and a different relief mechanism. In return, they will receive a benefit that is still significantly less than what was available under the SME regime prior to 1 April 2023. In fact, the 26.97% headline rate of benefit is not quite as good as it might sound. For companies that expect to be profitable in the future, the claimant must surrender losses for a 14.5% payable credit that could otherwise be offset against future taxable profits and save tax at 25%.

Losers

Conversely, who stands to lose out from the new regime and who might see their claims reduced or their ability to claim removed entirely?

• SMEs as a collective are clearly losing out here. The rates of relief for non-R&D intensive SMEs will decline from the comparatively lofty heights of the pre-1 April 2023 SME relief to a 15% benefit once into the new regime. To rub salt into the wound, many SMEs who previously claimed for subcontracted-in R&D activities under the existing RDEC regime may find they have no claim at all due to the new subcontracting rules. It’s not hard to envisage some smaller SMEs giving up making claims altogether. Under pre-1 April 2023 rates of relief, a claim for £100,000 of qualifying R&D expenditure by a loss-making company could generate a benefit of up to £33,350. Under the new regime, this benefit could be less than half at just £15,000. After factoring in the effort required to make a claim (which has increased due to new administrative requirements), the risk of HMRC enquiry (which has also increased) and adviser fees (which have also increased due to those factors), some may consider that it is simply not worth the trouble.
• Companies using overseas resources, usually for entirely reasonable commercial reasons (ie lower cost), will in most cases lose out. Our experience is that most companies will not change their business model or contractual arrangements but simply forgo the UK R&D tax relief, as it is either not possible or commercially sensible to do otherwise.
• Companies specialising in clinical trials, research and development services and testing activities or facilities may see their claims eliminated. The new subcontracting rules mean their customers are likely to be able to claim the relief instead. Clinical research organisations (CROs) and other incorporated research organisations are likely to no longer be able to access the relief except if their customers fall outside the UK corporation tax net (for example, where a UK-based CRO conducts trials for an overseas customer).

Summary

Overall, the new regime appears to shift the balance towards large companies at the expense of SMEs. This may initially seem like a strange policy choice for the government, but perhaps reflects HMRC’s current views on the level of fraud and error in the SME regime.

There will be specific fact patterns that mean some businesses gain or lose out disproportionately and therefore we urge all companies to look at their own situation and assess the potential impacts. It’s worth noting that for many claimants there will be up to two more accounting periods to apply the existing rules before the changes outlined above impact their claims.

Finally, look out for our next articles which will delve deeper and provide further analysis on specific aspects of the new regime.

To find out more about R&D tax reliefs and how we can help, please contact Graham Steele.