The R&D intensive SME regime – is this really needed?

Next in our series of articles analysing the recent changes in the research and development (R&D) tax relief regime, we look at the R&D intensive small and medium-sized enterprise (SME) regime. In our previous article, we discussed the potential winners and losers from the new R&D tax relief regime. In this article, we explore the rationale for its introduction and how this will impact companies. 

Introduction

In 2023, many changes were introduced to the existing R&D tax relief regimes, including the first confirmation of the ‘R&D intensive SME regime’ in the Spring Budget 2023. The regime was introduced for costs incurred from 1 April 2023, where a loss-making SME has an R&D intensity (broadly calculated as eligible R&D expenditure divided by total expenditure) of 40% or greater. 

Advisers and claimants argued that 40% was too high of a threshold. As a result of their lobbying, the 2023 Autumn Statement announced a reduction in the level of R&D intensity required to benefit from the regime. The threshold was dropped from 40% to 30% for accounting periods beginning on or after 1 April 2024. 

At a time when the benefit of the SME R&D regime has been substantially reduced, retaining a higher level of credit for those businesses investing most heavily in R&D should be positive news. We explore the reality of this. 

How will this impact companies?

Intensity ratio

To be considered R&D intensive, a company must calculate whether its qualifying expenditure is at least 40% of its total expenditure (or 30% for accounting periods beginning on or after 1 April 2024). Broadly, total expenditure is calculated from the total trading expenses which are taken from the profit and loss account. This is then added to any R&D costs that have been capitalised as an intangible asset and claimed as a tax deduction. 

To prevent any perceived manipulation of the intensity ratio, the qualifying R&D expenditure and total expenditure of any connected companies must be aggregated. For periods overlapping 1 April 2023, the intensive regime rate of payable credit will only apply for expenditure incurred from that date. However, the calculation to determine the ratio will need to be completed for the whole period.

The government has introduced a grace period rule for accounting periods beginning on or after 1 April 2024 where a company’s intensity ratio fluctuates around the threshold. This is to avoid situations where an SME is forced to alternate between claims under the new merged R&D expenditure credit (RDEC) regime and the R&D intensive SME scheme. Therefore, where the ratio is skewed by an item of exceptional spending in one year, the intensive relief can be claimed in year two (providing the threshold was met in year one).

Size testing

The merged RDEC regime has been introduced to provide simplification to R&D tax relief. However, introducing a separate regime for R&D intensive SMEs means companies still need to consider whether they meet the definition of an SME. Consequently, for many businesses, there will be no appreciable simplification.

Level of benefit

Prior to the merged regime taking effect, certain companies will see a significant reduction in the maximum payable credit claimable. Specifically, a company that is not R&D intensive, is claiming under the SME scheme, and incurring expenditure on or after 1 April 2023, will be impacted the most. Previously, R&D tax relief could be worth as much as 33.4p for every £1 of qualifying expenditure to some companies. However, from 1 April 2023 this will reduce considerably to below 19p, a substantial impact on many SME companies undertaking genuine R&D.

The R&D intensive regime would compensate against this reduction – enabling an eligible company to benefit from the higher credit which is worth just under 27p for every £1 of qualifying expenditure. Although still a reduction from previous rates, this new regime does go some way to restoring the earlier rate of relief.

The merged RDEC regime takes effect for accounting periods beginning on or after 1 April 2024. At the same time, the level of R&D intensity required to claim under the special regime will reduce to 30%. This is where the benefit of this intensive regime will really start to come to the fore. With the lowered intensity requirement, we anticipate an increase in the number of companies able to apply the regime. As a result, the gap between the intensive regime rate of benefit and the standard benefit is expected to widen. 

Summary

The concept of providing an additional benefit to loss-making SMEs investing heavily in R&D should be seen as a positive move. It’s expected to be particularly popular with start-ups in the life sciences and technology sectors, which are likely to be most affected by the wider reforms to the R&D tax relief regimes. On the other hand, the concept also contradicts the overall aim of simplifying and introducing the merged RDEC regime, as some complexity and uncertainty will remain for many companies.

We do see the potential merits and rationale for rewarding R&D intensive companies (this may lead to greater additionality, ie reinvestment of R&D tax relief into future R&D activities). However, the mechanism for providing this benefit feels overly complex. A specific (or tiered) rate of RDEC applicable to such loss-making companies may be a simpler way of incentivising and rewarding their R&D efforts.

For now, businesses will need to carefully consider their eligibility for the R&D intensive SME regime, and as ever, early advice will be important to provide certainty in forecasting. It is important to note that this relief has been included in the Finance Bill 2023-24, which has not yet been enacted. Therefore, companies that submit R&D claims for periods including 1 April 2023 won’t be able to apply this relief until the legislation is enacted. Those companies will need to resubmit their corporation tax return after enactment if they wish to access the higher rate of relief.

If you have any questions regarding the above, please contact Darren Griffin, James Tetley, or your local R&D contact.