The shifting R&D landscape: implications for private equity

The 2024 Autumn Budget confirmed no (substantive) changes to research and development (R&D) tax relief. While this perceived stability is crucial for businesses, it follows a period of piecemeal, often detrimental changes, with many of these only now starting to have an impact. 

We examine the ramifications of these changes from a private equity perspective, including the need for increased due diligence, along with the likely benefits to both cash flow and accounting for portfolio companies.

HMRC’s approach to R&D claims

Fraud and error are estimated to be over £1bn in the small and medium-sized enterprise (SME) scheme alone. For several years HMRC has been scrutinising R&D claims more than ever before. While we welcome HMRC’s attempt to police the regime more robustly, this has created uncertainty and, in many cases, pain for genuine claimants who, until now, had seen the R&D regime as a guaranteed source of additional funds to support investment in innovation. Portfolio companies should be mindful of this backdrop and ensure they are being well-advised in making R&D claims.

HMRC enquiries and their impact on valuations

Recent discussions with HMRC indicated that one in five R&D claims are enquired into. While this may not have impacted your portfolio companies yet, current statistics suggest it will. The impact can be twofold:

• Significant delays in payment due to enquiries lasting up to two years, severely impacting cash flow for many businesses. 
• More claims rejected in full, with a long-term impact on the ability to claim in future periods, removing an annuity source of income for many businesses which will impact valuations.

We recommend that reasonable focus should be given in the due diligence process of any entity previously claiming R&D tax incentives.

Case study: repayment to HMRC

Seven years after private equity took a majority stake in a business, a review found claims prepared by a boutique adviser had been made in the wrong company, leading HMRC to demand repayment of up to £3.5m. The portfolio company faced insolvency and required emergency finance from their investors. This could have been avoided if expert advice had been sought.

Changes portfolio companies need to be aware of

Changes to R&D tax relief have been introduced with varying timelines for claimant companies, and their impact will depend on the profile of each company’s claim.

Merged regime - For accounting periods beginning on or after 1 April 2024, most companies will now claim under a single regime and receive a net benefit of 15%-16%. Aside from the cash flow benefits, companies may recognise a gross credit above the tax line, resulting in an increase to EBITDA and earnings per share for listed companies.

Enhanced R&D intensive support (ERIS) - HMRC has introduced the concept of an R&D intensive company for loss-making SMEs where qualifying expenditure is 40% or more of its total expenditure (30% for accounting periods beginning on or after 1 April 2024). R&D intensive companies receive a much higher rate of relief of 27%. 

Private equity investors should be aware of how the intensity rate is calculated, as in many cases, portfolio companies will be aggregated by virtue of the private equity investment, and all connected companies must be considered which may require complex aggregation and significant legislative understanding from a specialist tax adviser.

Certain overseas expenditure - For accounting periods beginning on or after 1 April 2024, R&D subcontracted overseas, or externally provided workers (EPWs) based overseas and not subject to UK payroll taxes, will not be considered as qualifying expenditure, unless certain limited exemptions apply. 

This change will materially impact certain claims. Many advisers only review claims retrospectively, so it is essential to seek the advice of agents who actively engage in reviews of prospective claims to ensure commercial arrangements are reviewed and, where possible, amended to mitigate the risk of losing significant claim value. 

Industries particularly impacted include life sciences, automotive and technology.

Subcontracting rule changes - HMRC has moved to clarify the rules around subcontracted R&D expenditure and which company should be able to claim. As with overseas expenditure, this is a potentially complex area where claimants should review the impact on their claims prospectively.

Industries particularly impacted by this change include construction, life sciences and engineering.

Cloud computing and dataset costs - In addition to software license costs, HMRC has now extended which expenditure qualifies for relief so that relief can be claimed on certain revenue expenditure on cloud computing and use of datasets in qualifying R&D activities. This applies for accounting periods beginning on or after 1 April 2023 and could result in a significant increase in claim values for certain companies.

Industries particularly impacted include fintech, technology and wider financial services.

These changes can be reviewed in more detail using our the changing R&D landscape interactive tool.

As a private equity investor, what should you do now?

It continues to be an interesting time for R&D tax relief. Private equity investors should understand how the various changes will impact both the risk profile and cash flow of portfolio companies. Despite headwinds, the relief continues to offer a generous benefit to encourage further investment. When coupled with the patent box tax regime (offering a reduced rate of corporation tax on profits derived from patented intellectual property) and a relatively competitive rate of corporation tax, R&D tax relief ensures the UK remains an attractive place to do business. 

With plenty to digest, please contact our specialists to talk you through the changes in more detail.