Dr Martin Turner, Head of Policy and Public Affairs UK BioIndustry Association (BIA), delves into the Government’s proposed reforms of R&D tax relief system and the possible implications.
Don’t handicap start-ups and scale-ups in R&D tax relief reform
02 Feb 2023
The Government has announced plans to reform the UK’s R&D tax relief system that could have far-reaching consequences for the science and engineering community.
The tax relief system is the most valuable form of Government support for R&D-intensive businesses – it provided £6.7 billion in support of R&D in 2020-21 – and the proposals offer both opportunities and risks for UK ambitions to be a science superpower. Although this reform will only directly impact businesses, I think it should be of much wider interest to the sector.
The UK has a vibrant science and engineering ecosystem, with world-class universities, public sector research establishments, medical research charities, innovative SMEs, and large multinational companies. All of these play a vital role in the innovation pipeline and each needs the others.
Without great university science, industry is fed with far fewer discoveries and talented researchers. Without industry, the discoveries from our science base are very unlikely to reach the public (there’s not a modern medicine on the market that wasn’t developed by a company). Without start-ups and spin-outs, large companies will have fewer innovative ideas to purchase or partner with, and without large companies, smaller ones might not have customers or investors.
The reform of R&D tax relief is an opportunity to make sure the system works better as a whole, leverage more R&D and ensure taxpayers’ money is spent as effectively as possible to drive economic growth through innovation. It could cut down on bureaucracy for companies and HMRC alike, and tackle fraud.
But, if a merged R&D tax relief scheme provides less support to start-ups, spin-outs, and other R&D intensive SMEs, a key section of the innovation pipeline will be damaged. There will be fewer science and engineering companies created in the UK to translate our science into useful products, jobs and economic growth.
So, if you want to understand the consultation and how it could impact our science superpower ambitions, read on to find out more.
What is R&D tax relief and how does it work?
Introduced in 2000, R&D tax relief is a subsidy for UK businesses that reduces the cost of R&D by either providing a corporation tax relief for profitable companies (reducing how much tax they pay) or a cash payment for loss-making companies ( Government money paid into their bank account). Most early-stage R&D intensive businesses will be loss making, potentially for many years until they’ve developed their product to sell, so will receive the later.
The idea is that if it is cheaper to do R&D, companies will do more of it (although it’s a little more complicated than that, which I will come onto soon).
Currently, there are two R&D tax relief schemes: the SME scheme and the R&D Expenditure Credit (RDEC). Both work as described above, but the SME scheme is more generous than RDEC in the rate it offers and has more eligible costs. RDEC is primarily used by large companies but SMEs do sometimes claim through it for some of their R&D, including when that R&D was funded by a grant and therefore already a subsidy.
Both tax relief and cash payments are calculated as a percentage of past R&D expenditure. A company will submit a claim to HMRC stating how much R&D they did in the previous year. They must explain why they believe that the R&D was indeed R&D according to HMRC’s rules (essentially, it must be overcoming some kind of scientific or technological uncertainty) and set out what they spent their money on. Some costs are eligible for relief, while some aren’t – those that aren’t include capital investments like big bits of kit. Once approved, the company’s tax bill is reduced or they receive a cash payment.
How do R&D tax reliefs increase R&D investment?
As a sector, we all believe in the benefits R&D brings: it produces things that make our lives better, like medicines and cleaner vehicles, and it improves the productivity of businesses, which leads to economic growth, jobs. etc.
Some of the benefits from R&D are not captured by the business itself – these are called spillovers and benefit other businesses and society more broadly. As a result, companies may not want to invest as much in R&D as they should, because they won’t reap all the benefits. The earlier-stage and more risky the R&D, the greater this problem. This is the justification for government subsidy of R&D.
R&D tax reliefs help make up for this problem. In the case of cash payments to loss-making SMEs, it covers approximately a third of the R&D costs so companies are able to do more R&D. This is about to be reduced significantly, and the BIA and CaSE, among others, have expressed concerns about the risks this brings (I discuss the background and implications of this decision in the next section).
Not only does the existing system encourage companies to invest in R&D, it also incentivises investors to put money into companies that will then invest in R&D.
This is key, as – without products to generate revenues – many early-stage science and engineering companies rely on venture capitalists to fund them. The more investment you can get into spin-outs and start-ups, the more R&D they will carry out – both now and in the future, as those companies grow. The generosity of the UK’s SME R&D tax relief – until the recent changes – has made the UK an extremely attractive place to start a company; in the biotech industry for example, the UK is responsible for a third of all start-ups in Europe.
You may be wondering why the Government doesn’t do all this through the grant system, run by Innovate UK? Grants are great; they allow the Government to fund the R&D that it considers most important (sometimes broadly, sometimes very specifically) and use rigorous assessment to choose the best projects. But those strengths are also weaknesses: it’s bureaucratic, expensive to run and can miss breakthrough ideas that are too radical. Businesses can’t be sure they will get the grant and so can’t make long-term investment decisions. R&D tax relief therefore complements the grant system by allowing companies, entrepreneurs and investors the freedom to choose where to focus their R&D.
What is the Government proposing?
The Government is proposing merging the SME R&D tax relief and the RDEC into a single scheme with a single relief rate and set of eligible costs, meaning it will have the same level of generosity for companies, no matter their size. The Government is consulting on the features of the new scheme but it appears unlikely a merged scheme is going to provide as much support to SMEs as the current SME R&D tax relief scheme.
This comes off the back of the announcement at the Autumn Statement on 17 November 2022 that the current SME scheme will have its relief rate reduced by about half, which is already having a devastating impact on start-ups and spin-outs that suddenly face a hole in their budgets from April 2023 onwards. Following strong campaigning by the BIA and others, the Chancellor has now said he sees “merit” in further support for some R&D intensive SMEs, but we are still waiting for the details.
The consultation does also ask whether the Government should provide more generous support for different types of R&D or more R&D intensive companies, which is a nod to our concerns. This is very welcome and we hope recognises that there are different challenges affecting different companies. However, due to state aid rules, the Government is unlikely to provide different support based on sector or company size, which is why it is focusing on R&D intensity.
Why is the Government proposing this?
The Treasury believes the current SME R&D tax relief scheme is not as effective at incentivising R&D investment as RDEC. The SME scheme is said to leverage 60p to £1.28 of additional R&D for each £1 spent, compared to £2.40 to £2.70 additional R&D per £1 of RDEC. Treasury is also concerned about fraud in the SME scheme.
However, these analyses don’t differentiate between different sectors or types of companies. Fraudsters and companies that really stretch the definition of R&D in their claims are included, and these will significantly drag down the average. True start-ups and spin-outs from our world-class science base will provide a much greater leveraging effect.
The HMRC analysis also thinks too simply about how R&D tax relief works. Its metric – something called user cost elasticity – measures how much additional R&D investment a company makes based on a 1% increase in R&D tax relief generosity. This misses the point that R&D tax relief encourages venture capital investment into companies, keeps those companies in the UK (you can’t claim if you’re not based in the UK) and leads to those companies investing much greater sums in R&D in future years, not to mention the high-value science and engineering jobs they create, and the valuable products that improve our lives.
The consultation runs until 13 March and the new scheme is proposed to be in place by April 2024. The cuts to the SME R&D tax relief rate will be effective from April 2023 and we are campaigning hard to get extra support put in place for R&D intensive SMEs hit by that.
This consultation is the biggest reform of R&D tax relief since its creation in 2000. It’s going to be complex and there’s a high risk of accidentally damaging what’s been a very effective scheme for growing our R&D-intensive, high-tech industries.
At the Autumn Statement the Chancellor said equalising the generosity of support for SMEs and large companies would not reduce overall R&D investment in the UK. He means they expect large companies to make up for reduced SME investment. With the very recent revelation that SMEs are contributing £16bn a year more to UK business R&D expenditure than previously thought, that’s a pretty big gamble to take.
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