UK R&D schemes – Recent changes

In the 2023 Autumn Statement a second round of more significant changes were announced by the Chancellor - a new 'Merged R&D Scheme’ would come into effect for accounting periods beginning on or after 1 April 2024. This largely does away with the separate RDEC and SME schemes.

The Merged Scheme will apply to all companies except for loss making R&D intensive SME companies and is largely based on the current RDEC scheme in terms of the headline credit rate of 20%, the accounting treatment of the credit as an ‘above the line’ credit and the mechanical operation of how tax relief is obtained from the scheme. 

The key points that will impact all companies claiming under the Merged Scheme as the draft legislation currently stands are as follows:

The headline rate of the R&D Credit will be 20%. This is a taxable credit, and for companies with taxable profits it will generally be taxed at the main rate of corporation tax of 25%, giving an effective rate of relief of 15%.

For loss making companies, the notional tax applied to the credit will be 19% meaning the effective rate of relief will be 16.2%, which in a lot of cases will be provided to the company by way of a cash payment from HMRC.

This is the main area that is different from the existing RDEC scheme. Currently, a company claiming under the RDEC scheme can only include the costs of contracted out R&D activities if they are contracted out to an individual, a partnership of individuals or a qualifying body (typically universities, the NHS and other prescribed bodies), but cannot include costs that are contracted out to other companies. Under the new Merged Scheme companies contracting out R&D activities will, subject to conditions, be able to include the costs of these activities regardless of to whom they are contracted.

There will be a restriction to 65% of the expenditure incurred where the third party is not connected with the company and will apply to arrangements where there is an expectation (through intention or contemplation) that the services covered by the contract will include R&D activities. HMRC have published guidance on how the new subcontracting rules will work in practice.

The guidance states that there must be a contract in place, under which the R&D activities are performed, between the company contracting out the work (“the customer”) and the company carrying out the work (“the contractor”). Additionally, the customer must have a specific appreciation of what R&D will be done and therefore the ability to understand and specify that. If the R&D activities performed under the contract were not expected by the customer at the time the contract was entered into, then the customer will not be able to include the costs of these activities in its claim. However, in such circumstances, the contractor may be able to include the costs it incurs on R&D activity that it performs as a result of the sub-contracted arrangement.

Where the customer is able to claim the costs of R&D that is contracted out, the contractor that is undertaking the actual R&D activity will not be able to claim the costs they incur on carrying out those R&D activities unless, as outlined above, the contract is entered into without any expectation that the contractor will perform R&D activity to service the contract. This is a new development that will negatively impact many companies, likely smaller companies, that are doing the R&D activity on behalf of another company.

Specific rules apply where R&D activities are subcontracted between connected parties. In this scenario, the customer will be able to claim the R&D tax credit on the lower of a) the cost incurred by the customer itself or b) the costs incurred by the contractor that would have been qualifying if the contractor were able to make an R&D claim in respect of the activities. Group companies will also be able to make a joint election to treat the customer as being ineligible to claim to allow the contractor to include the costs of the activities in its claim instead of the customer’s.

Under the new merged scheme, expenditure on externally provided workers and subcontracting arrangements will be restricted to UK based activities. This is a new development as previously there was no UK territoriality restriction. For externally provided workers, PAYE will have to be applied to the workers in order for their costs to be qualifying and for subcontractors the work will have to be undertaken within the UK.

There will be limited exceptions for qualifying overseas expenditure where geographical, environmental or social conditions do not exist in the UK, but do exist elsewhere, and where it would be wholly unreasonable for a company to replicate these conditions in the UK. However, if any activities are located outside the UK because of the cost of the R&D activities or availability of workers, these activities will not be qualifying overseas expenditure.

HMRC released guidance on this point, which provides examples of when overseas activities will be qualifying overseas activities. In one example, if testing facilities necessary for the R&D are available in the UK but they are not available in the timeframe required for carrying out the R&D, then using facilities overseas would potentially be qualifying overseas expenditure. Similarly, if manufacturing facilities of a company could be converted into a testing facility in the UK but at great expense and with a significant reduction in manufacturing capability, it would be wholly unreasonable to undertake the conversion. In this example, if the only alternative facility is overseas, using the overseas facilities would be qualifying overseas expenditure.

Other measures were introduced, such as changes to make the scheme for ‘R&D intensive’ SMEs more accessible (by reducing the “R&D intensity threshold” from 40% to 30%) and increases to the cap on payable amounts by reference to a company’s PAYE and NIC costs. However, we expect these changes to have a relatively minor impact on R&D claims by comparison to the measures announced above.

As a welcome measure, companies registered in Northern Ireland that are loss making and claiming under the R&D intensive SME scheme will still be able to include overseas expenditure on subcontractors and externally provided workers in their claims, up to a limit, under specific provisions that reflect the market conditions in Northern Ireland. The additional benefit received by claiming under the R&D intensive SME scheme over the benefit that would have been received under the RDEC scheme will be limited to £250k over a rolling 3-year period. Any expenditure in excess of this limit will be eligible to be claimed under the new merged RDEC scheme.

HMRC have increased their focus on R&D claims over the last 18 months or so. They have invested in additional resources to review more claims in detail, issued letters to claimants in specific sectors and industries and introduced new compliance measures that companies submitting R&D claims need to follow. These measures aim to increase compliance and the accountability of senior officials within claimant companies, along with their tax agents. The number of enquiries into R&D claims has increased significantly with more expenditure and activity being challenged and potentially disallowed.

From 8 August 2023, an Additional Information Form is required to be submitted to HMRC before an R&D claim is submitted via the company’s tax return. It is important that the information submitted is correct and accurate and demonstrates that the technical requirements of the R&D claim have been met.

For accounting periods beginning on or after 1 April 2023, a pre-notification form is required to be submitted to HMRC within 6 months of the end of the relevant period of account (the pre-notification deadline) for any company wanting to make a claim that has not previously done so or has not submitted a claim in the 3 years before the pre-notification deadline.