Chapter 3: The Research & Development Intensive Scheme for Small and Medium Enterprises
Background
35.The introduction of an additional tax relief aimed specifically at SMEs that heavily invest in R&D, was first mooted at Autumn Statement 2022.48 The Institute of Chartered Accountants in England and Wales (ICAEW)told us that it was: “announced unexpectedly … without any prior public consultation”49. It was not until Budget 2023 that details about the scheme were provided.
36.The Government said that this scheme was aimed at channelling further support to those R&D intensive companies that generally obtained relief under the existing SME scheme through a cash payment (rather than as an additional tax deduction)50 and for whom the reduction in the rate of relief under the SME scheme from 1 April 2023 was: “creating challenges”.51 At that time, HMRC estimated that around 20,000 SMEs, out of a total of 39,000 loss-making SMEs, should be able to claim under the R&D intensive scheme—although that number has now increased to 25,000 as a result of changes to the scheme announced at Autumn Statement 2023.52 Draft legislation for the R&D intensive scheme followed in July 2023.53
37.Under the R&D intensive scheme, a loss-making SME that qualifies as R&D intensive54 will claim under the existing SME scheme, but a higher rate of 14.5 per cent (in most cases) will be used to calculate the cash payment due, rather than the 10 per cent rate that now applies under the SME scheme more generally. The additional tax deduction rate, however, will remain at the new 86 per cent level.55
38.The R&D intensive scheme took effect from 1 April 202356, the same date on which the payable tax credit under the existing SME scheme was reduced to 10 per cent. This meant that SMEs eligible to claim under the R&D intensive scheme would be effectively protected from the reduction in the SME rates that took effect on the same date. However, companies will only be able to claim for the higher relief under the R&D intensive scheme once the Finance Bill 2023–2024 has been enacted.57
39.Moreover, ForrestBrown told us, despite this being described as a higher rate of relief for qualifying SMEs: “relief will still decrease for these SMEs, just by a smaller amount than for others”58 and, as ela8 noted: “it is still lower than the benefit available up to 31 March 2023”.59
40.The UK BioIndustry Association (BIA), representing business in the life sciences sector, was concerned about the impact of this reduction in R&D relief on R&D intensive businesses but generally welcomed the new scheme, saying: “the sooner this comes in the better, because we get back to a rate of credit more like the old scheme”.60 It told us that the Chancellor had: “rightly recognised that the cut to the SME scheme announced at Autumn Statement 2022 would damage the UK’s life sciences sector”.61 The National Centre for Universities and Business (NCUB) agreed, describing the new scheme as: “a significant relief for those operating in sectors heavily dependent on research and development, particularly the life sciences sector”.62
Consultation process
41.Although the Government had said it would work with industry on the development of a targeted relief for R&D intensive businesses, there was no formal consultation on the scheme.63 The Institute of Chartered Accountants of Scotland (ICAS) described the scheme as a: “rushed response” to concerns about the reduction in the rate of relief under the SME scheme announced at Autumn Statement 2022,64 with Susan Cattell telling us that: ”there was a government announcement … [and then] … nothing until the publication of the draft legislation.”65
42.The consultation on the merger of the two R&D tax relief schemes—RDEC and the SME scheme—did not discuss the details of an R&D intensive scheme, although it did include two questions on whether (and how) the Government should provide a targeted relief to particular businesses under a merged scheme.66
43.Despite the lack of a formal consultation process, BIA told us that it had: “engaged closely with Ministers and officials after the cut [to the SME rate] was announced at the Autumn Statement … [and had been] … consulted in detail on the R&D-intensive scheme, which is very welcome.”67 Nevertheless, referring to the speed at which the scheme had been put together, it was concerned that those: “companies at which the policy is aimed may not be appropriately targeted”, particularly given the lack of time for: “proper testing [of the 40 per cent threshold for R&D intensity]”.68 Similarly, the Chartered Institute of Taxation (CIOT) confirmed that HMRC had engaged with stakeholders on the changes: for it, the issue was more that: “we do not have the detail … [as] … it has gone very quickly from one step to the next” rather than a lack of engagement per se.69
44.Information about how the R&D intensive scheme was intended to work was initially provided in an HMRC technical note published at the time of the Budget in March 2023. ICAS told us that the scheme: “took effect without any legislation, or details of the qualifying conditions, being available”.70 Draft legislation only followed four months later—more than three months after the scheme technically started to apply—providing stakeholders with their first formal opportunity to comment on the detail of the proposed scheme. In light of feedback on that draft legislation, various changes to the R&D intensive scheme were announced at Autumn Statement 2023. These included significant changes to the qualifying criteria for R&D intensity—to apply from April 2024—which we discuss below. 71
45.The Financial Secretary told us that there had been extensive consultation, and that the Government was: “largely implementing what industry has asked for”.72 The Government has said it will continue to engage with industry on developing the scheme further.73 The Financial Secretary told us that the: “SME loss-making R&D niche area is unique, which gives us the ability to target … [relief] … in a very specific way for an area where we see great things in the future for the UK economy.”74 Mr Henty of HM Treasury told us that the Government would be continuing to engage with industry on the new scheme: “because obviously it is new”.75 The Government has said that this continuing engagement would in particular consider further simplifications.76
46.As we discuss in Chapter 4, a number of our witnesses suggested that one possible further simplification would be to bring R&D intensive relief into the merged scheme, resulting in a single scheme for R&D relief, albeit one with a different rate of relief for R&D intensive companies.77 Although incorporating R&D intensive relief into the merged scheme would mean that R&D intensive SMEs would have to adjust to a different mechanism for receiving R&D relief,78 Ayming told us that there was: “no reason for the intensive scheme to remain a ‘below the line’79 super-deduction, as opposed to an ‘above the line’80 credit in the manner of the merged scheme”.81
47.We acknowledge that the Government responded promptly to concerns about the impact of the reduction in the rate of R&D relief for SMEs following its announcement in November 2022. However, the development of the R&D intensive scheme over only a few months, and without the benefit of formal consultation, was not an example of good policy-making.
48.It is disappointing that the Government did not carry out a public consultation on the R&D intensive scheme, but instead appears to have chosen to consult on a confidential basis with selected stakeholders. We acknowledge that a formal consultation would have taken more time, but this might have avoided the need to make significant changes to the scheme in November 2023, only a few months after first announcing it.
49.We welcome the Government’s continued commitment to work with businesses on possible further improvements to the scheme. It is important that the Government is as transparent as possible about its further engagement with stakeholders on this measure.
What is an R&D Intensive business?
50.The new scheme assesses R&D intensity by calculating the ratio of a company’s qualifying R&D spend to its total expenditure in a given accounting period. The qualifying ratio was initially set, at the Budget on 15 March 2023, at 40 per cent. This dropped to 30 per cent as part of the changes announced at Autumn Statement 2023.82 Mr Henty explained that these thresholds were designed to enable the Government to target additional relief at those companies that the scheme was specifically created to help.83
51.BIA considered that: “the overall policy is sound because R&D intensity correlates with SMEs bringing innovative new products to market or innovating internal processes”.84 CIOT told us this approach to defining R&D intensity seemed: “pragmatic”.85
52.Many other witnesses were rather less enthused about the policy. ICAEW told us that it did not see: “the level of R&D intensity of a company … [as] … a good measure of whether it deserves more support from the government or not”.86 It suggested extra support should instead be directed at early-stage companies that: “may or may not be R&D intensive”.87 ForrestBrown noted that: “a monetary threshold does not in itself target any given type of innovation.”88 The Association of Taxation Technicians (ATT) had concerns that the R&D intensive scheme might send the message that: “R&D carried out by, for example, an engineering company is less valuable than that carried out by a more R&D intensive business”.89 Ayming queried how providing additional support to R&D intensive SMEs fitted with other policy aims of the Government, for example in relation to net zero, noting the lack of evidence of a: “correlation between either intensity of R&D or size of company, and investments in ‘net zero’ R&D.”90 ICAS said the test was: “a very blunt instrument” given that, as any R&D could qualify (so long as the threshold was crossed): “it might not be the best R&D for generating economic growth.”91 Ms Cattell questioned whether an approach that targeted specific sectors, or specific types of R&D, should have been taken, remarking that it: “might have been sensible to have a proper consultation on the best way of incentivising the type of R&D that would promote the most economic growth.”92
53.For IoD, a focus on R&D intensity was wrong in principle. Dr Barker told us that his members: “are very much of the view that the R&D regime should be encouraging R&D across the economy as a whole, not in certain sectors or certain types of company.”93
54.For BIA, the question was whether the threshold was set at the correct rate, having been developed: “at speed” using: “imperfect data”94. The Government therefore needed to monitor use of the scheme to: “evaluate whether it is appropriately targeting the relief to companies as intended by the policy”.95 Ela8 feared that the threshold might: “disadvantage companies that are R&D intensive with respect to their science or engineering teams but incur unavoidable overheads on sales and operations personnel”96, reducing the ratio to the extent that they would not qualify.
55.For many witnesses, a significant concern was the need for companies to: “have to look year on year at whether they fall into that category [of an R&D intensive business]” which risked creating uncertainty as to future eligibility for some companies.97 Mr Moore said that, because of the 40 per cent threshold: “there is the possibility of a cliff-edge” given the potential to fall within the scheme one year and out of it the next.98 Of further concern, CIOT told us, were the differences between the R&D intensive scheme and the merged scheme, which an SME would need to adjust to each time it moved from one to the other. This contrasted with the pre-merger position, where movement from the SME scheme to RDEC was likely to be: “a one-time only, one-way movement” when an SME became a large business—businesses generally growing rather than shrinking over time.99
56.Ayming suggested that a possible solution might be to allow a grace period so that: “loss of R&D intensive status would only occur if a company fails to meet the criterion for two successive accounting periods”100—something other witnesses also suggested.101 An alternative approach, proposed by BVCA, was to allow a company to assess: “percentage expenditure on R&D over a period of several years, in circumstances where the threshold might be breached in a single year.”102
57.Mr Henty accepted that setting a specific threshold created a: “boundary issue” and that: “there will always be people nearer that boundary who will need to plan quite carefully.”103 However, he considered that alternative approaches could add complexity.104
58.Mr Henty told us that the lower threshold that would apply for accounting periods on or after 1 April 2024, announced at Autumn Statement 2023, and the targeting of the R&D intensive scheme at: “the most intensive companies… [would ensure that] … many companies will very clearly know what their plans and financial flows are and what they are expecting.”105 He told us that lowering the threshold to 30 per cent would bring: “about 5,000 additional companies” within the scope of the R&D intensive scheme. The reduction of the threshold to 30 per cent announced at Autumn Statement 2023 was coupled with a one-year grace period, which Mr Henty said would help businesses manage the boundary issue as it should avoid: “one-off events [of] dropping people out, in, out, in” and mean: “that people have more certainty year to year. If they know that they are in it this year, they will know that they are in it next year”.106
59.A scheme based on R&D intensity is agnostic as to the type of R&D that a company is undertaking. We note that a number of our witnesses did not understand why this approach had been taken, rather than targeting specific policy objectives, such as providing tax credits for activities that support the Government’s net zero commitments.
60.The Government should explain why it considers this approach to be the best way of incentivising the types of innovation that will support economic growth.
61.We acknowledge that the threshold test for R&D intensity creates a cliff-edge, but we recognise that many alternative approaches, such as tapering relief as R&D intensity decreases, could create more complexity. However, we welcome the announcement at Autumn Statement 2023 of a grace period to help mitigate this.
62.It is important that modelling of the threshold for R&D intensity is based on accurate data, is properly tested, and can be justified objectively by reference to the policy aim. We are concerned that this appears not to have been the case with the original proposed 40 per cent threshold—and this may also be true of the new 30 per cent threshold.
63.We recommend that the Government monitors the operation of the R&D intensive scheme and, in particular, keeps the threshold for R&D intensity under review to ensure that the scheme is appropriately targeted and effective in achieving its policy objectives.
Calculating R&D intensity
64.As explained above, the test of R&D intensity requires a company to compare its qualifying R&D expenditure in a particular accounting period with the total amount of expenditure that it is able to deduct for corporation tax purposes in that period.107 ATT told us: “to identify total deductible expenses, companies will have to go quite a long way down the route of preparing their tax computation, or perform significant amounts of work in-year”, meaning that:
“If you do not know until perhaps after the year-end whether you will fall into the R&D intensive category, it makes it hard to plan for that. In our view, for R&D relief to act as an incentive to investment and innovation, it needs to be something that you can factor in and plan for, not something that is nice to have that you end up with at the end of the year.”108
65.Other witnesses agreed, with Ayming telling us that businesses: “will have to work on the worst-case assumption that they are not going to be eligible”, with the result that the relief: “is a less effective incentive than it could be”.109
66.In addition, as Colin Hailey of BIA explained, although the test appeared easy to apply, this was not likely to be the case in practice given uncertainty about what could (or could not) be taken into account as qualifying R&D spend and/or total expenditure. He told us of particular concerns about how the new restriction on overseas R&D expenditure would interact with the test for R&D intensity, explaining that some HMRC inspectors: “say that they will have a light touch with this rule and that you can include overseas expenditure in your R&D as long as it would derail your business plan to have done that work in the UK”, while others have told him that: “the bar is set incredibly high. You’ll need a letter from the US drug regulator, the FDA, proving that it asked you to do your clinical trial work in the US before we’ll let you include it”. The result of this is that: “there is a swirling mass of uncertainty about what the HMRC’s view will be”.110
67.At the time it announced the R&D intensive scheme in March 2023, the Government referenced guidance being published later in 2023 but—as yet—none has been published.111 Mr Hailey urged HMRC to publish guidance on applying the R&D intensity test: “rapidly” to give businesses clarity.
68.Mr Henty told us he recognised our witnesses’ concerns about the retrospective nature of the R&D intensive test but that this was not significantly different from the position under the current SME scheme, where companies only knew the amount (and type) of relief they could claim at the end of an accounting period. This had: “been a feature of the SME scheme throughout its history”.112 However, in his view, the lower threshold of 30 per cent should make it easier for many companies to know whether they are R&D intensive upfront. He gave the example of a bio-tech company undertaking a drug-discovery programme being able to know it was: “very much higher than [30 per cent]” because: “that is [its] entire purpose”.113
69.It is disappointing that, although the R&D intensive scheme has applied since April 2023, HMRC has not yet published any guidance—including draft guidance—on how the scheme will work in practice. Businesses need to know whether they are R&D intensive in advance of April 2024, when they will be able to make their first claims under the new scheme, so they can plan accordingly.
70.We are concerned that the incentive effect of R&D intensive relief will be weakened because SMEs have no certainty about whether they are R&D intensive, and so eligible for additional relief, until after they have invested in R&D.
71.We acknowledge that the lower R&D intensity threshold should mean that more companies will have confidence that they qualify as R&D intensive in a given period. However, a lower threshold is no substitute for clear rules that businesses can readily understand.
72.We recommend that HMRC publishes draft guidance on applying the R&D intensity test as a matter of urgency.
Possibility of spurious claims
73.The previous Finance Bill Sub-Committee’s inquiry in 2022–23114 looked at the steps being taken by HMRC to try to reduce the high level of error and fraud in the R&D claims.115 In its response to the report of that inquiry, the Government stated that: “the SME scheme’s generosity had been a target for fraud”.116 The rebalancing of the R&D reliefs at Autumn Statement 2022 reduced that generosity, with the Government saying that the reduction was: “expected to reduce levels of non-compliance”.117 However, the R&D intensive scheme reinstates some of that generosity, albeit only for companies that satisfy the definition of R&D intensity.118
74.ATT was concerned that:
“the definition of ‘R&D intensive’ could lead to boundary pushing, manipulation or even abuse by unscrupulous claimants and advisers. In particular, where a company is just below the … threshold, there could be the temptation to increase the amount of expenditure allocated to R&D, or even disclaim other expenses to ensure the test is met.” 119
75.For BVCA, the:
“definition of ‘relevant R&D expenditure’ in the R&D intensity condition … lacks precision and could be open to abuse. The accounting treatment is not set in stone and there are instances in which, entirely legitimately within acceptable accounting standards, the same costs or income could be classified in two alternative ways, which would result in two very different figures for R&D expenditure.”120
76.The Government said it was aware that the R&D intensive scheme would bring: “compliance risks … [including] … the risk that there are those who will seek to take advantage or abuse the higher rate of support who are not eligible for the relief.” In recognition of this, HMRC would deploy 82 additional staff: “in operational compliance teams to mitigate the additional compliance risks … from July 2023.” 121
77.We are concerned about the abuse of R&D relief, which has increased due to exploitation of the tax repayment available under the SME scheme. We note the Government’s commitment to tackling this abuse but we agree with our witnesses that there is a risk that, with the creation of the R&D intensive scheme, new opportunities for spurious claims could be created.
78.We welcome the Government’s announcement that HMRC will be funded to deploy additional officers to manage the compliance risks relating to the new scheme.
48 HMRC, ‘Policy paper, Research and Development Tax Reliefs—Reform’ (21 November 2022): https://www.gov.uk/government/publications/research-and-development-rd-tax-reliefs-reform [accessed 3 January 2024]. See Chapter 2 above.
50 Q 80 (Matt Henty). The option of obtaining R&D relief by way of cash payment under the SME scheme is only available to a company that is loss-making.
51 HMRC, ‘Technical Note Additional tax relief for Research and Development intensive small and medium enterprises’ (15 March 2023): https://www.gov.uk/government/publications/additional-tax-relief-for-research-and-development-intensive-small-and-medium-sized-enterprises [accessed 4 January 2023]
52 Q 80 (Matt Henty) and written evidence from HMRC (DFH0020). By way of comparison, the Government estimates that the proposed merged scheme will apply to 50,000 to 60,000 companies.
53 HMRC and HM Treasury: ‘Consultation on draft legislation published for Finance Bill 2023–24’ (18 July 2023):https://www.gov.uk/government/collections/finance-bill-2023–24 [accessed 4 January 2024]
54 We discuss the definition of R&D intensive below but in broad terms the test of R&D intensity is by reference to the proportion of a company’s (tax deductible) expenditure that is on R&D.
55 HM Treasury, Spring Budget 2023 (15 March 2023), p 61: https://www.gov.uk/government/publications/spring-budget-2023 [accessed 4 January 2024]. The additional deduction rate applies in working out the loss that the SME would have made had it claimed the additional tax relief—and so determines the amount of the cash payable credit. The Government said this meant that eligible companies would receive £27 from HMRC for every £100 of R&D investment.
56 Finance Bill, Schedule 1 [Bill 14 (2023–24)]
57 HMRC, ‘Technical note: Additional tax relief for Research and Development intensive small and medium enterprise’ (15 March 2023): https://www.gov.uk/government/publications/additional-tax-relief-for-research-and-development-intensive-small-and-medium-sized-enterprises [accessed 4 January 2024]. At the date of this Report, Finance Bill 2023–24 has reached Committee Stage.
60 QQ 55–56 (Colin Hailey). The BIA contrasted the £27 cash credit (per £100 investment) under the R&D intensive scheme with the £33 that had applied under the SME scheme until 31 March 2023.
64 Written evidence from ICAS (DFH0018) and written evidence from ForrestBrown (DFH00016)
65 Q 8 (Susan Cattell). See also Q 54 (Dr Roger Barker) and written evidence from ForrestBrown (DFH00016).
66 HM Treasury, R&D Tax Reliefs Review: Consultation on a single scheme (13 January 2023), p 20–21: https://assets.publishing.service.gov.uk/media/63c51fc08fa8f572a9a36f33/20230113_R_D_Consultation.pdf [accessed 4 January 2024]
71 HM Treasury, ‘Autumn Statement 2023 Research and Development Tax Reliefs Reform’ (22 November 2023): https://www.gov.uk/government/publications/autumn-statement-2023-research-and-development-tax-reliefs-reform [accessed 4 January 2024]. In summary the relevant changes are lowering the threshold of R&D intensity from 40 per cent to 30 per cent, and incorporating a one year grace period.
73 HM Treasury, ‘Autumn Statement 2023 Research and Development Tax Reliefs Reform’ (22 November 2023): https://www.gov.uk/government/publications/autumn-statement-2023-research-and-development-tax-reliefs-reform [accessed 4 January 2024]
76 HM Treasury, ‘Autumn Statement 2023 Research and Development Tax Reliefs Reform’ (22 November 2023): https://www.gov.uk/government/publications/autumn-statement-2023-research-and-development-tax-reliefs-reform. [accessed 4 January 2024]
77 Cross ref paras re discussion on simplification in Chap 4 which link to R&D intensive scheme.
78 Although non-R&D intensive SMEs will only be able to claim an above the line credit under the merged scheme going forward, relief under the R&D intensive scheme is to continue to be provided under the SME scheme model: we discuss this in Chapter 4.
79 See Box 1.
80 See Box 1.
81 Written evidence from Ayming UK (DFH0014). Relief under the R&D intensive scheme is given using the SME scheme model—in the form of an additional tax deduction—whereas the merged scheme confers relief by way of an (RDEC-like) above the line credit.
82 Finance Bill, Schedule 1 [Bill 14 (2023–24)]. For these total expenditure is limited to expenditure that is deductible for corporation tax purposes.
93 Q 54 (Dr Roger Barker,) and written evidence from the FSB (DFH00019) and ForrestBrown (DFH0016)
97 Q 14 (Dr Emma Rawson). See also Q 47 (Michael Moore), Q 41 (Benjamin Craig) and written evidence from Ayming UK (DFH0014), ela8 limited (DFH0015) and ForrestBrown (DFH0016).
107 Finance Bill, Schedule 1 [Bill 14 (2023–24) and written evidence from Ayming UK (DFH0014). A company’s qualifying R&D expenditure is the expenditure on R&D for which it can claim relief under the SME scheme—which, by definition, also deductible for general corporation tax purposes.
109 Q 41 (Mark Davis). See also written evidence from Ayming UK (DFH00014) and ForrestBrown (DFH0016).
111 HMRC, ‘Technical note: Additional tax relief for Research and Development intensive small and medium enterprise’ (15 March 2023): https://www.gov.uk/government/publications/additional-tax-relief-for-research-and-development-intensive-small-and-medium-sized-enterprises [accessed 4 January 2024]
112 Q 81 (Matt Henty). This is because, under the SME scheme, the (effective) rate of relief is dependent on the company’s overall profitability in the relevant period, which can only be known at the end of that period—see written advice from Ayming UK (DFH0014) which includes an example at footnote 11.
114 Economic Affairs Committee, Research and Development tax relief and Expenditure Credit (3rd Report, Session 2022–23, HL Paper 137)
115 Economic Affairs Committee, Research and development tax relief and expenditure credit (3rd Report, Session 2022–23, HL Paper 137). We note that, for the fourth year, the NAO qualified HMRC’s annual accounts for 2022.23. See National Audit Office, ‘Report—HM Revenue & Customs 2022–23 Accounts’ (7 July 2023): https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/1179615/HMRC_annual_report_and_accounts_2022_to_2023.pdf#page=293] [accessed 4 January 2024].
116 HM Government, House of Lords Economic Affairs Finance Bill Sub Committee : Research and Development Tax Relief and Expenditure Credit (HL Paper 137): Government Response: https://committees.parliament.uk/publications/38977/documents/191609/default [accessed 4 January 2024]
117 HMRC, ‘HMRC’s approach to Research and Development tax reliefs’ (17 July 2023): https://www.gov.uk/government/publications/compliance-approach-to-research-and-development-tax-reliefs/hmrcs-approach-to-research-and-development-tax-reliefs [accessed 4 January 2024]
118 HMRC, ‘Technical note: Additional tax relief for Research and Development intensive small and medium enterprise’ (15 March 2023): https://www.gov.uk/government/publications/additional-tax-relief-for-research-and-development-intensive-small-and-medium-sized-enterprises [accessed 4 January 2024]