Penny Simmons September 2 2022 Review of R&D tax reliefs – where are we now? Pinsent Masons | Corporate Tax - United Kingdom Penny Simmons Corporate Tax IntroductionCurrent systemChanges to R&D tax reliefsCommentIntroductionThe United Kingdom's research and development (R&D) tax credits system will undergo significant changes in April 2023, both in the context of the types of R&D activities that will qualify for tax relief and the way in which businesses can claim relief. Draft legislation detailing the changes was published in July 2022 and it is currently intended to be included in the Finance Bill 2023.The changes are being introduced as part of a government-led review into the R&D tax relief system, which was first announced at the Budget in March 2021. The stated objectives of the review were "to ensure the UK remains a competitive location for cutting edge research, that the reliefs continue to be fit for purpose and that taxpayer money is effectively targeted".The government views boosting innovation and increasing investment in R&D as an important driver of economic growth and has set itself the target of raising total investment in R&D to 2.4% of UK gross domestic product by 2027. R&D tax reliefs are considered a significant incentive to encourage R&D investment and therefore ensuring they are effective forms an important part of the government's R&D investment strategy.This article outlines the changes that are being introduced, the impact they may have on businesses seeking to claim R&D tax reliefs and what should be next on the government's agenda when reviewing R&D tax reliefs.Current systemBefore discussing the forthcoming changes, it is useful to outline the two reliefs currently available on certain qualifying R&D-related expenditure. Both reliefs adopt the same definition of R&D and qualifying activities. R&D for tax purposes is defined by reference to activities that are treated as R&D under UK generally accepted accounting practice and that fall within the Department for Business, Energy and Industry Strategy's guidance. Broadly, the guidance specifies that the R&D activity must take place within a project that seeks to achieve an advancement in science or technology.SME reliefWhere certain conditions are met, relief is available for small or medium-sized companies (SMEs) in the form of an effective deduction of 230% on qualifying R&D costs. Loss-making SMEs may have the option of receiving a cash repayment of the tax credit in return for surrendering R&D-related losses. Any repayment is capped at 14.5% of the losses available for surrender. For accounting periods beginning on or after 1 April 2021, any repayment is also subject to an annual cap of £20,000 plus three times the company's total "pay as you earn" and national insurance contributions' liability.RDECAn R&D expenditure credit (RDEC) is also available. Although primarily targeted at larger companies, it may be used and can prove valuable to SMEs in certain circumstances. The RDEC uses a different method of calculating corporation tax relief on R&D expenditure. The "above the line" RDEC is brought into account as a trade receipt, increasing taxable profits (or conversely reducing losses). A credit of 13% of the qualifying R&D expenditure is then credited to the company. In certain limited circumstances, a repayment may also be available.Changes to R&D tax reliefsBroadly, changes are being introduced in three aspects of the relief system:territoriality restriction – to limit eligibility for tax relief to UK-based R&D;definition of R&D and qualifying expenditure – expanded to cover cloud computing and data costs and pure mathematics; andclaims process – introduction of measures to combat abuse.New territoriality restrictionUnder the draft legislation, a territoriality restriction will be introduced, whereby a business will only be able to claim tax relief for qualifying expenditure on R&D activities undertaken in the United Kingdom. However, there will be an exemption where it is necessary for R&D to be undertaken overseas due to geographical, environmental or social conditions not present or replicable in the United Kingdom, or where there are regulatory or other legal requirements for the R&D to be undertaken outside the United Kingdom. The cost of the R&D and availability of workers to carry out the R&D are specifically excluded and will not be considered necessary for R&D to be undertaken overseas.Currently, there is no requirement that R&D activity must be undertaken in the United Kingdom for companies to be eligible for R&D tax reliefs. UK companies that incur R&D expenses overseas may still be eligible for full tax relief.The new territoriality restriction is being introduced as part of the government's objective of ensuring that the reliefs are targeted and refocused on UK innovation. When the restriction was first announced, there was widespread concern across R&D-intensive industries that many UK businesses would be denied tax relief for R&D undertaken overseas, despite the R&D being integral to the development of UK innovation and being required to be undertaken overseas. For example, in the context of life sciences, when developing new drugs or vaccines, clinical trials may need to be undertaken outside the United Kingdom to gain licensing approvals.Industry representatives have been engaging with the Treasury extensively since the restriction was first announced in the 2021 Budget. It is very positive and constructive that the Treasury has listened to concerns and introduced this exemption. R&D tax reliefs often provide an important source of funding to R&D intensive start-ups. Without access to tax relief, R&D costs may be prohibitive, preventing the development and progression of UK-based innovation. The new restrictions could have posed a potentially insurmountable stumbling block to the development of R&D and the exemption has been welcomed among stakeholders.Areas of uncertainty remain regarding when the exemption will be available, for example, what will be included as "geographical, environmental or social conditions". It is hoped that any uncertainty or ambiguity in the exemption can be resolved before the draft legislation is enacted.Definition of R&D and qualifying expenditureThe draft legislation also includes provisions to expand the categories of R&D expenditure that will qualify for tax relief, to include data licences and cloud computing. Qualifying expenditure should extend to all cloud computing costs associated with the R&D, including storage. These changes are being introduced to "better reflect developments in technology" and the different ways that cutting-edge R&D is now undertaken.At the Spring Statement in March 2022, the government also announced that it intends to amend the definition of R&D to cover pure mathematics. This change will be introduced in secondary legislation and is also expected to take effect from April 2023.The expansion of activities qualifying for relief to reflect modern research practices and the inclusion of pure mathematics in the definition of R&D is hugely welcome. The importance of data and data processing when developing new technologies has become increasingly evident and, therefore, these changes will be beneficial to many R&D-intensive businesses. The changes also support the government's drive to ensure that the reliefs remain fit for purpose and act as an effective incentive to encourage UK-based innovation.Combatting abuseNew measures to combat abuse of the R&D tax reliefs system are also being introduced. These involve a requirement for all claims to be made digitally with endorsement by a named senior officer of the company and requiring advance notice to Her Majesty's Revenue and Customs (HMRC) before making a claim – unless the company has made a claim in one of the previous three accounting periods – with details of any agent who advised the company making the claim.Safeguarding the R&D tax reliefs system against abuse and fraud is vital. However, the changes are complex and increase the admin involved when making claims – something that the HMRC acknowledged in a recent policy paper detailing the reforms. It is important to ensure that the reliefs remain accessible to small businesses and start-ups that are driving forward UK innovation and that may be reliant on tax reliefs as a source of financing.CommentThe expansion of the definition of R&D to include pure mathematics and the widening of qualifying activities to cover cloud computing and data costs is welcome and will likely prove beneficial to a broad range of R&D-intensive businesses looking to develop new UK innovations. Although the new territoriality restriction will limit the availability of R&D tax reliefs, the UK government's desire to ensure that government funding (in the form of tax reliefs) is directed at UK-based activity is understandable. The proposed exemption should ensure that relief continues to be available where overseas R&D activity is necessary to the development of UK-based innovations and is reassuring to business across the life sciences sector and other R&D intensive businesses.It is unclear whether the review into R&D tax reliefs remains ongoing. To date, the review has been silent regarding how R&D tax reliefs can be better used to support the United Kingdom's net zero transition and global efforts to combat climate change. It is widely understood that developing new "green" technologies is paramount in driving forward global decarbonisation, from carbon capture and storage solutions to the development of new technologies to reduce reliance on fossil fuels. Given the unprecedented heatwaves and resulting fires and droughts that the United Kingdom and Europe has experienced this summer, the issue of climate change must not be ignored. It is hoped that the government will now refocus its review into R&D tax reliefs to address how R&D tax reliefs can better incentivise UK investment in green technologies and support global decarbonisation.For further information on this topic please contact Penny Simmons at Pinsent Masons by telephone (+44 20 7418 8250) or email (p[email protected]). The Pinsent Masons website can be accessed at www.pinsentmasons.com.