Philip Smith, journalist

Just ahead of lockdown in March this year, the UK government published details of its consultation on the tax treatment of research and development (R&D). It was going to be a short, sharp debate – until Covid-19 forced an extension to the end of August.

At stake is the cap that was originally due to be introduced this year on the amount of payable tax credit that a qualifying loss-making business could receive. This had been set at three times a company’s total liability for PAYE and national insurance contributions (NICs) for the relevant year. The cap has now been delayed until next year to allow for consultation on changes to the design of the measure.

Although the government sees R&D tax relief as core to its strategy for increasing innovation, it is concerned that the existing system is open to abuse and that it is not reaching those that need it most in the SME sector. The government believes the cap would deter abuse because fraudulent companies, and those with little or no UK-based activity, typically employ few people and therefore do not pay much PAYE and NICs.

The government says its intention remains for genuine companies undertaking R&D to not, as far as possible, be adversely impacted by the cap. This is why it has announced that the cap will be based on three times a company’s PAYE and NICs liability – higher than the 100% PAYE cap that was part of the R&D tax credit scheme until 2012.

While abuse of the system needs to be tackled, HMRC should support the genuine innovators who rely on R&D tax relief incentives to flourish


But now, as well as confirming that the design will include a £20,000 threshold (below which the cap does not apply) and that related-party PAYE/NICs can be included when calculating the cap, the government is proposing that claims will be uncapped where businesses can satisfy additional tests on the ‘hallmarks of businesses which develop and exploit intellectual property’. According to HMRC, fraudulent attempts to claim the R&D tax credit often involve a very high proportion of R&D expenditure contracted out to related parties and externally provided workers.

The government is facing a delicate balancing act here, and some tax advisers fear it may be missing the mark by restricting uncapped claims in this way. ‘While fraud must obviously be addressed, a blanket approach is completely inappropriate,’ says Jay Bhatti, R&D tax manager at MHA MacIntyre Hudson. ‘More effort should be made to ensure the rules work for different types of businesses.’

In particular, Bhatti believes the mitigation steps included in the proposals are ineffective. ‘An exemption on the first £20,000 of claims has been put forward, but some startups currently receive £100,000 or more through the scheme. The exemption is inadequate and could push companies to move development overseas.’

Bhatti also argues that for the three-times-wages rule to work, SMEs should be allowed to include spend on subcontractors in their calculations to reflect the scale of their R&D costs more accurately. ‘As they stand, the proposals risk stalling growth at a crucial time for UK businesses and the wider economy,’ he says. ‘While abuse of the system needs to be tackled, HMRC should support the genuine innovators who rely on R&D tax relief incentives to flourish.’

Sheetal Sanghvi, RSM’s R&D tax partner, agrees. She says: ‘Research and development is crucial for the UK’s long-term economic growth and plays a fundamental role in the government’s commitment to supporting strong and sustainable private sector-led growth. The government should continue to do all it can to support innovative businesses, particularly SMEs, which are facing many challenges as a result of the current Covid-19 pandemic. We strongly believe that legislation implementing the proposed measure should be drafted so that it does not supress or stifle UK SME innovation.’

Unintended consequences

As well as urging the government to increase the exemption threshold from £20,000 to £50,000, Sanghvi is concerned that some companies may find it difficult to recruit UK employees with the required skillset or at cost-effective pay rates, leading to the hire of subcontractors or externally provided workers. ‘Preventing these types of companies from claiming in the UK may lead such companies to set up their operations in other jurisdictions instead,’ she warns.

But for now, innovative SMEs and their advisers will need to wait for the outcome of the consultation process. All R&D eyes will be on what the chancellor does next month.