The UK’s R&D Tax credit system: what role will it play in economic recovery and meeting the 2.4%?

The UK’s R&D Tax credit system: what role will it play in economic recovery and meeting the 2.4%?

tAX BLOGBy Fariba Soetan, Policy Lead for Research & Innovation, NCUB

Amongst a number of initiatives and policy interventions that will underpin national economic recovery and our ability to attract business investment will be the R&D tax credit system.  NCUB’s response to the HMRC consultation on the scope of R&D tax credits can be found here.

R&D tax credits form a core part of the government’s support for innovation and support businesses as they invest, driving growth and productivity across the UK. Nations the world over will be considering how they can amend state aid rules or tweak their fiscal incentives to attract a larger share of foreign direct investment from global firms who can choose to invest anywhere.

R&D tax credits have, in some ways, taken centre stage in light of Covid19 and the ensuing economic crisis as company boards focus on managing cash flow and R&D budgets are at risk in cost-saving measures being proposed.  While impact across different sectors will vary, longer term impacts are expected to hit other parts of industries as smaller companies further down the supply chain continue to develop recovery plans, especially in sectors where demand and sales may remain low.  Therefore, it is essential that the UK provides incentives to businesses to continue to invest in R&D.

What role do R&D tax credits play in our R&D system and how do we compare?

R&D tax credits form a core part of the government’s support for innovation.. An OECD study found that one euro of either direct or tax support leads to around 1.4 euros of private R&D on average. In contrast, direct funding seems to encourage business research, which tends to be of an applied nature, but does not necessarily lead to a new product or process (for example, coming up with new molecules that may be later trialled as drugs).

The Research into the benefits of R&D tax credits has been extensive and as nations increase the quality of their research base, fiscal incentives – tax credits included- are starting to play a bigger role in large R&D-intensive firm decision-making about where (and if) they choose to invest.

The two principal tax reliefs available to companies undertaking R&D in the UK include both a scheme targeting SMEs and one for large corporates:

  • Research and Development Expenditure Credit (RDEC): a payable tax credit (subject to tax) equivalent to 13% of qualifying R&D costs claimed; and
  • Research and Development tax relief for SMEs: a 230% deduction of qualifying R&D costs from a profitable company’s yearly profit; or a tax credit worth up to 14.5% of the surrenderable loss of loss-making companies

Combined, these schemes provided £4.4bn of support to over 7000 businesses in 2016-17. To qualify for relief, expenditure on R&D must be incurred on particular types of activity, currently limited to staffing costs (employees and agency workers), consumable or transformable materials (such as water, fuel and power of any kind), certain types of software, payments to clinical trials subjects and, depending on the scheme, some subcontracting costs.

The UK’s system is considered to be quite generous in what it considers ‘in scope’ innovation for the purposes of R&D tax credits. There are two types of R&D tax credit systems:  a ‘volume-based’ system where the credit is based on the absolute volume of R&D expenditure (UK) and incremental-based, where the credit is driven by the increase in R&D spending over a base figure.

The OECD report cited above showed that in some countries (such as the Czech Republic and Belgium), corporate R&D performers receive the same rate of R&D tax subsidy, irrespective of their size or level of R&D spend, as no upper ceilings or thresholds apply that would limit the value of R&D tax relief or qualifying R&D expenditure. The same is true for countries that impose limitations but those are effectively not binding or only apply to a handful of firms (such as France). Other countries offer a preferential tax treatment to small and medium enterprises (e.g. Australia, Canada and Japan) or start-ups (e.g. the Netherlands and Portugal) in the form of enhanced tax credit or allowance rates. See here for more information.

Systems will vary significantly but there is still no magic wand that can be waved to claim the largest portion of the global R&D investment. Many factors will play a part, including something as simple as having an easy system that businesses can access and reflecting the scope of the current system to reflect new and emerging technologies.

What does the UK need to do to evolve its R&D tax credit system to fit the needs of new technology?

Reflect new technologies

Research by NESTA suggests that the world’s 1000 largest R&D companies report shifting R&D spending away from products and towards software and services. For example, between 2010-2015 R&D spending on products as share of global spend fell from 46% to 41% and is expected to fall to 37% by 2020. R&D spending on software and services meanwhile grew from 54% to 59% over the same period and is expected to increase to 63% of global spend by 2020.

This has important implications for policies aimed at supporting business innovation, including the need for sustainable research-data infrastructure,  the importance of openness and accountability, and rapidly evolving demand for data analysis and data management skills. Although software acquisitions and their maintenance costs are included within the R&D tax credit, businesses adopting more data-driven R&D practices are finding that their R&D activities are not recognised by incentive structures in the UK.  

Make the current system simpler and build more awareness

Businesses consistently cite challenges in navigating the complexity of the UK innovation support network and many are not aware of what support or collaborative opportunities are out there. Innovation authorities and universities need to take a more proactive approach to reaching business audiences and simplifying the system so that SMEs in particular can benefit.  There are many businesses undertaking data-driven innovation outside of the traditional audience for government R&D support and separating costs can be an additional hurdle for businesses, particularly SMEs, to jump.

With a high proportion of UK R&D financed by foreign-owned firms, realising the 2.4% target requires an even greater share of the global market to be captured by the UK. The UK already attracts an disproportionate share of research intensive foreign direct investment (FDI) relative to its size. It is therefore more important than ever that the UK amends the current system to help drive investment in the post Covid recovery and starts behaving as a competitor in the global market for R&D investment. This will help to retain existing business investment and attract higher levels of globally mobile business research to this country.

Date published: 22nd October 2020

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