R&D tax relief: proposed changes

The government is proposing to make the following key changes to the UK's research and development (R&D) tax reliefs:

• New restrictions on overseas expenditure.
• An expanded definition of qualifying expenditure.
• Updates to the R&D claims procedure.

On 20 July 2022, the government published the draft legislation to implement the proposed changes, which would apply to accounting periods beginning on or after 1 April 2023.

The UK's R&D tax reliefs comprise the R&D tax relief for small or medium sized enterprises (SMEs) and the R&D expenditure credit (RDEC).

Restriction on overseas expenditure

Proposed changes

R&D reliefs will be restricted for both sub-contracted R&D (and contributions to independent R&D under the RDEC scheme) and costs relating to externally provided workers (EPW).

Any sub-contracted R&D expenditure (or contributions to independent R&D under the RDEC scheme) must either be attributable to relevant R&D undertaken in the UK or otherwise be qualifying overseas expenditure. It is the location of the R&D activity undertaken that will be relevant to the eligibility of the costs for relief, not the corporate or tax residence of the entity undertaking the work.

Only costs concerning EPWs whose earnings are taxed through UK PAYE, or who are otherwise engaged in qualifying overseas expenditure, will continue to qualify for relief under the schemes.

'Qualifying overseas expenditure' is relevant R&D undertaken outside the UK where there are 'conditions' necessary for the purposes of the R&D that:

• are not present in the UK
• are present in the overseas location in which the R&D is undertaken, and
• it would be "wholly unreasonable" to replicate in the UK.

The legislation states that 'conditions' include:

• geographical, environmental or social conditions
• legal or regulatory requirements, as a result of which the R&D may not be undertaken in the UK.

This list of conditions is illustrative, not exhaustive, and so it may be expanded upon in practice (and hopefully in published guidance). However, the cost of the R&D and availability of workers are specifically excluded as conditions in the legislative definition.

Although cost is specifically excluded from being a qualifying condition in its own right (alongside staff availability), HMRC has commented that other commercial drivers may be relevant considerations. These drivers, such as timing constraints and whether business capability or operational capacity exist in the UK, would still have to be justified on the facts and appropriately evidenced in the taxpayer's claim. However, it is not clear whether such drivers would be assessed as 'conditions' in their own right or as relevant factors in assessing what is 'wholly unreasonable' for the purposes of the third limb of the test.

Examples of offshore activities which HMRC has indicated may be 'qualifying overseas expenditure' are the:

• on-site study of volcanos
• local study of a disease (where there are not enough suitable patients available for study in the UK)
• clinical trials where there are regulatory or other legal constraints that require such trials to take place outside of the UK.

HMRC has indicated that, within these examples, different R&D activities which form part of the same R&D project may require separate consideration. For example, while it may be 'wholly unreasonable' to replicate the collection of on-the-ground data in the UK for the study of volcanoes, it may not be 'wholly unreasonable' to replicate the onshore analysis of such data.

Consequently, any sub-contracted expenditure concerning the analysis of such data may not satisfy the third limb of the legislative test and such activities may need to be relocated onshore to remain within scope of R&D reliefs.

Guidance on the new legislation has not yet been published and the scope of qualifying conditions is an area where such guidance may be especially welcomed. Guidance on the factors that contribute to make replication of qualifying conditions in the UK 'wholly unreasonable' will also be key.

Why is this restriction being proposed?

The aim of the restriction is to refocus UK R&D reliefs towards innovation activity occurring in the UK that have broader benefits in the UK. In HMRC's view, the benefits associated with R&D activity (such as an increase in skills or knowledge in a particular area) tend to arise in the location where R&D activity is undertaken. 

The new restriction will reward companies whose activities generate such benefits in the UK and aims to encourage companies to locate as much R&D activity within the UK as is reasonable, so that the UK can more effectively capture the benefits of R&D funded by the reliefs.

What do the changes mean for your business?

Claimants will need to interrogate which elements of their sub-contracted R&D activities are undertaken offshore and the extent to which the cost of such activities constitute qualifying overseas expenditure. Those sub-contracted offshore activities which will not be qualifying under the new restriction will need to be de-coupled from any qualifying sub-contracted offshore activities and relocated to the UK, if companies wish to keep them within scope of the reliefs. 

Looking forward, consideration of the location of sub-contracted R&D work should be built into companies' vendor selection process from the outset to maintain full R&D eligibility.

Expansion of qualifying expenditure - data and cloud computing 

Proposed changes

The definition of qualifying expenditures applicable to each of the R&D schemes has been extended to include data licences and cloud computing costs. 'Data licence' is referred to in the proposed legislation as "a licence to access and use a collection of digital data", while 'cloud computing services' include "the provision of access to, and maintenance of, remote – 

• data storage;
• operating systems;
• software platforms;
• hardware facilities.".

Expenditure on data and cloud computing services will qualify for relief wherever that activity is undertaken (it is not subject to the new overseas expenditure restrictions).  However, it will not qualify for relief where:

• there is a right to on-sell the data or service or share the data with a third party, or
• the R&D is attributable to a qualifying indirect activity.

This treatment aligns with the inclusion of data licences and cloud computing services within the 'software and consumable items' category of qualifying expenditure for R&D purposes.

Secondary legislation will be introduced, with effect from April 2023, to further expand the definition of qualifying expenditure to include all mathematics for both R&D reliefs. The aim being to clarify that ‘pure maths’ (previously the subject of a legislative exclusion) may now qualify.

Why is this extension being proposed? 

This extension aligns the scope of the reliefs with real costs incurred by businesses (which, in the case of data and cloud computing, could not have been in the minds of the legislators when the reliefs were introduced in 2000) and recognises the growing volume of R&D being undertaken which is underpinned by mathematics. The changes will bring the UK R&D tax credit regime more into line with the regimes in a number of other jurisdictions, such as Singapore and the USA.

What do the changes mean for your business?

This extension will widen the scope of expenditure which is covered by R&D reliefs to the benefit of UK businesses. For many clients, this expenditure represents a material and growing element of their cost base.

Updated compliance

Proposed changes

Secondary legislation will be introduced with effect from April 2023 to:

• require all corporation tax returns that contain an R&D claim to be submitted digitally through HMRC’s tax return portal
• set out the additional information that will need to be provided for R&D claims going forward. The additional information will include a description of the R&D undertaken, a breakdown of qualifying costs, details of any agent who has advised on the R&D claim and will require sign-off from a senior officer of the company.

In addition to the above, companies that have not made a claim for R&D relief in the three accounting periods previous to any current claim will also have to submit a claim notification to HMRC within six months of the end of the period to which the current claim relates.

Why is this being proposed? 

This additional compliance is part of a package of measures to combat perceived historic abuse of R&D reliefs.

What do the changes mean for your business?

For all new claims being made for accounting periods beginning on or after 1 April 2023, businesses will need to submit their claims digitally and provide increased information and R&D analysis. For businesses that have never made a claim for R&D relief (or who have not made a claim in the three accounting periods immediately before any current claim) they will also need to make a claim notification.

Other notable changes

The draft legislation also includes measures to address anomalies in the R&D schemes. The most significant of these for businesses which sit within a wider corporate structure provides that, where an enterprise was treated as an SME and a linked enterprise becomes 'large', the first enterprise will continue to be treated as an SME for R&D purposes for that accounting period.

Previously, all entities in the group (other than the entity that has become 'large') would lose the SME status immediately (even for the part of any accounting period that preceded the related entity's change in status).  Where an enterprise that is the target in a corporate acquisition is only not an SME because a related enterprise is 'large', the target will be treated as an SME for the whole of the accounting period in which the acquisition takes place, if it is acquired by an SME.

Next steps

The deadline for comments from stakeholders on the draft legislation has now passed and the amended draft legislation should form part of the Finance Bill to be published this autumn.

Given the complexity of the underlying activities undertaken by R&D companies, this is an area where industry comment and feedback has been lively. Any amendments to the draft legislation, as well as any published guidance, could significantly move the needle on the scope of the available reliefs, especially concerning offshore expenditure.