Overseas R&D changes – what they mean for your business

On 20 July 2022, draft legislation was published by the government, which included important changes to research and development (R&D) tax incentives. Announced in autumn 2021, these adjustments were originally due to be introduced for accounting periods beginning on or after 1 April 2023 but implementation has subsequently been delayed until 1 April 2024. The changes will apply to both the R&D Expenditure Credit (RDEC) and SME R&D tax relief.

If your business may be affected by these changes, it is important to understand what the changes are, when they will take effect and what else you may need to consider to ensure you are adequately prepared.

What are the changes to overseas R&D?

From April 2024, the new conditions affecting subcontracted R&D expenditure and payments for externally provided workers (EPWs) will come into force. To include this type of expenditure within an RDEC or SME R&D tax relief claim, subcontracted R&D activity will need to be performed within the UK, and EPWs will need to be subject to UK PAYE.

As the below examples demonstrate, proposed changes to subcontracted R&D expenditure and payments for EPWs could result in a significant reduction in benefit for both RDEC and SME claimants. These examples are subject to the proposed merging of the two incentives.

There are some circumstances where overseas activity will be permitted, where the expenditure meets the definition of ‘qualifying overseas expenditure’:

• Circumstances where it would be wholly unreasonable to undertake the R&D in the UK due to geographical, environmental or social factors (e.g. deep ocean research),

• or, where legal or regulatory requirements require activity to take place in specific territories (e.g. clinical trials).

The draft legislation explicitly rules out ‘cost’ or ‘workforce availability’ as reasons for overseas expenditure to qualify for relief. 

These rules will apply to a company’s first accounting period which begins on or after 1 April 2024. This means that the restrictions will apply earlier to some companies than others. For example, a company which draws up accounts to 31 March will apply the new rules to its accounting period ending 31 March 2025 (which begins on 1 April 2024). One which draws up accounts to 31 December will apply them in its period ending 31 December 2025, which begins on 1 January 2025.

Why are the changes to overseas R&D happening?

The objective of this change is to refocus R&D tax relief on UK-based R&D activity, in an effort to better encourage innovation within the UK. The government has stated that it wishes to maximise the benefit to the UK from the spill-over effect of R&D activity incentivised by the relief.

However, the changes to relief for overseas R&D assume a commercial reflexivity to pivot towards using UK-based suppliers or resources, but companies who need to access a global skills base are unlikely to be able to do this.

This will come as a real challenge for innovative technology companies in particular, who are facing global competition for specialist talent. It has the potential to hamper the UK’s ability to be part of global R&D programmes and could lead to a talent drain away from the UK over time.

ForrestBrown’s view

The UK is part of a global economy. Innovation is both a matter of collaboration and competition. Concerns remain over the likely impact of limits to relief for R&D activity undertaken outside the UK.

R&D tax incentives should reward activity that directly benefits the UK economy. On the face of it, it would be natural to question relief given to activity not happening here. However, there are still tangible economic benefits to the UK even where some activity takes place overseas.

The current structure requires claimants to have a UK company with expenditure that is taxable in the UK. In addition, payable credits are already capped where the company doesn’t employ sufficient workers in the UK. As such, changes to the relief are not targeting companies with no economic substance in the UK, but are likely reducing the value of claims for companies that have chosen to base themselves here.

Whilst we understand the driver of increasing innovation in the UK, there is a risk that these new restrictions on R&D tax relief will hamper the UK’s mission to become a science and technology superpower.

There are, however, some changes which could be made to the overseas R&D measures which would be welcomed by businesses who may feel that they are being unfairly targeted with this measure:

• An amendment to the definition of qualifying overseas expenditure to include work outsourced because of skills shortages in the UK would help recognise the current challenges faced by companies who need to leverage skills and resource from across the globe.
• The measures make no distinction between connected party EPWs and those provided by third parties. This means that a UK headquartered group which draws on its global resources to deliver UK projects will also face additional complexity and reduced relief.
• As drafted, any company seeking to claim R&D tax relief and incurring expenditure on subcontracted R&D or expenditure on EPWs will be required to review the new conditions and demonstrate to HMRC that these have been met in respect of any relief claimed. A de minimis threshold would ease the administrative burden on companies where only small amounts of this type of expenditure are included.

At ForrestBrown, we understand the complex challenges faced by UK businesses that undertake R&D overseas. The upcoming changes to the legislation prove that it is more important than ever to ensure you understand how you may be affected and what steps you can take to ensure you are ready for implementation.