Proposals for a single R&D tax scheme

In January 2023, the government released a consultation inviting feedback regarding the proposed structure of a merged research and development (R&D) tax incentive. The aim of which was to combine the current research and development expenditure credit (RDEC) with the small and medium enterprise (SME) R&D relief, creating a simplified, single R&D tax relief scheme.

In publishing the consultation, the government suggested that the combining of the SME and RDEC schemes would present a remarkable chance to simplify taxation. This would offer enhanced clarity and assurance to SMEs and foster innovation within the UK.

In ForrestBrown’s response to the consultation, we endorsed the proposition of a merged R&D scheme that streamlined the accessibility and administration of the incentive. However, we suggested that it was crucial to ensure that such a consolidation did not result in diminished benefits for SMEs engaged in R&D. Our detailed response to the consultation presented a series of findings and recommendations regarding the design of the new scheme. You can read our response here.

On 18 July 2023 – known as legislation day, or ‘L-Day’ – the government published a draft legislation on the proposed design of a merged scheme for R&D tax relief. The purpose of the draft is to open a technical consultation period regarding the detail of the proposal. Any final decisions by the government on the matter will be announced at a future fiscal event.

In this article we look at what the government has proposed in the legislation, covering key aspects and what to expect next.

What is the proposed single R&D tax relief scheme?

The proposed legislation introduces a merged R&D relief scheme. This would be implemented in a manner resembling the existing RDEC scheme, wherein it is granted as an expenditure credit, calculated as a percentage of R&D expenditure. The credit can be offset against a company’s tax liability, or subject to some adjustment, paid in cash to the business.

The mechanism will be familiar to those already accessing RDEC. However, there are notable distinctions from the current RDEC scheme. Specifically, responding to feedback received via the consultation, some aspects of the current SME scheme will be incorporated.

Most notably, a key complexity in merging the SME and RDEC scheme was how to ensure that relief is most effective when R&D is subcontracted between companies. The draft legislation states that companies will need to ensure that they are not undertaking subcontracted R&D on behalf of another UK taxpayer, but conversely all will generally be able to claim expenses paid to subcontractors as part of an R&D project. This structure broadly mirrors the current provisions within the SME scheme.

Additionally, the draft legislation incorporates the more generous version of the PAYE/NICs payable credit cap found in the current SME scheme.

Previously delayed limitations on relief for overseas expenditure are included and remain unchanged, linking the commencement date for these changes with the R&D single scheme.

What are the key aspects of a potential merged R&D scheme for tax relief?

The government has said it believes the introduction of a merged R&D scheme for tax relief presents significant opportunities for tax simplification, whilst capturing R&D policy as intended – to drive innovation and economic growth.

The key aspects published in the draft legislation are listed below.

An above the line expenditure credit

As expected, tax relief will be delivered as an above the line expenditure credit. ‘Above the line’ refers to the fact that many companies will show the credit as income in published accounts, in a similar way to how the existing RDEC model works. ‘Expenditure credit’ means that the credit is calculated as a percentage of R&D expenditure. This differs from the current SME scheme, which offers an enhanced expenditure deduction when calculating taxable profits, followed by an option to surrender losses for a payable tax credit.

‘R&D intensive’ SME mechanism to remain 

When the Chancellor announced adjustments to the rates of R&D tax relief last year, feedback and pressure from industry led to the introduction of a distinct credit rate for R&D-intensive SMEs. Consequently, the draft legislation preserves the SME scheme for such companies. However, this is expected to be a topic of deliberation throughout the technical consultation announced on 18 July 2023, not least because it results in two schemes, not one.

Companies of all of sizes to claim for payments to subcontractors

A key aspect of the merged scheme is how to deal with contracted out R&D. Under the current structure, SMEs can claim for most subcontractor costs, but under RDEC, such costs are only eligible on a very limited basis.

Based on responses to the consultation earlier this year, the government is proposing to broadly adopt the SME scheme approach. For many large companies, the prospect of adding complexity through adapting to new rules should be softened by the further broadening of the cost base for claims.  

Dealing with supply chains

In recent years, the difference between a normal commercial relationship and outsourcing of R&D has posed challenges and uncertainties for SMEs, often sparking controversy within the incentive framework. This point is still to be resolved in the new single R&D tax relief scheme. However, the draft legislation and its accompanying explanatory notes demonstrate the government’s determination to leverage the unified scheme as an avenue to provide the much-needed clarity in this domain – clarity that would be widely anticipated and appreciated by the SME community.

The government’s main aim in this area is that the incentive does not allow two companies to claim for the same R&D expenditure, as this leads to exchequer wastage and dead weight in the system. To help with this aim, companies won’t be considered an R&D subcontractor if they are carrying out R&D for a non-UK taxpaying entity, which is a helpful clarification and step towards simplification. 

SME Definition of PAYE/NICs payable credit cap will apply

Both current schemes incorporate caps on the amount of cash credit available, linked to a company’s PAYE and NIC liabilities. This is an anti-abuse measure as it prevents credits from being paid to companies with little substance in the way of a UK payroll.

The current caps are different in design, with the RDEC version being simpler but less generous. The R&D single scheme will adopt the SME version of the PAYE/NIC cap, which is the more generous of the two – currently. The payable R&D tax credit awarded to an SME is subject to a cap of £20,000, plus 300% of the SME’s overall liability for Pay as You Earn (PAYE) and National Insurance Contributions (NIC) during the period encompassed by the R&D claim.

20% R&D single scheme rate of relief

The draft legislation for the single tax credit scheme notes that the percentage of qualifying expenditure translated into credit will be 20%.

However, it should be remembered that this is draft legislation, inviting technical consultation on the proposed measures. Therefore, the government should not be expected to include detail on policy decisions relating to when these changes will be implemented, as well as details of what the future single scheme rate of relief will be. We expect these specifics to be announced at a future fiscal event following economic modelling as part of forecasting from the Office for Budget Responsibility (OBR).

Restrictions to overseas R&D expenditure to remain

The previously announced limitations on the eligible deductions for your business’s overseas R&D expenses are set to come into effect at the same time as the proposed single R&D scheme. Expenditures associated with externally provided workers (EPWs) and subcontractors will generally no longer qualify for the deduction. However, exceptions may apply in cases where it is deemed impracticable for the company to replicate the circumstances within the UK.

Read more about the changes to overseas R&D.

In-year generosity vs future tax savings

From a tax calculation perspective RDEC works in a very different way to the SME intensive scheme. One of the advantages of RDEC is that it offers an in-year tax benefit with little impact on future tax liabilities, making it much easier to forecast.

On the other hand, SMEs must consider their tax position and if they are loss-making, and decide whether to forego future tax benefits in return for an immediate cash benefit.

Currently, SMEs first deduct an expenditure enhancement from taxable profit (or extend a loss). Losses can then be surrendered to receive a cash credit. Alternatively, loss-making SMEs can opt to carry forward their losses to a subsequent profitable year. Crucially, they cannot do both, so if a credit is the preferred option, those losses are surrendered and therefore won’t be available when the company does make a profit in the future.

While many SMEs opt for the immediate cashflow advantage the payable credit offers, the losses would ultimately generate a higher rate of tax saving in the future. This is an important decision, but not an easy one in such an uncertain economic climate.

RDEC removes the complexity that results from this timing difference. The credit is calculated as a percentage of R&D expenditure, then offset against the company’s tax liability. If there is no liability, subject to some adjustments, it is payable in cash.

When will the single scheme be introduced?

The government has opened a technical consultation on the proposals laid out in the draft single R&D scheme legislation, published as part of L-Day 2023. This consultation closes in September 2023.

The government had noted that they have published the draft legislation “in order to keep the option of implementing a merged scheme from April 2024.”

This would require a final decision to be announced at a future fiscal event, most probably in Autumn 2023.

R&D tax relief single scheme – keeping you informed

ForrestBrown is the UK’s leading innovation incentives specialist.  

We’re passionate about the transformative power of R&D tax relief for your business and the wider economy, which is why we play an active role in shaping R&D tax policy.

Since ForrestBrown was formed in 2013, we’ve been a member firm of the Chartered Institute of Taxation (CIOT) and have been putting professional standards at the heart of our culture.

We’re keen to hear from businesses and their advisers on the topic of the proposed single R&D tax relief scheme.