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Autumn statement 2023: reforms to R&D tax credits missing chance to boost UK science

20 November 2023

In this week’s autumn statement, the government has a chance to provide much-needed clarity around R&D tax credits and thus drive physics innovation, writes John Bagshaw, the IOP’s Vice-President for Business.

After 23 years of building up recognition of, and access to, research and development (R&D) tax credits the government is in danger of squandering the opportunity to reform them. The mixture of poorly defined guidelines for what counts as R&D, lack of clarity around the specific intention of the schemes, and a rush to implement the new policy is having a chilling effect on small business R&D.

The past 23 years have seen R&D tax credits grow from a niche business support scheme to the government’s most substantial vehicle for science and technology support. Official estimates for the amount claimed in 2021-22 land at £7.6bn – a notch above the UK research funding body UK Research and Innovation’s annual spend on R&D of £7.4bn in the same year.

In the run-up to last year’s autumn budget the Treasury was spooked by claims of widespread error and fraud in the schemes and the Chancellor Jeremy Hunt took the opportunity to reform R&D tax credits. He proposed to consolidate research and development tax relief for small and medium-sized enterprises (the SME scheme), which has only seen incremental revisions since its inception in 2000, and the research and development expenditure credit (RDEC) scheme, which replaced the large-company scheme in 2016.

This is a promising idea – the SME scheme was outdated and difficult to understand while the newer RDEC scheme benefits from improvements such as a more predictable rate of tax relief, while still retaining the beneficial elements of the SME scheme such as the cash credit for loss-making firms.

But these reforms have missed the opportunity to improve some of the most unhelpful aspects of the credits. The schemes still labour under the outdated, and unhelpfully vague, definition of R&D that has not been meaningfully updated since 2004. Last year’s addition of support for cloud-computing costs, data costs and pure maths was a sticking plaster, when what we need is a wholesale review of what the government considers R&D for tax credit purposes, with sector-specific examples. Without this clarity, companies that are not truly innovating may make claims in error, and companies that should be supported may not realise that the work they are doing qualifies for support.

“It has laudable goals but if the government wants to achieve any of them the tax credits will have to be designed clearly for a specific purpose.”

What’s more, the previously higher rate of relief for SMEs was reduced while the lower rate for large firms was raised, sending mixed messages about the government’s support for innovative firms. Will Richardson, Chief Executive of Wayland Additive Ltd – an advanced manufacturing company – comments: “This is a tremendously negative signal of the government’s opinion of UK R&D and the value it creates. Research-intensive SMEs are exactly what we need more of to generate future jobs and economic prosperity.”

The underlying problem with R&D tax credit reform is the lack of a clear policy intention from the Treasury. It is not clear whether the scheme is aiming to encourage all firms to spend more on R&D, or to support the most innovative firms to go further. Likewise, is the aim to attract more foreign R&D investment, or increase productivity in domestic firms? Are the credits designed to help smaller firms that cannot access sufficient finance for R&D or encourage large firms to invest more in research? These are all laudable goals but if the government wants to achieve any of them the tax credit will have to be designed clearly for a specific purpose.

Currently it appears HMRC’s driving motivation is to reduce error and fraud. But a focus on compliance staff – rather than clear guidelines on the purpose of the scheme – is likely to have a chilling effect on business R&D. The unclear definition of R&D can mean that companies apply in good faith, but the HMRC caseworker views the claim as illegitimate. For example, in the case of a spin-out specialising in advanced modelling techniques for the aerospace industry, HMRC has rejected the company’s R&D tax credit claim entirely, stating for one project that existing science and technology has been used and referring to this existing science and technology as “the computer process (using software and processors)”.

This is despite the fact the company primarily carries out Innovate UK-funded R&D projects, so by one government body’s standard is clearly doing R&D. The last thing our innovative businesses need is a drawn-out dispute with HMRC over R&D tax credits – time and resource they could be spending pushing the cutting edge of science and technology.

Small businesses have also been rocked by the speed at which the new policy has come into force. Announced last November, new rates of relief came into effect for the 2023-24 tax year, which started just a few months later, in April 2023. Firms that last year could have claimed a credit equal to 33.3% of their R&D spending are looking at receiving 18.6% for the same investment this year. This is in direct opposition to the opinion of physics businesses.

According to polling in our Paradigm Shift report, 59% of UK physics innovators believed that a more attractive tax rate for R&D would support greater activity in the UK. Dr James Mckenzie, CEO of Hirst Magnetic Instruments, explains: “It’s been a double whammy for small physics businesses – a tight finance market due to inflation and the reduced rate of R&D tax credit has really constrained the amount we can invest in research.”

The Institute of Physics believes it’s essential that the Treasury states a clear and specific intention for R&D tax credits, outlining the type of innovation it is trying to support, and to enlist the Department for Science, Innovation and Technology to develop an up-to-date definition of R&D with specific examples of what is, and what isn’t, eligible in different fields.

In this year’s autumn budget statement, we hope the Chancellor listens to the UK’s innovative businesses and ensures that the R&D tax credit reforms are fit for purpose. Only then will businesses have the clarity to plan their future R&D spending and continue to invest in the innovation the UK needs to recover from its recent economic malaise and become an Innovation Nation.

John Bagshaw is the IOP’s Vice-President for Business