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Comment: Why the proposed R&D changes need rethinking

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The R&D tax credit changes announced in the Autumn Statement will adversly impact innovative UK SMEs including, in particular, biotechnology companies where much of the R&D spend is subcontracted and/or overseas and where its means of raising finance on the equity markets is currently proving difficult. Rather than making such ‘blunt instrument’ changes, HMRC should properly review individual claims and/or use to the DOTAS rules to tackle rogue agents.

The R&D tax credit changes announced in the Autumn Statement 2022 have simply not been thought through, and UK companies in the biotechnology and tech sectors are not happy.

As previously set out in this journal (‘Autumn Statement 2022: R&D tax relief changes’ (J Tragner), Tax Journal, 17 November 2022), there are three changes planned for R&D expenditure from 1 April 2023:

  • SME R&D tax credit additional tax deductions are reduced from 130% to 86%;
  • SME R&D cash claims are reduced from 14.5% to 10%. Effectively this reduces the cash credit from 33p per £1 of spend (being 14.5% of 230%) to 18.6p per £1 of spend (being 10% of 186%); and
  • R&D expenditure credits (RDEC) are increased from 13% to 20%. For cash claims this means an effective rate of 10.5p per £1 of spend (being 13% less corporation tax at 19%) is increased to 15p (being 20% less corporation tax at 25%). 

There is one point of correction on the previous Tax Journal article on ‘additionality’, i.e. the amount of additional spend that is generated by RDEC for large companies versus SME credits for small companies. The Office for National Statistics has been systematically undercounting R&D by small companies for many years.

A methodology update published by the ONS on 29 September 2022 revealed that SMEs invested £16bn more in 2020 than previously reported, and figures for preceding years were similarly revised upwards. The new figures show that SMEs actually make a greater contribution to the UK’s overall industry R&D investment than large companies do.

The problem is particularly acute for UK SME biotechnology companies. This is due to the following:

  • A large proportion of R&D spend is on R&D subcontractors. A small biotech company cannot justify building huge facilities on a handful of drug programmes, so the work is outsourced to third parties. These costs are included in the R&D claim after a statutory restriction of 65%, with the cash claim benefit now falling from 21p per £1 to 12p.
  • The RDEC rate is to be increased. However, the large proportion of spend with corporate R&D subcontractors simply cannot be included in an RDEC claim. Only subcontractors that are individuals or qualifying bodies, such as UK universities, UK hospitals or overseas bodies on an approved list may be included.
  • Much of the R&D spend, whether subcontracted or spent on consumables such as clinical trial materials, is overseas. This is because of the need to use the best suppliers in the world in highly specialised areas of a very small talent pool. We are still entering the unknown in terms of overseas R&D spend and the HMRC interpretation of the proposed Finance Bill exemption of that spend. It will need to be ‘wholly unreasonable’ for the UK biotech  company to have replicated that R&D work in the UK, leaving claimants to prove a negative to HMRC.
  • Drug development is a high-risk, long-term, business. Drug development companies have no revenues until they obtain regulatory approval for their drugs, so they raise money tied to pre-regulatory successful drug development and long-term cash forecasts. However, forecasts of R&D tax credit cash inflows have just been slashed.
  • These companies raise equity finance from specialist venture capital firms, as they are too high risk for most debt providers. However, the equity markets are difficult at the moment. Consequently, some companies will not be able to raise money to plug the shortfall created by the Autumn Statement announcement, and will be forced to reduce investment, or at worst, some companies will fail.

What is particularly galling for the biotech industry is having the rug pulled from under it, when the chancellor wants to promote UK science, and investment in UK science. Drug development is clearly R&D for tax purposes. Hence, the helpful HMRC guidance in their manuals that most drug development up to and including phase 3 clinical trials is R&D. Consequently, biotech companies are not the typical users of no-win, no-fee R&D advisory firms.

The UK BioIndustry Association (BIA) has repeatedly asked the Treasury to outlaw contingent fee R&D claims, for example by using the DOTAS (Disclosure of Tax Avoidance Schemes) rules, since these claims are mass marketing for a premium fee. However, no action has been forthcoming to date.

Instead, we now have the chancellor arguing that the rate reductions in the Autumn Statement 2022 will help discourage fraud. That is not a robust argument. Fraudsters will simply make less money, rather than stop. But what is undeniable is the damage that will be done to the UK biotech industry if these changes are implemented. The industry is international. Existing biotech companies will reduce future UK investment, and new biotech companies will be founded outside the UK. International comparisons of R&D schemes is always difficult, due to differing cost bases, qualification requirements and credit calculation mechanisms. But what is clear is that this move by the UK government, coming hard on the heels of the PAYE cap and the planned overseas expenditure restriction, moves the UK from near the top of the R&D relief table right down to the bottom for SMEs.

What is needed is less of a blunt instrument. If rogue agents are the problem, then use the DOTAS rules. If fraud and spurious claims are the target, then there is no substitute for HMRC actually reviewing claims. If there is no budget for increased HMRC scrutiny, then allow ‘knowledge intensive companies’ to be unaffected by the rate reductions, using the existing EIS and SEIS risk capital schemes definition.

We have a world-leading life science sector, we have great science coming out of our universities and institutions, we have a government that wants to champion that, and drive economic growth from it. Any chance of a policy that matches the rhetoric?

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