Whether a business has series funding, venture capital (VC) or private equity (PE) backing, understanding the recent updates to research and development (R&D) tax relief is crucial not only for optimising tax incentive opportunities but also for navigating the complexities that can impact enterprise valuations and transaction outcomes.
Over the past 24 months there's been an unprecedented increase in HMRC scrutiny and compliance checks on R&D claims. This has mainly discouraged small and medium-sized (SME) claimants due to the cost: benefit ratio of defending a claim which can be lengthy and drawn-out, creating uncertainty on cashflows.
Two new R&D schemes have also been introduced, presenting further complexity and issues to consider for all claimants. The new merged research and expenditure credit (RDEC) scheme is applicable to all claimants where their accounting period commences on or after 1 April 2024. It offers an above-the-line R&D credit for all companies – which equates to a net cash benefit of at least 15% of the R&D spend (20% gross credit typically taxable at 25%) – but is a reduction on the previous SME scheme. The enhanced R&D intensive scheme (ERIS) is available to loss-making R&D intensive SMEs, which offers a more generous cash benefit.
It's crucial to model the potential accounting treatment and cash flow impact of any changes. Key actions will be to consider the new contracted-out rules which determine claim entitlement where R&D is undertaken between a customer and a contractor relationship; and the restriction to overseas expenditure in respect of contracted-out R&D and externally-provided workers.
HMRC’s increased activity heightens the risk of a claim being challenged, which requires more attention to the robustness of R&D claims. We're seeing investors question whether R&D claims should be discounted for the purposes of agreeing the net cash and asset position of businesses (from the perspective of the buyer) on transactions. This can be particularly problematic if there's an open HMRC compliance check, which also raises the risk of discovery powers being exercised into earlier returns, penalties, and interest. This can result in the buyer holding back on paying for the R&D benefit until HMRC checks are closed. The specific fact pattern in terms of claim robustness and whether reasonable care has been taken by the taxpayer is important in each individual case.
VC and PE-backed businesses may already be managing complex operational and financial structures, and the requirement of having to submit a digital additional information form (AIF) containing significantly more information for a valid claim, will only add to the administrative burden. There are also new rules that may require the advance notification to HMRC of making a claim. Some potential claimants therefore may miss the boat due to a six-month post-year-end deadline to notify or require specialist advice to navigate the new reporting requirements.
On a more positive note, the new RDEC scheme, which provides a 20% taxable credit based on the qualifying R&D expenditure, will be recorded above the tax line as income, thereby increasing the earnings before tax of the claimant company. If the credit can be supported, eg, it's consistently included and is sustainable, it could potentially be taken into account when determining the company’s enterprise value. As a result, not only will the RDEC result in an in-year cash benefit, but can sometimes be subject to the deal-multiple, depending on the wider commercials surrounding the transaction and consistency of claims.
Care is needed when accounting for R&D tax in the balance sheet, as complexities can arise when tax relief is accelerated ahead of accounting expenses. This is the case when R&D costs are capitalised as an intangible fixed asset. Consequently, deferred tax liabilities may arise which unwind over time as the tax relief for amortisation is disallowed. Deferred tax assets may also be created where notional RDEC tax credits are carried forward, which generally arise for companies in a loss position.
This is likely to be of particular interest to R&D-intensive start-ups and should be considered for any SME which carries out extensive R&D activity. It's necessary to look at whether the required rate of R&D intensity is met (broadly 30% of all costs on a group basis), which could increase the cash benefit up to 27% of the qualifying R&D expenditure.
The removal of restrictions on subsidies is a notable development, such that businesses can potentially access either of the new R&D tax regimes and grant funding on the same expenditure, which will provide welcome simplification and an area of potential opportunity.
New rules have broadened the scope of eligible expenditure to include certain data licences and cloud computing service costs which directly contribute to R&D activities. R&D-related to pure maths can also now be included within a claim.
Improve governance around the R&D claim process in anticipation of rigorous HMRC reviews. Comprehensive and contemporaneous documentation of all R&D activities and expenditure is a key area HMRC investigate during compliance checks. Improved governance will make a claim more robust and help to support the rigour of due diligence.
Explore the benefits of the new RDEC scheme, including the above-the-line credit, and consider whether the company could claim under ERIS to take advantage of higher rates of relief.
Structure contracts and claims carefully to navigate the new regime effectively. The general rule is that the party which takes the decision to undertake or initiate the R&D will benefit. For investors, it will be important to ensure that the claimant can evidence whether R&D of that sort was contemplated at the time of entering the contract and by whom. Whether a claim can be made for large amounts of expenditure could be 'all or nothing' depending on the analysis so it's crucial that the documentation and surrounding fact pattern is well considered.
Consider whether it's necessary to submit a claim notification form within six months of the year-end to ensure that a claim can be made so that value isn't missed out on.
The evolving R&D tax regimes present both challenges and opportunities. Compliance checks are expected to be maintained in the short-medium term, however with a new advance assurance scheme currently under consultation, this may provide some welcome certainty for some businesses in the future. In the meantime, businesses should review all aspects of their claim processes to optimise relief, and ensure documentation is robust and underpinned by a reputable adviser (disclosed on the AIF) to help manage risk and anticipated cashflows.
For more insight and guidance, get in touch with Ian Rowland.
