HMRC’s latest R&D Tax Credits report spotlights the impact of Covid-19 on UK companies’ investment in research and development.
Analysing the 2020-2021 tax year, the report revealed that the total amount of R&D Tax Relief distributed to companies fell from £6.9 billion to £6.6 billion – the first year-over-year decrease since the scheme’s launch more than twenty years ago.
This reduction was caused by a significant decline in R&D investments made by larger businesses. This is likely a result of the disruption caused by the pandemic.
In this blog, I will break down the key things you need to know about HMRC’s large and far-reaching R&D Tax Credits report and what the data tells us about the state of innovation in the UK.
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- Total relief fell 4% from £6.9 billion to £6.6 billion
- R&D expenditure used to claim relief fell 11% to £38.1 billion
- Total companies claiming R&D Tax Relief rose 5% to 84,565
- Funding through SME Tax Relief scheme increased 2% to £4.23 billion
- Funding through RDEC decreased 13% to £2.3 billion
Rise in small business claimants offsets decline in filings by large companies
The number of companies filing for R&D Tax Credits increased by 5% in the 2020-2021 tax year. This was driven by a 7% rise in the number of SME R&D Tax Relief claims.
SME R&D Tax Relief allows small and medium-sized innovators to recoup up to 33% of the development expenditure through cash credits and reductions to their corporation tax bill.
The roughly 79,000 SME claims were more-or-less evenly divided between companies claiming their relief as a corporation tax reduction and those that received some of their relief as a payable cash credit.
The number of SMEs claiming relief through the Research and Development Expenditure Credit (RDEC), the second of the two schemes that make up R&D Tax Relief, increased substantially.
In total, 6,485 SMEs claimed funding through the RDEC scheme, a 20% increase from the previous year.
SMEs are allowed to apply to the RDEC scheme – which allows eligible businesses to recoup 11% of their development expenditure as an above-the-line credit – if they meet certain criteria relating to their subcontractor relationships, financial ties to other businesses and funding for their development work.
Much of the 20% increase can be attributed to the government’s various Covid support programmes like the Coronavirus Business Interruption Loan Scheme and the Bounce Back Loans Scheme. Funding from these schemes was classed as notified state aid. Under EC subsidy control laws, which still affected UK businesses when these schemes were active, companies cannot receive more than one type of notified state aid for the same development work.
As SME R&D Tax Relief is also a form of notified state aid, companies funding qualifying development work with Coronavirus support money would have had to claim R&D Tax Relief on those projects from the RDEC scheme instead.
You can learn more about the relationship between R&D Tax Credits and other forms of government funding in this detailed blog.
All told, the number of small and medium-sized businesses claiming relief through one of the two R&D Tax Credits schemes increased by 8%, a clear indication that startups and scaleups are becoming more aware of this generous scheme and more eager to pursue sources of funding beyond equity investment.
The rise in SME claimants more than offset the 9% decline in filings submitted made by larger companies.
Total relief falls for the first time
The unprecedented decline in total R&D Tax Relief payments was driven by a 13% fall in the relief paid out by the RDEC scheme. The fall was caused by a £5 billion reduction in eligible research and development expenditure by larger companies.
Meanwhile, the relief provided by the SME scheme rose 2% year-over-year. However, it was not enough to offset the significant decline in the amount large companies are investing in investment in R&D.
The dichotomy between SME and large business R&D investment is understandable.
Many SMEs are reliant on innovation for growth and long-term success. It is an essential activity for them, one they were able to fund with a combination of existing capital, the raft of low-interest government loans like the Recovery Loan Scheme, and the record-breaking influx of investment in UK tech businesses.
Conversely, large businesses are less reliant on innovation for immediate growth and are, therefore, more likely to funnel their resources towards essential, day-to-day expenditure during periods of economic uncertainty.
Bigger firms also tend to fund research and development work with revenues, which were vulnerable to disruption during the pandemic.
Many firms also took advantage of the Coronavirus Job Retention Scheme, allowing them to temporarily furlough their employees. Furloughed staff were not allowed to work for their employers, meaning they could not participate in development activities, disrupting R&D efforts.
A Word on the BERD
Another interesting insight from the latest R&D Tax Credits report was the joint HMRC-Office of National Statistics (ONS) announcement that the statistical authority is tweaking the methodology behind its Business Enterprise Research and Development – or ‘BERD’ – survey.
There are two widely accepted measures of UK business investment in research and development: the BERD survey, which asks a pool of companies about their spending and extrapolates its findings across the British economy; and HMRC’s figures for how much expenditure companies are using to claim tax relief.
Since 2014/15, these two figures have been gradually diverging, with the BERD survey estimating that companies are spending significantly less on R&D than their tax relief claims suggest. In its 2019-2020 R&D Tax Credits report, HMRC recorded that companies had claimed relief on £47.5 billion of R&D investment, nearly double the BERD survey’s estimate for the 2019 calendar year: £25.9 billion.
This large discrepancy has raised concerns that the R&D Tax Credits scheme is being systematically exploited by unscrupulous R&D Tax Credits providers and their unsuspecting clients, who are put at risk of an HMRC enquiry. It has also prompted questions about whether the scheme effectively incentivises innovation and generates value for money for the taxpayer.
The suspicion that R&D Tax Relief is not creating a sufficient return prompted then-Chancellor Rishi Sunak to announce a series of changes to the scheme, including the restriction of relief on development work subcontracted overseas. If legislated, these changes will apply to accounting periods starting on or after 1 April 2023.
However, the joined HMRC-ONS announcement revealed that the BERD survey has significantly underrepresented the amount of development work conducted by SMEs, which has skyrocketed in recent years. “Essentially, the BERD survey population has under coverage for small businesses,” the organisation said of its methodology, which has remained unchanged since the 1980s. The ONS is therefore altering its statistical model to account for the changes in SME investment and will bring its estimates more in line with the figures published by HMRC.
ONS is still working on its revised methodology, which will require peer review. However, its preliminary updated figures for the survey are much closer to those in HMRC’s report. In the 2020-2021 financial year, companies claimed relief on £38.1 billion in eligible expenditure.
The BERD’s original numbers for the 2021 calendar year put business R&D expenditure at £26.9 billion – a difference of £11.2 billion – while its recalculated ‘uplifted’ figures put development expenditure at £43 billion – a difference of just £4.9 billion.
The Covid-19 pandemic had a profound impact on businesses, creating unprecedented logistical and economic disruption that hampered their ability to innovate.
This year’s R&D Tax Credits report shows how the pandemic had a particularly large impact on bigger companies’ ability and appetite to invest in innovation, an essential activity for ambitious startups and scaleups.
While the impacts of the pandemic will be felt long into the future, we should expect to see a recovery in large company investment in next year’s figures, though it remains to be seen what impact the long-tail disruptions such as the supply chain squeeze, and other economic headwinds, will have on UK R&D.
It will also be interesting to see what impact the ONS announcement has on government sentiment towards the R&D Tax Credits scheme.
The ONS’ announcement that much of the discrepancy between its BERD survey and HMRC’s data was down to a statistical modelling issue could temper the government’s desire to change the scheme in a way that would make it less generous, especially at a time when they are attempting to achieve more than 2% economic growth.