Potential changes to the overseas expenditure rules for R&D tax relief and what they mean for your business
New changes to the Research and Development Tax Relief and the PAYE and NICs cap on payable credits could prove to be bad news for many SMEs claiming tax relief that could come into effect in April 2023. The PAYE and NICs caps were however introduced in April 2021.
For the Spring Budget 2021, the Government reviewed the R&D SME and RDEC tax relief schemes. The objectives of this review were to ensure that the UK remains a competitive location for cutting-edge research and that the reliefs were fit for purpose and that taxpayers are constructively targeted. Alongside this, a published consultation explored the nature of the R&D investment private sector in the UK. It investigated how the relief supports or impacts the sector and sought to devise changes where appropriate. Then the Autumn Budget 2021 brought about three key changes to reform the relief schemes. One of these changes – that will be explored in this article – is “to capture more effectively the benefits of R&D funded by the reliefs through refocusing support towards innovation in the UK.”
The Spring Statement 2022 and the Government’s tax administration and maintenance day announced further details of the reforms, and draft legislation is now being published to implement them.
The scheduled draft legislation will include the following: (not all changes are described here)
The relief will now endeavor to focus on effectively more UK expenditure. This is so that more of the spillover benefits – such as employee skills and industrial know-how – produced by the R&D activity will benefit the UK. It ensures that, with narrowly defined exceptions, payments for subcontracted activity will only qualify where that activity takes place in the UK – and that the costs of externally provided workers (“EPWs”) will only qualify where those workers are liable for tax under PAYE, or where the same narrow exceptions apply.
The legislation is set to take effect in accounting periods on after April 2023. Rest assured that the legislation is only a draft at this stage as stakeholders are consulted for their views. The results will be published in the Finance Bill 2022-23 to be approved by the Chancellor of the Exchequer; now Kwasi Kwarteng. The Finance Bill is presented to the House of Lords to be debated, not amended but only after the Budget resolutions.
The government has an ambitious target to raise the total investment in research and development to 2.4% of UK GDP (£60bn spend in today’s money) by 2027 (from 1.74% of UK GDP and a £35bn spending currently). R&D tax reliefs play a key role in incentivising this investment by reducing the costs of innovation. These measures will incentivise R&D spending on qualifying activities, as the government wants to use this investment to raise domestic and international business investment into UK R&D, increasing economic productivity and prosperity through new products, services, and jobs and helping to transform public services. The specific legislation in question is sections 1134 and 1136 of the CTA 2009. Due to the current political landscape, it is difficult to ascertain what the impact may be on R&D. Especially with the appointment of Liz Truss as the new PM, and with her, that means a new cabinet that will see Jacob Rees-Mogg as the new Secretary of State for Business, Energy and Industrial Strategy that oversees R&D.
The new condition in the legislation for R&D expenditure is that it must be from the UK or qualifying overseas expenditure, these are defined in 1138A of the CTA 2009. A subsection of 1138A defines the circumstances in which exceptions are made that allow for overseas expenditures to become qualifying expenses. The narrow exemptions to the restrictions, with the legislation pertaining to the ‘qualifying overseas expenditure’, are that these are attributable to activity undertaken overseas that is necessary due to geographical, environmental, or social conditions not present or replicable in the UK (for example, deep ocean research), or legal or regulatory requirements which prevent the R&D being undertaken in the UK (for example, clinical trials). Commercial reasons, such as cost of the work, and availability of workers, are specifically excluded.
HMRC has also mentioned that the 65% restriction for unconnected parties on the qualifying element of a subcontractor or EPWs’ activities is to be applied after the assessment of the quantity of the qualifying R&D activity for tax purposes.
The Treasury is, however, permitted to further limit these conditions by regulations.
No further detail can be provided at this moment to the above conditions so we can only assume that there is a level of interpretation needed by both HMRC and the courts that have yet to be seen.
It is also worth noting that there is no mention in the legislation as to how a company with overseas offices or resources will be impacted. It is also unknown if a company that has subcontracted R&D work to a domestic business that then went to an overseas company – if this will have any effect on an R&D claim as well. Again, as there is little information here interpretation will be needed to make an informed decision.
The measures overall, are expected to have a significant business impact on approximately 90,000 businesses claiming R&D tax reliefs. Firstly, what businesses can do to stave off any negative impact that could affect their R&D claim is to investigate whether there are any subcontractors they work with either directly or indirectly. They would then have to determine if there is a legitimate reason the subcontracted work had to be conducted outside of the UK. These reasons would need to fall inside the realm of the exceptions that were mentioned above that included geographical and regulatory requirements.