In this podcast, Graeme Blair, Head of Tax talks to Andy Royce, Head of Consulting at R&D specialist advisers, Kene Partners  about the new R&D merged scheme.

The full transcript is shared below:

Graeme Blair
Historically, there has been a differential between the claims and the process for making claims between a company in the SME sector and a large company. We have the SME scheme and we have the above the line, ie: taxable income scheme for the large companies. I understand going forward, they’re going to be merged, is that correct? And what’s the practical impact of these changes?

Andy Royce
Sure, yeah. In terms of the proposed merge scheme, the idea will be that the vast majority of companies will fall under the merged scheme, whether or not they be SME or RDEC. Historically, if you’re claiming under the SME scheme, it would be a below the line credit and the RDEC would be the above the line credit. But it’s intended that for practical purposes, everything under the merged scheme would be an above the line credit. So again, this is a credit that would appear within your accounts and within your profits as well, that you would then be taxed upon. Hence the rate tending towards 16% with the new enhanced CT rates going forwards as well. So in terms of their operation, it will still be the case that it’ll either be an offset of your existing tax or reduction in your potential tax liability. On the most part, if you’re looking prospectively, however, subject to certain set-offs regarding pay and NIC, you will still be able to claim a credit if you are loss-making as well. And that, again, will be around the 16% mark, depending on the exact tax position that you have. So the ability to claim a credit is still going to be available, even though it’s an above the line credit, as you see. But, yeah, essentially, it’ll operate in a lot of ways, practically from a tax standpoint, as the existing RDEC scheme does.

Graeme Blair
So if I understand it correctly, the SME scheme is almost coming to an end and everyone was being ported into the large company scheme with the practical impact that SMEs will be claiming lower rates. Is that a fair reflection?

Andy Royce
That’s pretty broadly correct, yes. In terms of the practical application of how they will receive their credit and the rate of benefit, it will, in a sense, be a limitation of what the previous SME scheme would look like. Like we said regarding the intensive SMEs, those would still exist under what we’d sort of call the older SME regime. The other major difference being that, again, historically we’d be looking at those subcontracted costs not being available at all under RDEC. However, going forwards, the ability to claim those subcontracted costs will still be available, provided, of course, you’re not being contracted too. But yeah, that to me, the two major differences on that side.

Graeme Blair
Amongst our client-base, subcontractor costs have constituted a large percentage of the claims. But I understand, under the merged scheme, that’s not going to be possible going forward. What are the changes?

Andy Royce
Yeah, it’s obviously a big concern because on first reading of the draft legislation for it, it does seem as though the ability to claim those subcontractor costs for a lot of SMEs is going to be limited. But I suppose it’s worth taking a step back and thinking what the purpose of that limitation has been on the subcontractor side of things.

What HMRC has always struggled with is their own ability to, I suppose, control those companies abilities to not claim for the same cost twice. So what they don’t particularly want to see is a head contractor claiming for their subcontracted costs, as well as that subcontracted company claiming for those costs. It’s always been an area of difficulty for HMRC for the SME side of things. I suppose on the merged scheme that I can to do is bring things more in line with the RDEC scheme where those subcontractor costs are much more difficult to claim. They’re only able to be claimed in very limited circumstances, let’s say, where the head contractor is a university or a charity or a non tax paying entity. So their difficulty has been to regulate those costs. And I suppose the merge scheme is pushing things more towards a regulation on that. What it does say is that where a company is being contracted to, that severely limits their ability to claim for those costs. So yeah, under the new merged scheme, it’s proposed that you wouldn’t be able to claim for those costs if you’re being subcontracted too.

The draft guidance, and actually there was some further guidance released earlier this month that aims to explain a little bit more. What they’re trying to do is push that ability to claim towards what they call the decision maker. Again, that isn’t really clearly defined, but they have given some useful examples and some scenarios. The reason for them wanting for those costs to sit with the decision maker is, I suppose, because what do you want to encourage with the scheme? You want to encourage investment in R&D and you want to reward the company. That is, I suppose, taking the financial risk on that particular project so that they’re encouraged to do it again in the future. It’s always been difficult to pin down who that is. In short, though, you still will be able to claim as long as you’re not being subcontracted to. So the important thing is to establish whether you’re being subcontracted to within that supply chain.

HMRC does give some useful examples on that side of things where, let’s say you have a tripartite relationship. Company A is seeking to set up a contract for a large scale building and employs company B for the building of that project, which would then involve company C instructing a particular firm for a specific aspect within that. So in this specific example, unless the company instructing intended that R&D, or intended or contemplated that R&D would need to be conducted during the course of that project, then that restricts their ability to claim. So it would be the case that in this example, company B, which would probably be the mid contractor, in our example, they’re going to be the main driver of that. They’ve probably collaborated with company C on it, and in that circumstances they’re probably taking the financial risk. And ultimately it matters very little to company A as to whether R&D is being conducted at all. They may be unaware of it and it’s not, I suppose, anything that. Well, actually HMRC uses the words indifference as well. If they have a level of indifference as to whether R&D is taken out or not, it will be the case that it’s not deemed that, that R&D has been contracted to company B. So whilst on the face of things, it is going to limit things, limit companies ability to claim for that subcontracted work, there’s going to be plenty of circumstances in which it’s still available. The important thing, I suppose, to understand with that is how you look at those relationships between maybe yourselves and your contractors, as well as your lead contractors, because the contractual construction is where HMRC will look at things. They will look at several factors, much as they did under the previous SME scheme in terms of who’s taking on the financial risk, retention of IP, the degree of autonomy within that contract as well. So lots of different factors to be considered in terms of advising companies on how best to go about this. It’s probably going to, because this is still draft guidance and not actual legislation as yet. We’ll see what happens in the next budget because it affects accounting periods starting 1 April. So we hope that they’re able to legislate in time for this, but it’s important to take advice and plan ahead. Also, keep good records of those sort of conversations around the time in terms of the planning of the R&D, and having a look at what sort of financial responsibilities you hold under your own contracts as well.

Graeme Blair
You say it comes into effect accounting periods, 1 April. Is that accounting periods beginning on or after the 1 April?

Andy Royce
Accounting periods beginning on or after the date for this have sort of shifted back and forth a few times, because since the original measures were announced back in 2022, things have sort of been pushed and pushed. We think HMRC themselves are struggling to put the systems in place to properly account for this. It’s important that HMRC take the time to take into account consultation on this, which to their credit, they have done. What it has meant, though, is a bit of a delay in terms of implementation, which doesn’t help businesses in terms of certainty and planning. Hopefully, we’ll see legislation on it, on it very shortly. But most of the changes that come into effect are going to be for accounting periods starting on or after 1 April 2024, with some exceptions that I’m sure we’ll come on to in a bit.

Graeme Blair
And you gave the example out of the revenue guidance of companies A, B and C that I guess you can fit quite neatly into the construction sector. If you look at the chain in the construction sector that also comes down to professional practices, is this likely to give significant change to the claims that professional practices may or may not have made in the past? What I’m thinking of is, for example, the client is company a. Constructing builder is company B, and company B then subcontracts to company C for some technical advice in an area of a building development.

Andy Royce
Okay. So I suppose within that example, it would have to go back to the nature of the contractual relationship between the three. Again, you’d be looking at primarily, if you’re company A, how much interest you’ve got in what’s happening down at the B and C level and how much control you have over that. And again, it’s how much you’ve foreseen that a lot of the contracts are not going to be very vocal on that particular scenario. So it may come down to discussions that have happened after such time. In terms of the relationship between b and C, you’re talking about probably subcontracting out for specific advice or work, and then it’s going to go to how collaborative it is between b and C. If B is again looking to contract out that element of the work and has very little idea of what’s going on in company C, then most likely it may sit within company C, and there’s an argument for that, again, if the rest of the contract is favourable in their terms, in terms of financial risk, IP, et cetera. So in that scenario, it may be the case that company C would be able to claim under the scheme, and again, on the nature of the contract, it may be the case that company B would also be able, well, sorry, would be able to claim were it to be more collaborative between B and C. And again, company A may also be able to claim if they have a greater level of involvement in the R&D and, it’s like I said, reasonably contemplated the start of the project, that R&D may have been necessary to be performed. There’s also scenarios in which companies may not be able to claim if they’re non tax paying or elect not to, in which case then you’d still be able to claim as well. You could have a contract that can be explicit on this. But again, it may be the case that work to come down to be assessed, then they may look behind the actual wording of the contract as they would in any other scenario to see the true nature of the relationship as well.

Graeme Blair
So it sounds to me like the contractual relationship is going to be perhaps more important going forward than it has perhaps in the past.

Andy Royce
Yes. And I think this is again down to the fact that it’s really difficult to directly legislate on this because you’re then interfering with those companies abilities to freely contract. I suppose, whilst legislation is always welcome, because it creates a bit more certainty, I do think that actually it’s good news that that ability to still claim those subcontracted costs is present under the merge scheme, and ultimately it’s going to reward the decision maker, or whatever HMRC you want to call it, in terms of who’s driving the R&D. In a lot of cases that will be, I suppose, company B in our scenario, because they’re going to be mainly pushing things on that side. But ultimately it could be anyone within the supply chain who’s able to successfully argue that they are the driver of the R&D, and ultimately that supports the intentions of the scheme to reward the company that is pushing for the R&D, because that’s what will create future opportunities for R&D as well.

Graeme Blair
The merged scheme has many, many hallmarks of the old, what I would call large company scheme, but there are many, many entities in the SME sector that make R&D tax credit claims. Do you think the merger of the schemes will have any practical impact on their abilities? To make claims, or their desires to make claims.

Andy Royce
Inevitably, I think that the historic generosity of the SME scheme has been there to, and the difference in between the two has been there to potentially support the smaller, obviously, it’s an SME scheme, so it’s the smaller to medium enterprises, but the ability to surrender losses at a greater rate has been, in my experience, invaluable to startup companies and things like that, who aren’t able to immediately turn a profit, which is the big difference. It may be less encouraging for them to claim going forwards. And yes, indeed, the difference in the rates, it won’t be as generous as it previously has been, may make decisions in terms of whether to invest in an R&D project more difficult, because if you’ve historically been able to say that you’re able to get 33% of those costs back in terms of a credit, it may make you R&D decision to do that project a bit easier. And if you’re looking at rates, as they’re tending towards 16-15% in terms of that, it’s lessening the margin on that. I suppose HMRC’s reasons for doing that are seeing not as much value in their returns on their own investment within the scheme. I caveat that with they’re based upon their own figures and their own understanding of those figures as well. But I do hope it’s not the case that companies refrain from claiming under this scheme. I think it’s potentially an effect of HMRC’s overall approach, whether it be legislation or their approach to enquiries, that fewer companies will be claiming, because I do think it’s an important driver of innovation in the UK. But I think it may be a consequence that fewer companies will be able to claim, or will look to claim, because of the increased complexity around things.

Graeme Blair
You use the expression “innovation in the UK”. Certainly amongst our international client base, we have seen many instances of work, maybe done outside the United Kingdom, but for the economic benefit of a UK based company, I understand those rules might be changing. What are those changes?

Andy Royce
Yeah, in terms of the foreign expenditure restriction, this was something that first came about, I suppose, the back end of 2021 or so, in terms of having a real focus on it. And in a way, it’s understandable for HMRC wanting to limit the scope of costs going abroad, it’s always been the case that companies based in the UK, historically under the SME scheme, have been able to claim for subcontractors and externally provided workers, whether or not they’re based in the UK. It continues to be the case that companies will be able to claim for their own staff costs as long as PAYE is going through the UK, etc. And indeed, consumable costs, software and clinical trials as well, will continue to be available, whether or not they’re based in the UK, as long as those costs are going through the company’s own UK based P&L.

What is and has been legislated on, albeit pushed back, so originally, I think it was intended to come in for accounting periods again starting 1 April 2023, now it’s being pushed back to accounting periods. 1 April 2024 is to limit the scope of the ability to claim on subcontracted and externally provided worker costs. When those are based abroad, there is very much going to be a limitation on that. And I suppose the justification behind it is that if it’s an investment in UK innovation, if a company doesn’t have a great amount of costs or tax going through the UK, a lot of it’s pumped abroad, then it’s supporting sometimes costs that are going offshore rather than benefiting the UK economy. So there is reason behind it. The reason they probably push things back is because it’s still very unclear from their side the circumstances under which you may be able to claim those costs, and they are very limited. For HMRC’s limited examples, what they have said is that in order for the overseas subcontracted, or certainly provided worker costs to be able to be claimed under the new scheme going forward, a) those conditions are not present in the UK, b) those conditions are present in the location in which that work is being conducted and c) finally, it would be wholly unreasonable for that work to be conducted within the UK. So, quite tight scenarios and the original examples that they gave when this was first released were very, very limited. I think the intention that they’ve outlined with that is that there will be limited circumstances. I think the use of the word wholly unreasonable makes it clear that their intention is that, however, they do give some reasonable examples within their own guidance, such as if, a and apart from the sort of obvious ones with clinical trials and things abroad, where it’d be necessary to conduct that within that foreign environment, material prototyping, where, for example, a construction company might look to be testing things within a certain climactic environment that’s just not present within the UK, and it’s necessary to engage with a foreign subcontractor, it’s clearly satisfying those three conditions. It’s not present in the UK because the climate, it’s obviously the foreign climate we’re interested in. And finally, it wouldn’t be reasonable to try and replicate those conditions within the UK. So, yes, there are limited circumstances in which it will be applied, but it remains to be seen how HMRC will apply their own guidance on that. Like I said, with the words wholly unreasonable, you’d expect that there would be a high threshold for that. However, there are useful examples of the sort of scenarios which would allow for that, basically taking a common sense approach to say, well, would it be reasonable to be aiming to replicate those conditions within the UK? Another example they do give is based upon time considerations as well. So if there were two different facilities, one based abroad and one based in the UK, and it wasn’t available, and that would make the project unachievable, then of course it would be legitimate to have those costs from the company abroad. So, yes, probably quite a high threshold, but still available in those circumstances where it’s necessary.

Graeme Blair
And turning to administration, is there any mechanism for advanced clearance on the availability of either R&D tax credits or maybe the ability to claim overseas costs?

Andy Royce
So, for many years, HMRC have run something called advanced assurance. How well staffed that was in the past. It’s been rare that that’s become available from HMRC. I think they’re taking a more active approach than that, and we’ve seen people use it to relatively helpful effects. What it does is allows you to consult with the government and set out a regime under which you can claim as long as your costs stay within that regime, then they’ll seek to approve those more quickly. It’s probably not advisable for the majority of claimants because you have to be a first time claimant. So if you’ve historically been claiming that’s of no particular use to you. So it will remain in many ways a retrospective assessment. And HMRC’s guidance on it would only be available subsequent to you claiming in the majority of circumstances, however, that is in theory available, often the best thing to do is to seek specialized advice on it. And again, it’s an area which remains relatively complex and poorly legislated on, which is unhelpful for the most part. We’re hoping that there will be some further tribunal claims to offer some touch of guidance, because it is an area which suffers from quite a bit of a lack of relevant case law, particularly because the guidance in and of itself has remained relatively unclear over the years. So, yeah, further legislation would always be welcomed in terms of certainty, but I think judicial interpretation would also be useful as well.

Graeme Blair
In the business pages of the national newspapers, there have been many stories about HMRC’s approach to compliance and almost giving the suggestion that the Revenue have been rejecting a lot of very valid claims, or opening enquiries into situations where claims are very obviously available from our client base. We haven’t experienced that and I think that’s down to Kene’s approach. What do you think sets you apart from other organizations that provide R&D advice?

Andy Royce
Sure. I mean, I think the HMRC’s approach to inquiries in general has probably been born off the fact that their own statistics and their own analysis suggests an increase in the level of fraud and error. Their own data, I think, released at the back end of last year suggested an error in fraud rates in the SME scheme of 24.4%, which they equated to around a billion pounds in lost revenue per year. And that was over the course of the last 18 months, simultaneous with suggestions that areas which shouldn’t have been claimed in were pervasively claimed in. And that’s partly because I suppose the encouragement to claim has maybe been used in an unscrupulous way by certain advisors and they’re suggesting to that within the market in terms of poor marketing practices as well, and encouraging non legitimate claims to be going through, which has probably led to HMRC’s own understanding of the higher level of fraud and error. I think what sets Kene Partners part is our strong basis of technical expertise. We have a lot of young, very intelligent graduates who have experience within the technical areas of industry, so they’re able to understand what is and what isn’t an advance within those particular industries. So we aim to work with companies that are seeking those advances. It’s not in our interest to put forward any claim that we don’t believe is a valid R&D claim, we offer the full support should HMRC enquire into the matters. But in the first instance, what we’re looking to do is build a robust claim from a technical standpoint and make sure the assessments in terms of the qualifying costs and projects are done in the proper manner. It’s probably the case that, yes, HMRC’s approach has been a little bit heavy handed on a lot of claims and that’s probably as a response, like I said, to their own suggestion that the level of fraud and error was as high as they’ve suggested. Unfortunately, I think within that a lot of perfectly valid claims have been caught up whilst they aim to reduce the number of, in their view, invalid claims, often the difficulty is the lack of coordinated response on HMRC’s side. Whilst I think further regulation of the market is welcome in order to make sure that those claims that shouldn’t be going through are not going through. It has had the knock on effect of harming perfectly valid claims, because often it may be the case that certain companies who do have a valid claim don’t wish to pursue the argument with HMRC anymore. It takes a huge toll in terms of stress and time and resource on those companies side in terms of dealing with things, if HMRC aren’t responding in a helpful manner, and by helpful, I don’t mean agreeing with everything, I mean in a constructive manner in terms of discourse. So it can be difficult from that perspective and often perfectly valid claims. Companies who’ve historically claimed for a long time with excellent projects, struggling with the process so much that they don’t wish to claim anymore. And we talked about some of the impacts of the merged scheme on discouraging perfectly valid claims. I think also HMRC’s approach to things will discourage some perfectly valid claimants to continue. I think the important thing is to have the support and to back yourself when you do believe that you have a valid claim. That’s what we aim to do. We support all of our customers throughout the enquiry process, and we believe in all the projects that we put forward in those terms. There’s a lot of positives to come out of HMRC’s approach in terms of potentially reducing some of those less valid claims within the market. However, the side effects are that , for others, it will mean that they are less encouraged to claim.

Graeme Blair
Thank you.  And an expression I’m hearing a lot is ‘R&D Intensive’. What does that mean in practice and what are the consequences for making a claim?

Andy Royce
Yeah. So in terms of the R&D intensive SMEs, this is quite a welcome suggestion from HMRC’s side of things. Amongst the proposals for the merge scheme, the idea will be that most companies, whether they’d historically been claiming under the RDAC scheme or the SME scheme, would be claiming under the new merge scheme, which involves a little bit of a lower benefit rate. Historically, under the SME scheme, you’d be looking at up to a 33% credit if you were loss making and up to about 24.7% if you’re profit making. And those rates will vary how close you tended towards break even as well under the proposed merge scheme going forwards, ultimately that will tend towards about whether you’re loss making or profit making. And obviously marginal relief would push that closer to sort of the 15% rate. It’s a little bit of a drop in that to counterbalance that, I suppose for certain companies that are looking to have a high level of R&D activity within themselves. HMRC have proposed the R&D intensive scheme. What this seeks to encourage is a higher rate of relief. It won’t be an above the line credit, it’ll be below the line credit. Much of the way that the old SME scheme would operate, it will be at a marginally lower rate, so you’d be looking up to 27% based off the fact that the enhanced deduction has gone from 130 to 86. However, you will still be able to surrender your losses at a 14 and a half percent rate rather than a 10% rate. This will be introduced for accounting periods starting from 1 April 2023 and then changed for some reason for accounting periods starting 1 April 2024. For periods starting 1 April 2023, companies that have 40% of their total expenditure devoted to R&D will be able to claim under the R&D intensive scheme and get that higher rate of relief that will drop to 30% for accounting periods beginning 1 April 2024. There will also be a year of grace so that if they fall below that threshold in the future, they will still be able to claim under the R&D intensive scheme, so that will also be helpful. The final legislation, again, isn’t quite ready on this, but the proposed scheme and how it will it’s based off total expenditure and I think they’ll look to bring in group companies as well when assessing that to stop any manipulation of those rates. But HMRC’s own stats suggest that it should benefit in the region of, I think 23,000. I think they’ve suggested SMEs, so it can be very beneficial because you are getting that far enhanced rate of relief, but it remains to be seen how easy it will be to claim under that, how your costs will be assessed under that scheme. It will obviously require quite a bit of evidence to be put forward in support of it, but it is welcome to a certain extent because it will reward those companies who are more R&D intensive on that side, those for those smaller pocket of companies, it will be very beneficial.

Graeme Blair
Thank you, Andy, that was very informative. If you have any questions, feel free to contact your normal Goodman Jones relationship partner or contact myself via the Goodman Jones website.