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In one of the biggest policy shifts since the introduction of the R&D tax relief regimes in the UK, the government is considering moving to a territorial based incentive by removing reliefs for R&D activities undertaken outside of the UK. Arguably, such a policy may do more harm than good.

Currently, companies that undertake qualifying Research and Development (‘R&D’) activity can claim tax relief, which is calculated by reference to their eligible expenditure.  

Provided the costs are incurred within a company that is subject to UK corporation tax and meet relevant criteria, they can qualify for the relief irrespective of where the activity is being undertaken. For example, a UK company may choose to subcontract an aspect of development to another company based in Europe – provided these costs are borne by the UK company they can still qualify for relief. 

Proposed changes

The government has proposed changes to the tax relief for companies that subcontract R&D to a third party, or engage with external labour resource (externally provided workers, or ‘EPWs’), which is intended to be effective from April 2023. In the case of subcontracted activity, R&D relief for such spend will only be available where that third party performs the work in the UK, and in the case of EPWs, R&D relief will only be available where these workers are paid via a UK payroll.

The aim is to encourage innovation within the UK, to ‘buy British’, and to avoid incentivising any perceived knowledge leakage to other countries. The reality, however, is that these changes are likely to negatively impact many businesses that choose to access a global knowledge base, leading to a reduction in the value of R&D tax relief claimed. 

The consequences

R&D tax relief is a key incentive that is intended to encourage innovation and ensure the UK remains a location favoured by businesses that are seeking to grow through the commercialisation of leading-edge technologies and intellectual property. 

Whilst the intention to ensure the relief is focussed on ‘UK plc’ is understandable, it also assumes that businesses will have the commercial flexibility to change the way they engage with external suppliers and move towards UK-based resources. For many, this won’t be the case, it could simply result in UK companies claiming less R&D tax relief and reduce the incentives available for UK innovation. Key barriers businesses are facing include:

• Lack of UK resource - The Open University Business Barometer showed 63 per cent of business leaders were struggling with recruitment due to lack of specialist skills or experience; and 24 per cent believe that the lack of appropriate skilled resource will be the number one challenge over the next five years. These skills shortages are particularly seen in R&D intensive sectors such as engineering, software and manufacturing. As a result, businesses don’t have the option of buying British vs buying overseas, but rather, are accessing the resource wherever they can find it.
• Brexit/migration - Brexit has led to a number of workers returning to the EU and less migration into the UK from the EU. Arguably, with the loss of free movement with member states, accessing new workers is now more costly and time consuming than before, creating further skills shortages in short-term.

The ultimate impact of such a policy change may be that some innovative companies choose to relocate overseas, which would have a detrimental impact on ‘UK plc’.

Potential remedies

There are a number of changes the government could consider to reduce the negative impact on UK businesses, whilst retaining its main policy intent:

• Recognise that we are part of a global economy. Business will inevitably continue to use overseas resources for many reasons, so rather than a blanket exclusion, a restriction or cap could be introduced instead. By providing relief for such costs, on the basis they do not exceed a particular proportion of UK-based spend, this could achieve the dual purpose of incentivising UK-based R&D activities, whilst not stifling the ability of UK businesses to innovate.
• There are potentially other ways to allow an element to be included within a claim e.g. an allowable purpose test, where work is required to be undertaken overseas for specific commercial or regulatory reasons (advance approval in such cases would also be welcome).
• Recognise that many businesses are global in nature, therefore the government could allow relief for costs incurred with connected parties overseas.
• Recognise that the intended start date of April 2023 does not give businesses enough time to reconsider existing contractual terms and negotiate new ones, especially as these rules are still not finalised. Many companies may want to exit overseas arrangements and find UK-based resources, even if there is a commercial cost in doing so, and therefore delaying any new changes until April 2025 would give business more time to adjust to these changes.

Although this is still a draft proposal and there is an ongoing consultation, it seems clear that the government is committed to focusing R&D tax relief towards UK-based activities. Whilst we have sympathy for the policy intent, we would encourage the government to consider all options when introducing any changes to make it as fair to UK business as possible. In addition, to consider the commercial barriers that may prevent businesses from transitioning to procuring only UK-based services. Without such considerations, there is a risk that rather than boosting R&D in the UK, this policy becomes an own goal for UK innovation.