Defence Online

Unpacking R&D tax relief changes for A&D supply chains

Homeland April 22, 2024

New figures from the ONS show that R&D expenditure by UK businesses reached almost £50 billion in 2022, growing by £3 billion on the previous year’s estimate. As these firms invest in the future to develop new products and solutions, many will be looking to claim R&D tax relief.

Jenny Tragner (Director and Head of Policy, ForrestBrown)

The aerospace and defence (A&D) industry, which spends approximately £1.6 billion a year on R&D activity, is a significant contributor. But what will recent changes to the government’s R&D tax relief programme mean for businesses in this sector, and their supply chains?

A new era for R&D claims

R&D tax relief in the UK is a powerful incentive for businesses, encouraging innovation by rewarding investment in R&D projects. R&D tax incentives have been described as the government’s flagship innovation tax policy, with a key role to play in achieving its ambition to make the UK a global leader in scientific innovation.

Tax relief for R&D was previously split into support for smaller businesses through the SME scheme, and larger firms through the Research and Development Expenditure Credit (RDEC), which operated on different rates of relief, with different rules on how to claim. In 2023, there was a ‘rebalancing’ of the rates, with a rise in fraudulent and erroneous claims prompting a reduction in the rate of relief for SMEs, alongside an increase to RDEC. At the same time, HMRC continued to scale up its compliance resources.  HMRC’s evidence to the Public Accounts Committee included the confirmation that over 20% of R&D claims are now subject to compliance checks by HMRC, compared to 1% previously.

In the government’s last Autumn Statement, it was announced that the SME and RDEC incentives would be merged into a single R&D tax relief scheme, operating under the 20% RDEC rate from April 2024. The changes mark a step in the right direction by streamlining the claims process for A&D firms, and the draft guidance has provided some clear examples on sector specific challenges that some businesses may be grappling with ahead of the changes. However, there are still some grey areas surrounding the implementation of the single scheme that the sector requires much needed clarity on – and the deadline to prepare is approaching rapidly.

‘Grey areas’ around R&D subcontracting in draft guidance

While some draft guidance for the single scheme has now been provided, it is still under consultation and only covers some aspects of how the revised incentive will work. The new scheme is live from 1 April 2024, offering A&D firms little time to plan ahead for the new framework.

Perhaps more concerning is the lack of clarity surrounding the impact of these changes on supply chains, particularly on the issue of contracting out R&D. Aerospace systems are highly integrated, and often rely on components from multiple suppliers that are conducting R&D to make bespoke components, so any policy changes that could affect commercial relationships for subcontractors will undoubtedly add another layer of complexity.

One area which has been particularly uncertain in recent years has been how to determine whether R&D has been contracted between parties and thus which entity can make claim for R&D tax relief and under which scheme. Disagreements on this point went as far at the First-tier Tribunal yet still failed to resolve the issue, with HMRC continuing to consider the presence of any customer contract to which R&D relates as evidence of contracting out.

It is therefore no surprise that the news scheme has introduced a new legislative definition. This new definition aims to align the right to claim relief with the decision-maker for the purposes of the R&D carried out. If a company is carrying out R&D to deliver goods or a service to customers, its right to claim R&D tax relief should not be affected unless that customer has specifically requested the R&D be carried out.

This brings R&D tax relief into line with the policy intent of encouraging more R&D investment. However, it will inevitably mean changes for many A&D companies who will need to review their supply chain contracts with the new definition in mind. Where the new rules trigger a change from the previous tax relief position, this opens up the risk that R&D relief becomes a bargaining chip in commercial negotiations.

Overseas R&D restrictions finally bite

Restrictions to overseas R&D were tabled back in 2022 but delayed following strong feedback from industry. Following this temporary reprieve, the changes – intended to refocus tax relief towards innovation in the UK by excluding third party costs where activities are carried on outside the UK – will come into force alongside the introduction of the merged scheme.

The original areas of criticism remain valid, in particular the potential to push R&D away from the UK. In a global market for R&D, multinational businesses may choose to locate their R&D activity in more welcoming jurisdictions. The changes also add complexity at a time when the direction of travel is towards streamlining the rulebase. Existing caps which reference a company’s PAYE and NIC liabilities already prevent companies with little or no UK substance claiming large cash sums.

There are exceptions where it can demonstrated that geographical, environmental, social, legal or regulatory conditions required for the R&D are not available in the UK. But cost or availability of workforce is not considered a relevant exclusion, despite ongoing the UK’s ongoing skills challenge.

A single scheme – in name only

Alongside the merged scheme, enhanced R&D intensive support (ERIS) will be available for loss-making SMEs meeting the intensity condition (R&D expenditure making up at least 30% of total business expenditure). Those eligible can claim a more generous rate of relief (up to 27%), although this is still a reduction to the rate available prior to April 2023.

Positive progress, but the clock is ticking

Following a period of instability, the reformed R&D tax relief incentive marks the government’s intention to bring to a close its long running consultation into the scheme. Judging from the draft guidance provided, HMRC has listened to the concerns of businesses likely to claim relief through the merged incentive, providing practical guidance on new areas such as the treatment of contracted out R&D. But the timetable for implementation remains tight, meaning A&D companies should be preparing now to ensure they understand what the changes mean for them and their supply chain partners.

Article submitted by Jenny Tragner (Director and Head of Policy, ForrestBrown)

aerospace R&D

Post written by: Vicky Maggiani

Vicky has worked in media for over 20 years and has a wealth of experience in editing and creating copy for a variety of sectors.