Scope of the review
In the budget, on March 3, 2021, the Chancellor of the Exchequer announced a major review of the research and development (R&D) tax relief system to ensure that “Britain remains a competitive location for cutting-edge research and that the relief remains fit.” to this end and that tax dollars are effectively targeted “.
The government’s goal is to increase total investment in research and development to 2.4% of the UK’s gross domestic product by 2027. Research and development tax breaks are seen as a key incentive to encourage such investments. Fostering innovation and technology is also part of the government’s strategy to achieve better dismantling after the COVID-19 recovery and reaffirms the view that access to aid should be improved rather than restricted.
Scope of the review
The extensive review is detailed in a consultation document published by Her Majesty’s Treasury Department and Her Majesty’s Treasury Department. By and large, the scope of the review is to check that:
- expand the definition of R&D;
- continue to maintain two separate support systems for larger and smaller companies;
- Make changes to the management of the system; and
- Introduce territoriality requirements to make the relief more targeted.
The life sciences sector invests more in research and development than any other UK sector, so any improvement in tax breaks will be welcomed. However, as set out below, some of the possible reform pathways for life science companies could prove problematic and lead to unintended consequences which should be highlighted by stakeholders when responding to the consultation.
Before discussing the review, it is helpful to first outline the two reliefs currently available for certain qualified R&D related expenses. Both reliefs have the same definition of R&D and qualifying activities. “R&D” for tax purposes is defined by reference to activities that are treated as R&D under UK generally accepted accounting practice and are subject to the Department of Business, Energy and Industrial Strategy (BEIS) guidelines. In general, the guidelines state that the R&D activities must take place in the context of a project aimed at advancing science or technology.
If certain conditions are met, small and medium-sized enterprises (SMEs) can benefit from an effective deduction of 230% on the qualified R&D costs. Loss-making SMEs may have the option to receive a cash refund of the tax credit in exchange for returning R&D related losses. Each repayment is capped at 14.5% of the losses available for return. For billing periods beginning on or after April 1, 2021, any repayment is subject to an annual cap of £ 20,000 plus three times the company’s total compensation and liability for social security contributions.
The Research and Development Expenditure Credit (RDEC) is also available. Although it is primarily aimed at larger companies, it can be used and, in certain circumstances, prove to be of value to SMEs. The RDEC uses a different method of calculating corporate tax relief for R&D spending. The “above the line” RDEC is considered as a trade record, increasing taxable profits (or, conversely, decreasing losses). The company is then credited with a 13% credit of the qualified R&D spend. A repayment may also be possible under certain circumstances.
The consultation document does not contain any clear reform proposals. Rather, the document vaguely alludes to the direction reforms could follow by outlining aspects of the system that need review and asking for input on whether changes should be made. Many of these issues will be of interest to life science companies, who are urged to respond to the consultation and ensure that government is informed of changes that may have unintended consequences for R&D within the sector.
The remainder of this article highlights some of the key review suggestions.
Structure and management of reliefs
The first part of the review examines whether the two relief systems should be consolidated. Consolidation can simplify the regime, which can be attractive. However, this can be difficult to achieve in practice.
There are significant differences between the two systems, and most importantly, there are circumstances where one relief may be available while the other is not. For example, an SME discharge may be available instead of the RDEC if one SME has outsourced the R&D to another company. The ability to subcontract R&D activities can be critical for biotech startups that may not have the resources and funding to conduct the R&D themselves. It is also more likely that cash repayment will be possible as part of SME facilitation. Simplification should be welcomed but should not dilute the effectiveness or availability of SME assistance, which is essential for biotechnology and life sciences start-ups.
The consultation will also take into account the definition of R&D and the types of activities that should be considered for facilitation. Unsurprisingly, the review of the current R&D definition falls within the scope of the consultation as it is based on the BEIS guidelines first published over 15 years ago.
However, the government should take into account that the definition is well understood by many companies whose success may depend on R&D facilitation. In the life sciences, research and development tax credits are often an integral part of an SMB’s financial planning. Many biotech startups will lose out for several years, and therefore the availability of SMB help can be critical to their viability and an integral part of their initial capital-raising structure.
For biotechnology and other life sciences SMEs, when considering whether to change the R&D definition, it is likely a case of “if it ain’t broke, don’t fix it”. Any change to the definition should be carefully considered to ensure that it remains broad enough to allow further developments in science and technology, while being straightforward and easy to apply.
The consultation also asked whether a territoriality requirement should be introduced for the eligibility criteria for R&D tax relief. There is currently no requirement that the R&D activities be carried out in the UK. UK companies doing R&D abroad may still be eligible for full tax breaks. However, the government wants to ensure that the facilities incentivize innovation in the UK and are appropriately targeted so that UK industry can best benefit from it. Given Brexit, it is not surprising that the government is currently questioning whether to introduce restrictions on the availability of R&D facilities for activities abroad.
However, territorial restrictions are likely to affect life science companies, especially those in the biotech space focused on medicine or vaccine development. Overseas research can be of crucial importance for the later development and approval of a new drug or vaccine. For example, in order for a new vaccine or drug to be approved by the US Food and Drug Administration (FDA), it is likely that a clinical trial be conducted in the US. Given the size of the US market, FDA approval may be essential to the viability of the new drug or vaccine. However, when tax breaks are not available in connection with overseas clinical trials, a UK biotech company may simply find it too costly to develop or innovate. Hence, a territorial requirement could become an insurmountable stumbling block for some innovations in life sciences.
If the government insists on introducing a territoriality requirement, it should be strongly advised to consider introducing outsourcing for R&D overseas, which is essential for the development of innovation.
It remains unclear how the R&D tax relief system can be reformed. Hence, it is difficult to draw any conclusions about the impact of the review on the life sciences sector. However, if the consultation provides evidence that change could lead to increased investment in innovation, especially if higher investment supports the UK’s recovery from COVID-19, it is likely that the government will be keen to introduce reforms quickly. Across the life sciences sector, affected companies and interested stakeholders are urged to respond to the consultation before it ends on June 2, 2021, to ensure that any unintended and potentially undesirable effects of the review are thwarted before concrete reform proposals are formulated.
For more information on this subject please contact Penny Simmons at Pinsent Masons by phone (+44 20 7418 8250) or email (email@example.com). Pinsent Masons’ website is available at www.pinsentmasons.com.
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