R&D tax relief has been a valuable source of innovation funding for thousands of UK businesses since it was first introduced but HMRC’s approach to subsidised expenditure could soon see many of those claiming for customer-led R&D at risk of challenge.

Covid-19, Brexit and the resulting economic downturn have wreaked havoc in the UK during the last 18 months. Over 800,000 people have lost their jobs and the economy has shrunk by 9.9%. However, the tide has finally started to turn.

Businesses are now focusing their attention back on growth and recovery, rather than just survival, and for many of them, research and development (R&D) tax relief is playing a vital role in their efforts.

It has been well documented that investment in innovation is critical to a nation’s economic recovery from recession, so it is no surprise that the R&D tax incentive could provide significant benefit to businesses and the wider UK economy in the challenging years to come.

However, there is now an added complication. HMRC has started to challenge a number of R&D tax relief claims for customer-led R&D, on the basis that the underlying activities are being subsidised by the claiming company’s customers.

As a direct result of this, any businesses that entered into a contract relating to R&D, either before or during a project, needs to proactively review their R&D tax relief claim now, or they could be putting themselves at greater risk of a challenge from HMRC.

It is a move that could, if applied broadly, have a huge impact on SME businesses claiming R&D tax relief – and something that accountants and R&D tax advisers need to actively discuss with their clients.

Unfortunately, the types of businesses and projects that this change in approach could affect is broad, given that the majority of commercial R&D will be customer-led. It would include any R&D undertaken to develop products or services with a specific customer in mind.

As most businesses have little or no interaction with HMRC when they file their R&D tax relief claim, it is likely that many of them will not have realised that things have changed. In fact, the only businesses that will be aware of this will be the small number who have already been the subject of a HMRC enquiry.

There are already trends in a small number of the claims we handle for clients, and in those prepared elsewhere that we have supported through the enquiry process – but things could be set to gather pace quickly, and soon.

HMRC needs to reconsider this approach, as we believe the technical interpretation is incorrect and leads to unwelcome policy outcomes. However, HMRC is in the process of updating its published guidance on this issue, and as soon as this new guidance is live, all companies making SME R&D tax relief claims will need to reconsider their filing position and the disclosures to HMRC required to protect their business.

Why is HMRC taking this approach?

For some time now, the government and HMRC have taken a piecemeal approach towards reducing error and fraud in R&D tax claims, which is estimated to account for around £311m of the relief paid out each year. This new approach to subsidised expenditure appears to be the latest tactic to achieve this.

While the majority of R&D tax advisers actively share HMRC’s concerns about errors and fraud in such claims, our technical interpretation of the law regarding subsidised R&D expenditure and the contracting out of R&D activities is now at odds with HMRC’s, driving a deeper wedge between them and the agent market.  

There is a real risk that, should the revised approach be applied more broadly, it would not only render SME R&D tax relief vanishingly in narrow scope, but it would also create unintended and unwanted policy outcomes. There are plenty of alternative ways in which HMRC could seek to reduce error and fraud, with on obvious answer being regulation of the tax advice market. Another recommendation would see HMRC work with the Treasury and the Department for Business, Energy and Industrial Strategy (BEIS) to reform the R&D incentive to improve targeting and define a simpler rule base.

The incentive has been designed to encourage businesses to invest in more R&D, by reducing the cost of carrying it out. To achieve its policy intent, it is essential that relief is awarded to businesses and projects where it is able to directly influence whether more R&D is undertaken.

While some SMEs will develop new products in the hope of being able to sell these profitably at some future date, more will seek to manage their commercial risk by identifying customers earlier than that. Somewhat regrettably, it appears that HMRC’s new approach to subsidised expenditure seeks to penalise these efforts – and this is wrong, both technically and economically.

Ensure the best possible outcome

At a time when UK businesses are already facing increasing uncertainty and challenges, HMRC’s revised approach to subsidised expenditure could soon impact them dearly.

For the avoidance of doubt, any businesses making use of the SME R&D tax incentive and undertaking any customer-led R&D projects must act swiftly if they are to protect themselves from challenge – and it is the responsibility of reputable accountants and R&D tax advisers to ensure that their clients are well-prepared for what may lie ahead.

Preparedness has long been the key to success – and when it comes to R&D tax relief, it may now be the difference between a good outcome and a bad one.