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R&D Tax Credits

To Be Or Not To Be… An R&D Leader

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When it comes to innovation, research, and development, the United Kingdom presents a study in contrast. It’s ranked among the top three “innovation economies” in Europe (alongside Switzerland and Sweden)—and fourth overall among all economies. It’s home to four of the top ten universities in the world, and more than 75 Nobel Prize winners—second only to the U.S. in both categories. 

The government offers a wide range of R&D incentives (available to various constituencies, and currently used by 60,000 companies in aggregate)—an R&D tax credit, a generous R&D super-deduction, a one-year R&D allowance, and a patent box scheme—which it has continued to sweeten since the program’s introduction in 2000. And in 2018, the United Kingdom ranked third among OECD countries in government support to business R&D, as a percentage of GDP—doling out £7.3 billion a year in tax credits and £1.1 billion a year in patent box benefits. 

And yet, when you look at overall R&D spending, the United Kingdom punches well below its weight. The whole point of incentive programs is to stimulate privatesector R&D spending—yet barely more than half of the financing comes from businesses, well below the OECD average of 62.5%. 

According to the OECD, in the last three decades, the U.K.’s overall R&D intensity (total R&D share of GDP spending) has barely budged from its current level of 1.7% (by contrast, the United States has just surpassed 3%).

And, because so many fast-growing rivals have outspent it, the U.K. has dropped from ninth in the world to 20th in that category, below countries like Slovenia and the Czech Republic. The U.K. spends 40% less on R&D as a share of GDP, for example, than South Korea (a country whose economy it dwarfs)—and one-tenth of the $550 billion the U.S. spends in a year. Against that backdrop, the government’s stated goal of reaching a 2.4% share-of-GDP rate within six years seems more a post-Brexit talking point than a credible target.  

So where’s the disconnect? There are plenty of opinions swirling around. Some wonder whether the U.K.’s incentives are misallocated—too generous in some places, not generous enough in others—and too complicated overall to make sense. 

Others fret that both foreign and homegrown businesses, having lapped up the government milk to nurture its innovations, then simply move to the United States to exploit them. The government proudly trumpets the fact that more than half of all U.K.-based R&D business spending is undertaken by foreign-owned companies—and, in fact, the U.K.’s R&D tax regime is unique in that it does not require the expenditure to take place in the U.K. (Almost all other countries have rules limiting overseas spending.) 

The government has taken several steps to address these points. It announced that it intends to double its R&D spending to £22 billion by 2025 to help “unleash a new wave of innovation.” In an effort to keep U.K. innovators at home longer—and encourage them to go public in their home country—the British Business Bank has launched the Future Fund: Breakthrough, a £375-million scheme aimed at encouraging private investors to team up with the government and invest in innovative U.K.-based companies. 

The government has also created a new agency (Advanced Research and Invention Agency, or ARIA)—loosely modeled on ARPA, the groundbreaking 1958 U.S. agency that eventually gave birth to the Internet—aimed at catalyzing homegrown, shoot-for-the-moon innovation. (ARIA’s launch has been delayed by well over a year; critics charge that the future agency’s purpose is unclear and that its relatively meager, £800 million budget—under 2% of the country’s science spending—would be a drop in the bucket relative to its goal.) 

But probably the most consequential decision was announced in March 2021: a top-to-bottom review—with public input requested—of R&D reliefs to ensure that the program is competitive, up to date, and focused on the right companies. 

Will that do the trick? Not everyone is onboard. According to a provocative report in May 2021 by Cambridge University’s Centre for Business Research, the U.K.’s 20-year-old R&D tax credit system has “completely failed to deliver” on its promise, noting that aggregate business expenditure on R&D in the U.K., as a percentage of national income and net of tax credits, is between 10 and 15% lower than it was before R&D tax credits were introduced. 

The report also argues that the Treasury’s £1.1 billion annual patent box plan has failed to meet its objectives, claiming that the lion’s share of the benefits has gone to companies that would have likely conducted the patent work regardless (or have taken it overseas).  

There may never be a more consequential time to look carefully at the U.K.’s generous-but-much-criticized R&D incentive plans.  

What Constitutes R&D?  

The United Kingdom’s definition of R&D shares some characteristics with the U.S.’s—but it is far more sharply circumscribed. While the U.S. rules allow for improvements and innovation in many industries, the U.K.’s R&D incentives are open only to advances in science and technology. And, while the U.S.’s definition of R&D requires only that the development be new to the applicant’s company, in the U.K. it must aim to advance knowledge across an entire field or industry—a much higher bar. 

To claim the tax incentive, a taxpayer must explain: (a) how the project attempts to advance overall knowledge or capabilities in science or technology, (b) what scientific or technological uncertainties the project is seeking to resolve, and (c) what actual processes it has used to attempt to resolve that uncertainty. As in the U.S., whether an R&D activity succeeds or fails does not affect its eligibility for the incentives. 

Qualifying expenses generally must be directly connected to the R&D activities. These include employee costs, software and software licenses, essential ancillary activities such as leasing labs, equipment and computers, materials fully consumed in the R&D process (and not sold to others), and utilities. 

As part of a larger review of its program, the government has announced it is considering broadening its scope of qualifying expenditures to include data and cloud computing. 

Subcontracting costs are generally limited to 65% of the total expenditure, and for large companies claiming the Research and Development Expenditure Credit (RDEC, described below), only payments made to certain types of subcontractors (for instance, universities and scientific research organizations) are eligible. Where expenses are commingled, only the portion directly related to the R&D work can be claimed.  

No industry is excluded and there is no minimum spend required to qualify. R&D incentive claims are filed with the corporate tax return, within two years of the fiscal period in which the qualifying expenses were incurred. Government scrutiny of returns is high, rules are strictly enforced, and audits are known to be grueling. (That’s why it makes sense to engage R&D specialists from the start for help in clearly documenting not only the expenses but also their scientific and/or technological eligibility.) 

What’s Available, and Who’s Eligible? 

When it comes to R&D tax incentives, the U.K. draws a bright line between small- and medium-sized enterprises (SMEs) and larger companies, with SMEs entitled to more generous benefits. But first they must ensure they qualify: An SME must have fewer than 500 employees, annual turnover of less than €100 million or a balance sheet total under €86 million. 

No more than 25% of the company share capital can be owned by large enterprises. And there are enough additional specific rules concerning shareholders and linked companies to give even a seasoned tax lawyer a headache. (This may be one reason why so many small businesses fail to even apply for the benefits—a problem the U.K. has in common with the United States.)  

The government offers four kinds of R&D incentives: Large companies generally can apply for an R&D tax credit (RDEC); qualifying SMEs can get an R&D super-deduction; and all qualifying companies are entitled to a one-year R&D allowance and/or a patent box benefit offering a reduced income tax on profits from qualifying intellectual property. The U.K. also offers numerous cash grants and loans, aimed at stimulating both R&D and economic growth in targeted areas.  

One attractive benefit of the tax credit and super-deduction is that they can lead to refunds if the taxpayer has no liability. The RDEC headline pre-tax rate was increased in 2020 from 12% (9.7%, post-tax) to 13% (10.5%, post-tax) for large applicants. 

Unused RDEC benefits may be carried forward to future accounting periods or shared with U.K. affiliates having corporation tax liability in the same period, if desired. While SMEs may claim credits under the RDEC scheme under certain circumstances, the SME super-deduction is generally more advantageous, allowing a deduction of 230% of qualifying costs from taxable profits. 

SMEs in loss positions may also claim a tax credit worth up to 14.5% by surrendering the loss. All companies are entitled to a 100% allowance on qualifying capital expenditures (plants, machinery, buildings, but not land) in the first year.  

Profits earned on patented intellectual property get a reduced corporate tax rate of 10% (compared to the ordinary rate of 19%), under certain conditions: Companies must be paying corporate taxes, earn profits from the patented inventions, own or have exclusive rights to the patent, and have contributed “significantly” to the development of the innovation. 

They also must elect into the scheme. There are no restrictions on when the patent was granted; profits earned while it is pending (up to six years) can be included in the accounting period of the grant. As required by the OECD’s Base Erosion and Profit Shifting (BEPS) project, companies must also demonstrate a nexus between the profits falling within the patent box and the R&D activities that generated the underlying technology. 

Another advantage: The patent box and R&D incentives exist side by side—meaning, they can be generated from the same qualifying activity.  

Small Business, Big Impact 

Many countries are making special efforts to include small businesses/start-ups in their R&D eligibility. That has certainly held true in the United Kingdom since the start: SMEs were the very first group to benefit in 2000, when the program was launched, and they have been repeatedly singled out for increases—both in allowance rates (2012-13, 2015-16), and in the payable credit rate (2014-15). 

So, it’s no surprise that in sheer number of recipients (although not funds), SMEs have accounted for more than 90% of R&D tax relief recipients, according to the OECD.  

Still, the government is concerned about low application rates among eligible SMEs. In response, they are reportedly considering a more generous headline rate for SMEs, as part of a larger effort to make their overall R&D scheme both simpler and more appealing.  

The Takeaway: Whither the Future? 

The United Kingdom’s innovation agenda appears to be at an inflection point, and there are plenty of questions buzzing around. Have the long years of Brexit struggle left its sense of self dazed and confused? Is all the government largesse being targeted correctly? 

Are the lofty goals now being promised actually realizable? With criticisms from outside and disappointments within, the entire R&D incentive program is under the microscope—and the top-down review and public input now in progress are likely to bring change.  

Some aspects of the coming changes are already visible. To address the generally accepted concerns that the system is too complex, too cumbersome—and too loose when it comes to keeping the spoils of its innovation investments at home—the government is considering consolidating the current bifurcated R&D incentive regime into a single credit, modernizing the types of expenditures that qualify, and making distinctions between R&D that takes place in the UK versus abroad.  

There will likely be more change to come. Given the speed of both technological evolution and competition, it’s worth keeping a close eye on how quickly—and how well—this highly rated “innovation economy” unfurls its true potential.