Should the Government be criticised for their handling of the R&D Tax Credit Scheme? - Stuart Lisle

The Government has recently come under renewed criticism over mismanagement of the R&D tax credit system, but is this really fair? The Government's tax credit scheme was originally introduced in 2000 to encourage companies to invest in R&D and we have seen a number of changes (which started with the guidance issued in 2002 and subsequently amended in 2004).  Since then further changes to the guidance have been drafted as HMRC specialist units have become more ‘expert’ in the field and have seen larger volumes of claims. In recent months we have seen some extremely severe criticisms from parts of our profession in respect of some of the draft internal guidance being produced by HMRC, but is this criticism really fair?

A number of the large accountancy firms seem to have misinterpreted new guidance being developed by HMRC, suggesting it means that any work that results in anything being sold is production activity and does not qualify. This blanket interpretation would disqualify a lot of bespoke machinery and plant from the tax credit system, even if scientific and/or technical uncertainties were resolved during its development. From our experience of dealing with claims across a broad spectrum of industry sectors, our review of the guidelines and our discussions with a number of the HMRC specialist R&D units this interpretation of the new guidelines is overly harsh. 

HMRC have identified an issue relating to claims being made for the costs of new product being put through production runs in order to fine tune the production process as consumables for R&D.  The technological uncertainty with regards the product appear to have been resolved and the initial production runs are part of the production process.  This seems to be a fair interpretation of the rules.  If, as a result of the production process, an issue is identified that suggests that there is further uncertainty there may well be a further qualifying R&D project to resolve that.  Any R&D expenditure on developing the product (whilst technological uncertainty is being overcome) still qualifies, HMRC have simply tried to sharpen the focus on the line that divides true R&D from production.

The crux of the problem is that they are worried about big companies coming in and claiming for commercial production. There is a line that needs to be drawn there.

In July this year, the CBI and EEF joined accountants to lobby the Government to try and revise the scheme - urgently. It has been claimed that HMRC started refusing claims last year, with the number refused accelerating through 2009. There is now a huge backlog awaiting approval, which is delaying the delivery of millions of pounds of tax credit relief across the industry. BDO have not experienced this as a general trend.  This has only happened when there are genuine concerns regarding areas of the claim, or where the claim includes the costs for a “whole system prototype” which has been subsequently sold – more on this later.

There certainly seems to be a considerable amount of ‘HMRC bashing’ going on in the press from a number of firms, however our R&D teams are not experiencing these difficulties, regardless of the which R&D unit they are dealing with or which industry sector. The key to a successful claim is the quality and robustness of the submission.

Sub Contracted R&D services

This is another area that has received considerable recent comment in the accountancy press.  In 2003 the legislation was changed to allow an SME that is providing R&D services to a large company to claim R&D relief for the costs it incurs (despite being remunerated for this work) under the large company scheme, since the large company itself is unable to claim itself for this work.  The idea behind this was to encourage all work in the R&D supply chain to be undertaken in the UK.  Again, our experience is that this continues to be the case, although there are the usual challenges from HMRC to ensure that the claim is accurate, with no obvious change in HMRC policy or interpretation in this area.

It should also be noted that despite the poor tax revenues currently being experienced by the Treasury, HMRC continue to process our claims promptly, often within a couple of months of making the claims.

Prototypes

The treatment of prototypes that have been built during the R&D process have been the subject of a recent exchange of views in the Tax Journal, with Peter Faherty, Team Leader, Enterprise, Innovation and Intangibles team, HMRC writing an open letter to the editor responding to a previous article by Anthony Newgrosh of Vantis. In his letter he clearly sets out that true prototypes are qualifying costs, whereas those constructed for sale to a customer are not.  This is an area that we have been expecting some definitive guidance on for some time as it has caused long arguments with HMRC regarding expensive “first of class” high value products and whether they are prototypes or simply the first of an often short production run.

In addition to this I would add that, despite some long running arguments that we had with HMRC regarding the classification of a prototype and whether selling it changes its nature, Peter Faherty’s comments have to make sense. They do not prevent the claiming of the costs in design, testing, etc, whilst the technological uncertainties are overcome, but the actual costs incurred in building this saleable product cannot be”.

The future?

Taking the lead from abroad

Our system is not ideal, but it is getting better, the uncertainties are being ironed out and HMRC are continuing to learn and develop their knowledge as they see more and more claims. is there a better way? Maybe, but do we want to throw everything away and start again, with the further confusion and learning that would cause?

Some commentators have suggested that one solution would be to try and replicate the Canadian system where the authorities publish guidance that explicitly distinguishes between experimental and commercial production and then provides a "claw back" on tax relief claimed if the company then goes on to sell the trial goods. In Australia, applications for R&D are made to OzIndustry, the Australian equivalent of the DTI, which then reviews applications and passes successful ones onto the Australian Revenue. Our rules are based very much on the Canadian rules that have been place for decades longer than ours – this was a deliberate choice when the DTI guidelines were originally written in 2002/04.

Overhaul the whole system?

The UK think-tank, Policy Exchange, said in September that the whole R&D tax credit system should be abolished and the funding channelled into innovation elsewhere. The think tank claimed that the tax credit system had done little to enhance R&D innovation in the UK (in 2007, R&D accounted for 1.79% of GDP compared to 1.8% in 2001) and urged for the extension of tax relief for small companies and providing "seed capital" for innovative businesses. However, in my view, R&D tax credits continue to be part of the lifeblood of early stage technology companies, which rely on this boost to their cash pool once a year and is directly linked to their innovation effort.