The £1bn ban on R&D tax credits for overseas costs and the options for affected companies

Date: December 3, 2021

by Nigel Holmes, Head of R&D Technical Operations


R&D tax relief isn’t usually centre stage when the Chancellor delivers a Budget but Rishi Sunak took everyone by surprise last month.


While he added to the country’s R&D spending commitments, he pulled the rug out from underneath businesses when it came to overseas costs qualifying for tax credits. They will no longer be eligible from April 2023.


On the face of it, this change is well-meaning. It will encourage businesses to perform their R&D in the UK and not overseas, creating a virtuous circle of increased spending, investment and job creation.


However, this will heavily impact tens of thousands of businesses who perform R&D overseas. That includes plenty of SMEs because, of course, the fact that contractor costs qualify for relief means that you don’t have to be a large multinational with boots on the ground to be spending money on innovation performed abroad.


This is also a fundamental shift because companies subject to UK Corporation Tax have been able to claim on overseas expenditure ever since the scheme was created in 2000. While it is not clear exactly what the impact on claims will be, HMRC’s latest estimate of overseas expenditure is between £4bn and £7bn for 2017/18. This would equate to a loss of approximately £1.09bn in tax relief at the top end of that estimate under the new rules.


Companies usually outsource work overseas for a combination of two reasons — workers in those territories have expertise that is not available in the UK or they are better value. A common example of the type of company that could be badly hit would be a software company that outsources a lot of its work to India where programmers are not only skilled but can be far less expensive.


Relationships can also play their part. If a company has strong relationships with a supplier, then helping them to improve a product or service that would ultimately be destined for their own customers is another factor that influences why R&D may be performed overseas.


The overseas supplier could also be a key introducer of businesses to the UK-based entity or even a member of the same group of companies. It still remains to be seen whether the government will penalise overseas members of the same group.


So the big question is, what should those companies affected do?


The Chancellor did say that, like Australia, where there are similar rules, there would be some exemptions. We’re still waiting for further clarity on what that will look like here in the UK. However, we can already see that, in Australia, the rules dictate that costs are only eligible if the R&D could not be practically performed at home, so long as a few other conditions are met. These include being linked to R&D activities deemed to be ‘core’ to the country and R&D costs not exceeding those of the company’s domestic R&D.


The UK government’s approach is likely to be very similar and it will be SMEs and larger corporations in specialised industries who are most likely to benefit.


The new UK rules won’t be introduced for nearly 18 months and that gives companies a window to decide what they will change, if anything, to mitigate the impact.


Some companies will decide that their overseas expenditure is such good value that it’s not worth onshoring the work just to claim the tax relief, as it wouldn’t result in a net benefit.


Businesses could also move some or all of their R&D activity to suppliers in the UK or hire their own experts to take this work in-house. However, it will only make financial sense to do either if the additional costs — including pay, NIC and pensions in the case of employees — don’t outweigh the tax relief benefits.


The risk to the government’s aim of boosting R&D spending in the UK is that companies could also move their activities to countries with similar tax benefit schemes of their own — in effect side-stepping the Chancellor’s reforms.


The only other option is to do nothing and accept that the company’s R&D tax relief benefits will fall.


It’s unlikely that most companies will make significant changes in light of the restrictions but, for a minority of businesses, there will be a significant cost benefit to bringing R&D back to Britain. Tax advisers and companies need to see the detail of these reforms quickly to inform business decisions and ensure whatever steps they want to take can be completed in time.


If the government decides to include entities within the same group of companies in the restrictions then it will be client businesses in certain skilled industries that are most likely to feel the pressure to bring innovation back to the UK, assuming those countries don’t have their own schemes that can easily take the place of the existing relief.


This article first appeared in Taxation.

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