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Explainer: How R&D tax relief cuts will hit tech startups

R&D tax relief
Image credit: photocosmos1 via Shutterstock

From 1 April the amount that UK companies can claim in research and development (R&D) tax credits will change. Startups developing new technologies will be able to claim less tax relief, while larger businesses will receive more R&D support.

Chancellor Jeremy Hunt, who first announced the change in the Autumn Statement, said the move is aimed at reducing the number of erroneous and fraudulent R&D tax relief claims, with the eventual goal of creating a more streamlined system.

The decision has not been well received by the UK tech industry. One letter to the government, signed by more than a dozen UK startups, described the R&D tax relief changes as a “blunt instrument” that means smaller companies will be less incentivised to invest in technological innovation.

But how exactly is R&D tax relief changing, and why are tech startups so worried by the new policies?

What is the current R&D tax relief system?

The R&D tax credit system was first introduced in the UK in 2000. It is a financial incentive designed to encourage companies to develop new technologies that typically require a longer time to provide a return on investment, such as climate tech or quantum computing. Companies putting time and resources into innovating in these or similar fields can claim some cash back in tax relief.

There are currently two R&D tax relief regimes. The first is the R&D tax relief for small and medium (SME) sized companies. This, as the name suggests, is geared towards smaller businesses and startups. Eligible companies must have fewer than 500 staff, turnover of less than €100m and gross assets of no more than €86m.

Under current rules, there is a 130% deduction rate on costs for profitable SMEs under this scheme. Loss-making startups can claim tax credits worth up to 14.5% of surrenderable losses.

From the new tax year, the SME R&D deduction rate will drop from 130% to 86%, while the surrenderable losses rate will drop from 14.5% to 10%.

According to auditor BDO, support for loss-making companies will drop from an effective 33.4% subsidy to an 18.6% subsidy.

The second regime is R&D Expenditure Credit (RDEC). This is a standalone credit and is primarily aimed at larger companies, but is sometimes claimed by SMEs. Eligible companies have fewer than 500 staff but exceed both the turnover and gross asset thresholds of the SME scheme.

Under the current system, the scheme offers a tax credit of 13%, meaning eligible businesses can claim 11p (after corporation tax) for every £1 spent on R&D.

From 1 April, the RDEC rate will increase from 13% to 20%.

In addition to the tax relief rates, HMRC is introducing a more rigorous verification process for applying firms.

Why are tech startups concerned?

The changes will be felt widely. According to the Institute of Chartered Accountants in England and Wales, more than 78,000 SMEs are projected to have claimed R&D relief in the 2020/21 tax year. Meanwhile, nearly 10,500 are expected to have claimed using RDEC during the same period.

The decision has been met with harsh criticism from industry stakeholders. The chief concern is that the changes will cut support for early-stage startups at a crucial time in their growth and when companies are being battered by economic headwinds and rising costs.

A recent study by the Coalition for a Digital Economy (Coadec), a policy voice for UK startups, found that the R&D policy change could see companies on average worse off by £100,000.

Observers have also pointed to a contradiction between the government’s rhetoric and actions, with Hunt stating several times his goal is to make the UK the “next Silicon Valley”.

Charlie Mercer, head of economic policy at Coadec, told UKTN: “Cutting R&D tax credits would stunt innovation in this country at a time where the chancellor himself has set the ambition to make the UK home to the next Silicon Valley.”

Mercer added: “With such a squeeze on cash flow… founders were concerned that they would need to raise investment sooner than planned, and on potentially worse terms.”

‘We’re confident they’ll see sense’

Coadec is not alone. In February, the Federation of Small Businesses (FSB), one of the largest business groups in the country, urged the government not to go ahead with the R&D slash.

The science and technology committee of the House of Lords has also advocated for greater R&D support, while a host of UK universities signed a joint letter in October 2022 calling on the chancellor to spare R&D tax credit cuts.

Sam Aiken, head of R&D tax relief at Grantree, a consultancy helping UK tech startups access funding including R&D tax relief, said that the cuts will “deprive early-stage companies of more than £1bn of much-needed funding”.

Aiken said the cuts would be a “massive hit” for early-stage companies “at the best of times”, but introducing them during a period of rising inflation and interest rates would make things even more challenging.

However, with the Spring Budget set to take place next week, tech founders and entrepreneurs remain hopeful that Hunt will change course.

“Based on the stark impact of the cuts, the only course of action must be to reverse the cuts to R&D tax credits for these firms,” said Mercer. “If the government is serious about supporting UK startups, we’re confident they’ll see sense.”

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