Confederation of British Industry (CBI) – Written submission (DFG0024)

Background 

1.       As the UK’s leading business organisation, the CBI speaks for 190,000 businesses that together employ around a third of the private sector workforce, covering the full spectrum of business interests both by sector and by size. 

2. We welcome the opportunity to submit evidence to the Sub-committee’s inquiry and have been engaged at all stages of the government’s reviews of the R&D tax credit regimes. This includes contributing to several government consultations over the last few years including the consultation in 2022 on the proposed changes included in Finance Bill 2022-23 and on the draft legislation published in July 2022.
3. We welcome the Sub-committee’s interest in this area and the opportunity to support businesses in their call for a system of tax credits that supports innovation, allowing businesses to invest with certainty over the longer term in R&D, create new technology and make breakthroughs that benefit the entire economy. 
4. If you have any questions or would like any further detail, please do not hesitate to get in touch. 

Summary

1. The CBI welcomes government’s and HMRC’s continued interest in R&D credits as one part of a complete strategy to support UK innovation that also includes public R&D funding. We were delighted that the Science Minister reiterated the government’s commitment to increase public R&D spending to £20bn by 2025, and to ringfencing funding committed to Horizon Europe in the event that we are unable to associate to Horizon Europe. This funding will be essential to continue to unlock business R&D investment in the UK for long-term economic growth.
2. The CBI generally welcomes the changes proposed to widen the scope of the definition of qualifying expenditure to include data, cloud computing and pure mathematics. These are essential components of twenty-first century R&D. It is now important that the final legislation matches the intention behind these policy changes and that HMRC produces clear and consistent guidance to support the legislation, on which businesses can rely.
3. The CBI also welcomes the latest statistical updates from the ONS on private business investment in R&D. These updates show the gap between ONS and HMRC data is nowhere near as large as estimated previously – and SMEs are contributing much more to UK R&D than had been thought. In light of this, the CBI invites government to reconsider their approach to compliance and estimates of fraud in the R&D tax credits system. In particular, government should reconsider whether advance notification is a proportionate and effective way to address compliance issues. It should also reconsider whether spending 2.4% of GDP is a truly ambitious target when the OECD average is now higher than this, and world-leading international competitors achieve as much as 5%.[1]
4. There is still more work to do to ensure the UK R&D tax credit system is truly world-leading, and the CBI welcomes government’s ongoing commitment to review the system. Further policy changes the CBI’s members have proposed include looking again at the definition of R&D to ensure it aligns with OECD standards, improving the support available for innovation that supports the net zero agenda, expanding the scope of the regime to cover capital expenditure, and increasing credit payment rates to ensure the net value of tax credits remains at least at their current levels when the corporation tax headline rate rises to 25% from April 2023.

Queries raised by the inquiry 

1. Have the changes to the definition of R&D gone far enough in modernising R&D relief, and if not, what more needs to be included?

The proposed changes

1.1.        Businesses welcome the changes to the R&D tax credits system to include data and cloud computing costs and the costs of pure mathematics within qualifying expenditure. There is, however, an urgent need for more clarity from government on how this will work in practice.

1.2.        Data sets are essential for data-driven research, particularly in life sciences, bio- and med-tech and financial services. Given the importance of data sets to UK innovation, it is important for businesses to have clarity on when they can claim and when they cannot.

1.3.        In some cases, the position is unclear and businesses would appreciate more detailed guidance on how it should apply in practice. One example is the exclusion for data costs if the licence gives the user a right to share, communicate or otherwise publish the data to third parties other than for purposes “reasonably necessary for, or incidental to, the purposes of the relevant research and development”[2].

1.4.        As businesses explained to government during the consultation process on these R&D tax credit changes, publishing or sharing data with third parties is also an essential part of scientific and technological progress generally. Innovative businesses are, by their nature, involved in furthering scientific and technological advancement, and often contribute their findings to wider academic discussion by publishing in journals or at academic conferences. Regulated businesses may also be required not only to retain but to share data with regulators.

1.5.        It is therefore important for HMRC to publish guidance that makes clear that sharing information for academic and regulatory processes is clearly reasonably necessary for, or incidental to, the purposes of the relevant R&D.

1.6.        In other cases, businesses are concerned the position taken in the draft legislation limits what businesses can claim in a way that goes against the intention to modernise the rules. For example, there is an exclusion for expenditure on data and cloud computing “so far as it is attributable to a qualifying indirect activity”[3]. This exclusion makes little sense when the definition of qualifying indirect activities (QIAs) is those activities that are qualifying expenditure for R&D purposes despite the fact that they are “activities which form part of a project but do not directly contribute to the resolution of the scientific or technological uncertainty”[4]. If costs from these activities qualify when they are not stored in the cloud it is unclear why they would not qualify when they are.

1.7.        The definition of QIAs includes several elements that businesses would expect to be included in cloud computing costs: including research (including related data collection) to devise new scientific or technological testing, survey, or sampling methods; and administration or clerical work. The CBI therefore thinks that this exclusion has the potential to undermine the value of the extension of R&D tax credits to cloud computing costs and recommends that it is removed.

Further changes

1.8.        While the changes announced this year are a positive step, businesses also think that the government could go further to support UK private business innovation.

1.9.        In previous consultations, the CBI has set out in detail to government how the expansion of the R&D tax credit schemes to include capital expenditure could be a key driver in levelling up regions and devolved nations, bringing high skilled jobs and long-term capital investment to the UK. It would also make the UK more competitive when compared to other jurisdictions, including France and Ireland, which both include capital expenditure in their R&D credit regimes.

1.10.   In a recent CBI survey 19% of firms say including capital into R&D tax credits would have the greatest impact on their innovation investment in the UK, increasing to 30% among manufacturers. Firms would raise capital investment on average £1.03m this tax year, £1.3m/year by 2025 and £2.2m/year by 2032.

1.11.   CBI members also consider that any further review should look at the definition of R&D used in the UK tax credit regimes – as set out in the BEIS Guidelines – in comparison to global competitors, many of whom use the OECD’s model definition, known as the Frascati definition, in full[5].

1.12.   While the BEIS Guidelines limit claims to areas of scientific and technological advance or uncertainty, the Frascati definition includes any “creative and systematic work undertaken in order to increase the stock of knowledge – including knowledge of humankind, culture and society – and to devise new applications of available knowledge.” This broader scope captures activities such as economic research, humanities and activities in the creative industries, which do not necessarily benefit from UK R&D tax credits at the moment (although separate – and often highly valuable – sector-specific corporation tax reliefs are available for a number of those industries in the UK[6]).

1.13.   It is unclear whether the difference between the UK and the OECD definitions is a deliberate policy choice by government, or if the original intention was for the scope to be aligned, but the BEIS Guidelines were drafted in a way that diverged. Any review of the definition should consider this question, and whether such divergence limits the competitiveness of the UK’s R&D tax credit regime.

1.14.   Finally, one technical point that businesses are concerned about is that RDEC credits are paid before corporation tax is calculated and increasing the corporation tax rate to 25% from April 2023 could reduce the net value of these credits. One way to address this would be an increase in the main RDEC rate by 1.5% to 14.5% from April 2023 – this would ensure that R&D credits remain at least as valuable to business after the corporation tax rate rises as they are now.

2. How effective will the changes be in countering error and fraud resulting from spurious R&D claims and is there more that can be done, or different approaches that could be adopted?

2.1.        Businesses understand the need for the R&D tax credits system to be robust and fully support government’s desire to minimise fraud and error in the system. However, government has not explained how the latest compliance measures, including the advance notification requirement, will do that.

2.2.        The CBI notes that the government has referred to the gap between ONS estimates of UK private business R&D investment and HMRC calculations based on R&D tax credit claims in its narrative on compliance and conversations with businesses, as evidence of the need to address potentially substantial fraud in the system[7]. However, as of 29 September 2022 the ONS has published new retrospective estimates which suggest the gap is much smaller than thought, with ONS data now exceeding HMRC estimates by nearly £5bn in the year 2020.[8] While fraud and error may make up a part of any remaining gap, the ONS set out a number of other factors that could also explain it.

2.3.        Given this substantial shift in understanding, this is a perfect opportunity for government to reconsider their approach to R&D tax credit compliance. Any new measures they propose must be proportionate to the actual risk posed to government revenues, be effective at combating that risk, and take into account – and where possible mitigate – the likelihood of legitimate business claims becoming collateral damage.

2.4.        The CBI was pleased to learn that HMRC are currently reviewing their own fraud and error estimation methodology to ensure more accurate, real-time calculations are used. Businesses look forward to hearing more details and seeing the results of this review.

3. How successful is the refocusing of the relief in encouraging activity in the UK without adverse consequences?

3.1.        The CBI understands the key policy intention behind the proposal to restrict claims for sub-contracted R&D which takes place outside the UK is to narrow the gap between the level of R&D claimed for overall, and the amount of privately funded R&D taking place in the UK, on the basis the UK government should be concentrating its support where there are immediate domestic spill-over benefits.

3.2.        However, in discussions with government the CBI has questioned whether this approach aligns with government’s approach to R&D more generally, where they recognise that global collaboration on research and development has huge benefits for the UK economy and celebrate and seek to promote the UK’s place as a global innovation centre. The government’s own R&D Roadmap recognises that “research and innovation are inherently global, and international collaboration and mobility of talent are associated with more impactful research.”[9] The 2019 International Research and Innovation Strategy confirmed that the UK wants to remain a partner of choice for other world-leading and emerging research and innovation nations, attracting global talent and supporting our world-leading researchers to collaborate with the best in the world in the face of increasing competition.[10]

3.3.        This approach has proven long-term benefits for the UK economy as well: R&D is a precursor in most cases to the creation of intellectual property, which can be managed and exploited from the UK for the benefit of the UK economy long after the R&D has concluded. A competitive R&D tax credits system is recognised as a key lever government can use to ensure the UK is, and remains, a global innovation hub.

3.4.        Businesses have previously discussed with government reasons why they may not be able to undertake some of their activities in the UK and restricting businesses’ ability to claim in respect of these activities could have a negative effect in the longer term on the UK’s attractiveness as an R&D hub. For example, regulatory restrictions, access to particular pools of subjects for study, materials or demographic groups, or environmental restrictions, might make a UK-only project unfeasible.

3.5.        Businesses therefore welcome the decision to include a flexible exclusion to the new restriction on overseas subcontracted R&D to cover the most common of these scenarios, including where the research or development must take place under conditions which are not present in the UK, are present elsewhere, and which it would be wholly unreasonable to replicate in the UK.[11]

3.6.        What would be helpful is further guidance on what is meant by “wholly unreasonable” in this context. Businesses are concerned that the word 'wholly' will be interpreted literally by the courts, which could render this flexible exclusion practically ineffective. They would appreciate HMRC guidance sooner rather than later on how it should be understood.

3.7.        For example, a CBI member in the mining industry has identified that while it could theoretically ship raw materials to the UK for testing, if the main supply to which it has access is in another jurisdiction it is much more environmentally and time efficient to test them in situ. They would value more guidance on when it might still be wholly unreasonable to use a UK location even if it is theoretically possible.

4. How aware are smaller businesses of R&D relief? Is there more that HMRC could be doing in practice to help smaller businesses access relief to which they are entitled?

4.1.        While many SMEs are aware of the R&D scheme there is a concern among such businesses and the advisory firms supporting them about the level of understanding of the scheme. Some members still report high levels of cold calls from unregulated R&D advisers. Their view is that speaking to these advisers left them less comfortable because the scheme was presented in a way that seemed ‘too good to be true’ and they are concerned about reputational risk and conflict with HMRC.

4.2.        In many cases, the CBI believes SMEs’ uncertainty could be addressed by better guidance from HMRC and BEIS. At the moment, guidance either takes the form of very detailed legalistic manuals or short introductory guides. It would be helpful if HMRC worked with BEIS and businesses to produce materials aimed at non-tax specialist business managers who are involved in making R&D investment decisions and supporting any potential R&D claims. This could include webinars with live Q&As, aimed at specific sectors (i.e. R&D and manufacturing, R&D and software, etc.)  This would allow HMRC to control the narrative on when a business is eligible for R&D tax credits rather than leaving it to unregulated advisers.

4.3.        HMRC could also help SMEs by ensuring it acts proportionately and consistently in the application of its own guidance. The CBI has previously raised concerns to government about HMRC applying guidance inconsistently with case law or changing the way it interprets guidance without warning (as in the case of what counts as subsidised expenditure). We continue to hear this concern from members, particularly among SMEs. 

5. How helpful is HMRC and BEIS guidance in interpreting and applying the R&D relief rules?

5.1.        The HMRC and BEIS guidance is complex to navigate and much of that complexity is unavoidable. It is perhaps no surprise, then, that businesses’ experience with the current guidance depends to a great extent on their size, with larger businesses more likely to have access to in-house and third-party specialist advice, and access to HMRC through their CCM. Advisory firms and the businesses they support, including many SMEs, were more likely to report inconsistency in HMRC’s approach to applying their guidance and to be uncertain how the rules apply to their business. That is why many of them would value the further support suggested in paragraphs 4.2 and 4.3 above.

5.2.        In addition to the review of the definition of R&D to ensure it remains internationally competitive (as discussed in paragraph 1.11 above), businesses can also see benefit in a review of the BEIS Guidelines and HMRC guidance to ensure they are up to date and fit for purpose.

5.3.        The BEIS Guidelines have not been updated since 2010 and some of the case studies are now woefully out of date – for example, one considers the research done to determine whether a DVD player is an appealing product.[12]

5.4.        Rather than hardware, most tech innovation is now software based – and it often involves either applying existing algorithms to new scenarios or writing software by means of machine learning and open-source AI engines.  Here, the innovation results from people defining the problem and setting the parameters for the machine rather than writing new code. This scenario does not fit neatly within the UK definition of projects designed to make an advance in science or technology, as the technology already exists and the innovation is more about how it is applied. Our members would encourage the government to look further at the kinds of innovation that are taking place in tech and AI and update their examples to confirm how such scenarios could qualify for the R&D credit regimes.

6. What view do you take of the requirement to give advance notification of R&D claims? What effect would you expect it to have on genuine and spurious R&D claims respectively?

6.1.        As per our answer to question 2, it is unclear how advance notification will assist HMRC to identify spurious claims and it could potentially do serious harm to genuine claims.

6.2.        In most businesses – and particularly larger businesses – the individuals involved in preparing corporation tax returns and R&D claims are not likely to also be involved in R&D activities so are not always in a position to gather the necessary data by the advance notification date.  Early stage and small businesses are less likely to receive support from specialist advisers, so are less likely to be aware of advance notification requirements. As a result, legitimate claims from across the business spectrum could be excluded.

6.3.        We therefore recommend that government reconsiders this requirement to ensure it is proportionate to the risk actually posed to government revenues.

6.4.        An alternative would be for HMRC to engage more widely with businesses early in their planning process on a voluntary basis. A similar approach has been used with some success in other countries. The Netherlands Enterprise Agency seeks to understand the nature of an innovative project that is at the planning stage and then is able to agree with the business whether or not that project will qualify for the Dutch WBSO wage tax incentive regime.  The French government allows for companies to make a request, within the 6 months prior to a claim being submitted, for pre-approval of the R&D activities, to ensure they are applying the rules correctly. In both cases, greater up-front engagement allows businesses to factor the incentive into their decision-making and gives the government greater visibility and control over the incentives they provide. A voluntary approach also allows companies which are focused on innovation early in their development – rather than tax incentives – continued access to the scheme.

6.5.        The UK government has an advanced assurance programme for SMEs although it is not well known or understood, and once a company has engaged with it once they are not allowed to do so again. This means it is of limited benefit to innovative SMEs with multiple projects. They have also previously set up a pilot for advance clearances for RDEC. This pilot was meant to report in 2020, but the CBI are not aware of a report having been made public and the pilot has not led to an advance clearance process becoming available to large companies. It would be helpful to understand the benefits and limitations of these schemes to see whether this approach could be used more widely for the benefit of both taxpayers and the tax authority.

7. What is your experience of HMRC’s approach to dealing with claims to R&D relief which it suspects to be invalid, either through misunderstanding of the rules, or fraud?

7.1.        Businesses’ experience of HMRC’s approach is very mixed. Larger businesses with a CCM, and which undertake a lot of R&D, generally have had more positive engagements with HMRC. Some of them have found HMRC collaborative, flexible and engaged.

7.2.        Advisory firms and smaller businesses were much more likely to report issues. These include delays in payment of claims (creating cashflow issues for the business), inconsistent interpretation of what was qualifying expenditure, and lack of communication.

7.3.        Businesses of all sizes have expressed a concern about resourcing levels within HMRC, including in specialist R&D teams. They understand the constraints placed on HMRC by the pandemic and by real-term funding cuts, but are concerned that these constraints are causing a negative shift in HMRC’s engagement with taxpayers.

7.4.        One member described HMRC’s approach as ‘extremely combative’ and examples were given of drawn-out investigations which then concluded with little or no extra tax to pay, or receipt of generic letters alleging fraud when no investigation had been opened or evidence provided of why the allegation was made. Some members found that it was only when an investigation reached alternative dispute resolution or the courts that HMRC were willing, or able, to dedicate the resource to engage on the technical issues.

7.5.        Investigations and dispute resolution are time consuming and expensive for businesses and HMRC in terms of both time and the financial costs of specialist advice. This approach threatens to put businesses off claiming R&D credits for fear of HMRC denying and investigating the claim, and so undermine support for legitimate UK innovation.

8. Are there lessons the UK could learn from the tax systems of other countries about how to encourage R&D?

8.1.        It is important for the UK’s R&D tax credit regimes to remain internationally competitive, particularly at a time when more limitations are being introduced to what businesses can claim. It is therefore important to learn lessons from other countries. For example, both Ireland and France allow businesses to claim for capital expenditure under their tax credits regimes.

8.2.        The UK has capital allowances for R&D spending related to capital assets, but this is primarily of value to profitable companies whereas many highly innovative companies are either early stage or small companies which are loss-making, or are larger companies which invest on a multi-year cycle (for example in sectors like construction, defence, mining, aerospace and life sciences) and are often subject to the corporate interest restriction rules. In both cases profits may not be realised for a long time after the investment is made, so the benefit of capital allowances – and increased losses – is limited. As the R&D credit schemes pay a cash credit, this can be hugely beneficial to loss-making companies.

8.3.        Some businesses also find that their interaction with tax authorities in other jurisdictions is more predictable and positive. One member noted that, while Canada has a very prescriptive R&D credits regime, the Canadian authorities take a positive and pre-emptive approach to their relationship with taxpayers and seek to build strong relationships with them in advance of claims being made. Businesses would welcome the greater certainty and reduced administrative time required if a similar approach was taken by HMRC to all taxpayers. Similarly, as noted in paragraph 6.4 above, the Dutch WBSO regime (which subsidises wage tax rather than corporate income tax) allows for greater up-front certainty for both government and businesses.  The Dutch agency that conducts these assessments is an arm of the Ministry of Economic Affairs and benefits from being populated by experts in R&D.

8.4.        Other countries also provide examples of ways the UK tax credit regime could be extended to future proof and incentivise positive behaviour in the labour market. For example, the French R&D system provides a 200% deduction (as compared to 100% for most salary costs) for PhDs employed on their first work contract. This encourages companies to employ recently qualified staff who do not have a lot of experience. The UK already has a similar recognition of the value of graduate education in innovative companies in the additional benefits available to ‘knowledge intensive’ companies under the EIS and SEIS investment support regimes. It could consider something similar for R&D credits.

8.5.        Other countries also use R&D support to support their transition to net zero. For example, Italy provides a higher tax credit rate for technological innovation aimed at 4.0 innovation or ecological transition and Spain provides a higher tax credit rate for expenses in technological innovation activities aiming at new or relevant improvements in the production processes in the value chain of the automotive industry in Spain.[13] In the UK, we could provide additional incentives if a project aims to improve energy efficiency, reduce carbon use or support other environmental aims such as habitat formation or protection, or plastic or carbon capture.

9. How successful are the changes in R&D relief likely to be in encouraging innovation and development?

9.1.        The changes to the scope of qualifying expenditure could be incredibly powerful in encouraging innovation and development in data and cloud computing, as long as the guidance from HMRC is clear what falls within the scope.

9.2.        To drive innovation from discovery through to real-world impact upon commercialisation of the final product, it is critical to have a package of fiscal reliefs and incentives that support investment at each stage in the product life cycle. In this respect, the UK’s existing package of innovation incentives (tax credits, capital allowances & patent box) is a very powerful tool in helping achieve this. 

9.3.        However, there is still more work to do on HMRC’s relationship with taxpayers, and a proportionate and consistent approach to compliance will be key to encouraging innovation in all types of businesses across the UK.

9.4.        As mentioned above, it is important to note that the R&D tax credit system is just one part of the broad landscape that impacts business innovation in the UK, alongside public R&D funding, regulation, the skills base, access to private finance, and many others. A clear, joined up, long-term approach across all these areas is important to inspire confidence and unlock business innovation investment. In a recent CBI survey 63% of businesses, rising to 80% of large businesses, said that they would increase their innovation investment in the UK if the government set out long term (5+ year) innovation priorities and funding.

9.5.        We were delighted that the Science Minister reiterated the government’s commitment to increase public R&D spending to £20bn by 2025, and to ringfencing funding committed to Horizon Europe in the event that we are unable to associate to Horizon Europe. This funding will be essential to continue to unlock business R&D investment in the UK for long-term economic growth.

2 November 2022