Leyton UK – Written submission (DFG0025)
Leyton is a leading consultancy in the UK specialising in R&D tax relief, among other innovation incentives. Leyton operates in 13 countries with c. 24,000 customers and 2,200 employees.
In July 2022, the government published draft legislation containing R&D tax relief changes. This draft legislation is to be included in Finance Bill 2022-23, which will apply for accounting periods beginning on or after 1 April 2023. As explained below, we believe that the current draft legislation may have an adverse impact on achieving the policy objective of raising the total investment in research and development to 2.4% of UK GDP by 2027.
We do recognise the need for increased compliance and regulation to curtail abuse but ourconcerns are shared throughout Leyton’s professional network of taxpayers and other advisers. The strongest objections are to the pre-notification of claims and the inevitable unintended consequence that many businesses will lose access to R&D relief. This downside outweighs any potential benefit of such a measure. While we understand HMRC’s reasons for requiring pre-notification, we trust that the collective concerns submitted to this sub-committee will be taken into account.
We welcome the expansion of qualifying expenditure for both the SME Scheme and RDEC to include licence payments for datasets and cloud computing costs. Such costs are an integral and substantial cost for certain companies undertaking R&D and we consider that it is right that they be included in R&D claims. Our points below are not suggestions to amend the legislation, but instead requests for further guidance where there is a lack of clarity.
Licence payments for datasets
We would welcome further HMRC guidance on when datasets will be considered “used directly for R&D in a qualifying R&D project” and on when a dataset is considered to have a lasting value to a business. We note that where an end user access agreement covers multiple datasets, not all of which are to be used in a qualifying R&D project, or where access to data is granted as part of a wider package of services, the claimant will be required to apportion costs. We would welcome HMRC guidance on how this apportionment can be made. Dataset access can be provided in a number of ways, for example an annual licence for unlimited access to real time data or on an individual dataset licence basis. The annual licences can be very expensive. How would HMRC suggest dataset costs are apportioned where access to data is granted as part of a wider package of services and the service provider has not provided an itemised bill? We consider that published guidance, including worked examples, will be important in ensuring that the new rules are applied appropriately and consistently.
Staffing costs for creation of datasets
We would welcome further clarification in this area. In particular, we would be grateful if HMRC could provide published guidance on how we draw a distinction between collecting data for R&D purposes and market research.
Cloud computing and software
Our experience suggests that most suppliers traditionally provide a single line item charge for datasets and cloud computing services. If suppliers choose to change their billing model to provide a breakdown which is relevant to claimants (and it’s not clear to us that they will), we consider that a grace period will be required to enable suppliers to reach a level of granularity of the kind provided by popular provider Amazon Web Services. Where a bill does not provide a breakdown, we consider that it could be difficult, in practice, to make an apportionment. It would be helpful to know a percentage of the total cost which HMRC would reasonably expect to be qualifying and non-qualifying in cases where a package is acquired with no breakdown of the individual components of that package provided. The apportionment will be difficult for claimants to determine absent information about the inner workings of the different suppliers, which we suggest is unlikely to be forthcoming (and likely to involve trade secrets). Uncertainty in this area could make it very difficult for claimants to claim and, in turn, mean the government’s proposed changes have a limited impact in practice. HMRC guidance on the appropriate way to make an apportionment in this scenario is essential.
Multinational top-up tax: UK adoption of Organisation for Economic Co-operation and Development Pillar 2
Modernising the R&D regime will need to include considerations of wider changes to global tax regimes. We therefore briefly wish to mention the interaction with the new tax on UK parent members within a multinational enterprise group (“MNE”). A top-up tax will be charged on UK parent members when a subsidiary is located in a non-UK jurisdiction, and the group’s profits arising in that jurisdiction are taxed at below the minimum rate of 15%. This is in accordance with the agreement (“BEPS”) made on 8 October 2021.
While we appreciate that the majority of R&D claimants are not MNEs, there are some MNEs which will have their innovation incentives undermined by these changes. Relief for MNE R&D expenditure may be extinguished by the top-up tax.
Leyton strongly agrees that reform is needed to prevent the misuse of the R&D tax relief. However, instead of reducing abusive claims, the requirement to pre-notify claims is more likely to prevent businesses that are conducting genuine R&D from claiming tax relief. Beyond reducing funding for individual R&D projects, the change is counterproductive to the government’s strategy to boost productivity and economic growth in the UK.
Conversely, requiring the taxpayer to name their R&D adviser is an excellent suggestion. Certain advisers are known in the market to be highly aggressive and more likely to push at the boundaries of R&D definitions. Conversely, there are well established reputable firms (such as Leyton) which rarely see any adjustment to their R&D claims following an enquiry. This will allow HMRC to focus its resources on claims which are of higher risk.
This may accelerate an existing trend in the market towards achieving a perceived “low risk adviser status” with HMRC. The existing Business Risk Review (“BRR”) process for large businesses may provide an interesting template for R&D advisers. By meeting certain low risk criteria set by HMRC, advisers could be awarded low risk status by HMRC. We are in no doubt that most advisers would make great strides to achieve this status as it would attract more business.
Paragraph 3 introduces restrictions on the costs of externally provided workers (“EPWs”) that can qualify for the two R&D tax reliefs. The costs of such workers can only qualify for tax relief or credit where the EPWs or the company are taxed through PAYE or, alternatively, the R&D satisfies narrow exceptions for activity that cannot reasonably be undertaken in the UK.
This change will exclude an integral part of a UK company’s R&D process. Indeed, it may reduce investment in the UK and be counterproductive to the government’s vision of a Global Britain. Limiting incentives for international cooperation could risk making UK SMEs less competitive and compromise the UK’s international reputation. We take particular exception to the draft s 1138A (3) (b) (ii) as it is unreasonable to deny relief where no suitable workers are available in the UK. By way of comparison, the Australian tax authorities explicitly allow R&D relief where no domestic labour is available. The changes are overly restrictive for work done with international businesses for commercial reasons, where it might not be practicable to conduct the work in the UK due to lack of facilities, expertise, equipment, or a combination thereof. Furthermore, the current draft legislation is highly subjective in terms what would be wholly unreasonable for the company to replicate in the UK and so we would expect further guidance in this regard.
We suggest that the exceptions are widened, such that EPWs outside the UK will qualify for tax relief or credit as long as there was a demonstrable commercial reason for using them. Where exclusions do still apply, we would suggest that some relief is still provided at a lower rate, say 35% of the EPW costs, to mitigate the sudden impact for many businesses.
As a further point, draft s 1132A could often give rise to practical issues where a claimant uses an unconnected EPW which invoices the claimant through its own personal service company, (“PSC”). The EPW remunerates themselves via a small salary and dividends. The draft legislation suggests that the claimant company will only be able to make a claim to the extent of costs which went through the PSC’s payroll. We query the extent to which a SME will always have (or be able to have and the extent to which it is reasonable for them to have) awareness of whether EPWs are paid through a UK payroll. We understand HMRC’s focus on the IR35 issue but we feel this is a step too far and is punishing the wrong person. Recent changes to the IR35 rules have already added an administrative burden on companies using contractors who operate through PSCs. We would strongly suggest redrafting this section in a way that does not have this consequence.
Due to maturity of the scheme, we would say that the majority of SMEs are now aware of the scheme. However, that is not to say that there is a good understanding of the rules. HMRC has previously published a 44 page guide (“Making R&D easier for small companies”) which is now out of date. The full version of the guidance is substantially longer and intimidatingly complex for small businesses. What is more, HMRC’s interpretation of the legislation (including the contents of HMRC’s guidance) continuously changes with retrospective effect. In summary, businesses have no certainty regarding the complex and changeable R&D tax relief rules. Indeed, advisers have no way of knowing how HMRC’s interpretations will change in future.
A clear and simple statement of intent is needed from the government on the purpose and focus of R&D tax reliefs. This statement of intent would provide a foundation for a modernised definition of R&D, which could be more easily understood by small businesses. In practice, most small businesses will not have the time to digest any further detail regarding the rules. Taking note of the government’s statement of intent, HMRC then needs to consistently provide these businesses with certainty regarding the available R&D tax relief.
HMRC guidance
Due to the broad and encompassing nature of the underlying legislation, there has been the need for substantial guidance from HMRC regarding the practical application of the rules. We are grateful for HMRC’s efforts to produce detailed guidance. Indeed, we feel that clear and comprehensive HMRC guidance is an excellent way to reduce the number of technical disputes with HMRC (and thereby increase efficiency for all parties). We understand why the legislation is drafted in a broad way but this does imply reliance on the guidance. HMRC’s shifting interpretation of the legislation is where the issues are.
As mentioned above, the main issue with the guidance is that it is changeable. Businesses may file for tax relief on the basis of published guidance, only to find that HMRC has changed this guidance by the time an enquiry is opened. This lack of certainty and the inherent risk of enquiry deters many businesses from seeking the funding owed to them. While these changes may go unnoticed by the wider public, the damage caused by a lack of certainty regarding tax policy (due to recent government U-turns) has been front and centre for everyone.
By way of an example, we can refer to HMRC’s recent changes to their guidance regarding sub-contracting (see Appendix 1) for SMEs. As at 20 April 2021, the guidance stated “A contract to provide services rather than to undertake a specific part of the activities is not subcontracted R&D” . HMRC has since “clarified” this guidance and changed the wording to now read “Any activities carried out in order to fulfil the terms of a contract are considered to have been contracted to the company [i.e. subcontracted R&D]”. The effect is that HMRC is now denying R&D relief under the SME scheme if the claimant had a contract in place which may have incidentally required R&D work to be carried out. Many SMEs will fall into this bucket and so the latest guidance will drastically reduce R&D funding for SMEs. Following external legal advice from a QC, we know this new guidance to be wrong in law. The R&D work is not contracted to the company simply because these activities were carried out to fulfil the terms of a contract.
Legal validity of the current guidance to one side, the point remains that many taxpayers have filed returns based on the old guidance. This includes the subsequently deleted point found in the 2021 HMRC guidance that “it may be useful to examine the degree of autonomy enjoyed by the person engaged, the ownership of intellectual property, and the economic risk in any arrangements”. These same taxpayers are now receiving copy-paste enquiry letters stating that “the legislation does not indicate that taking an economic risk, having ownership of IP or enjoying autonomy would be evidence that the activities were not subcontracted”. Well-meaning HMRC inspectors are now denying R&D relief and threatening penalties because the HMRC guidance has taken a complete U-turn. To answer the sub-committee’s question, this sort of guidance is not helpful. It results in the wastage of scarce HMRC resources and potential legal costs for HMRC in defending a position which is wrong in law.
BEIS guidance
We consider that this guidance is long overdue for modernisation. Our main recommendation would be to create separate guidelines for different industries. In practice, it can be very difficult to apply the same guidelines to every industry.
Paragraphs 15 and 16 introduce a requirement for claimants to R&D reliefs to provide a claim notification. This notification must be submitted not more than six months after the end of the accounting period to which the R&D claim relates, or the claim will be invalid.
By bringing forward the deadline for making a claim, the window to apply for tax relief is more restricted. This change will have the biggest impact for early stage companies, which are often most in need of R&D tax relief.
This is very concerning. From Leyton’s vast experience of engaging with small and medium-sized businesses across the UK, we know that R&D tax reliefs are still not widely understood and there is now a real risk that SMEs conducting R&D will miss out on the tax credits to which they are entitled. The new notification deadline has not been sufficiently publicised by HMRC and it does not coincide with other relevant tax deadlines. It will be missed very easily.
In summary, we consider that the pre-notification requirement should be removed. It will have the same effect for genuine and spurious claims alike. A more effective way to reduce abuse of the scheme would be to enforce formal regulatory requirements or create a more informal code of conduct, such as the existing Professional Conduct in Relation to Taxation (PCRT), for providers.
While we are aware of 8 arrests that have been made in relation to the scheme (which we applaud), we do not have first-hand experience of HMRC’s approach to fraudulent claims. However, we are surprised that HMRC has not taken more action to investigate advisers which may be knowingly preparing false claims.
As stated above, we believe that HMRC sometimes misunderstands the rules. Indeed, we are aware that, due to staff turnover, many of the R&D inspectors have recently joined HMRC and so have little experience. This can sometimes result in a privatisation of HMRC’s training programme whereby enquiries seem to be used as a way to train HMRC inspectors.
Where there is technical dispute, HMRC will often seemingly seek to coerce a taxpayer into accepting HMRC’s view by threatening penalties for careless behaviour. We take strong exception to this tactic from HMRC (despite the success they may have with it). These inspectors appear to be ignoring HMRC’s guidance which states that such penalties should not apply where a “person had taken advice from an advisor and/or counsel and they appeared suitably qualified to give that advice and the person had provided all the relevant information” .
Please see our above comments regarding the Australian tax authorities which explicitly allow R&D relief where no suitable domestic labour is available.
As stated in our executive summary and explained above, we consider that the proposed changes will have the net effect of substantially reducing R&D relief. This will consequently reduce innovation and development in the UK as businesses continue to invest in more attractive tax jurisdictions.
Appendix 1:
CIRD84250 - R&D tax relief: categories of qualifying expenditure: subcontracted activities - meaning of subcontracted [as at 17 October 2022]
SME Scheme, Activities contracted to the SME – ss 1052(5) & 1053(4) CTA09
Expenditure incurred by a company in carrying out activities contracted to it by another person is not qualifying expenditure. This is intended to prevent both parties to a contract from claiming relief for the same activities.
Whether the activities were contracted to the company is a question of fact and each case should be looked at individually. Any activities carried out in order to fulfil the terms of a contract are considered to have been contracted to the company. However, where a company continues to conduct relevant R&D after the contract has been fulfilled, those post-contract activities will not be considered to have been contracted to the company.
SME Scheme, Activities contracted out by the SME 1053 CTA09
Where there is a contract between persons for activities to be carried out by one for the other, and those activities form the whole of an R&D project or are part of a wider R&D project, then R&D activities have been subcontracted. A contract to provide services other than a specific part of those activities is not subcontracted R&D. Nor is a contract of personal employment.
There are obviously a considerable variety of possible contractual arrangements. The following examples illustrate a range of situations, but they are not exhaustive and each case will need to be judged on its particular merits.
Where a company carries out R&D on its own account and simply receives a subsidy from another entity, this is not subcontracting - it is subsidised expenditure.
Where two companies are both carrying out R&D on the same subject they may decide to pursue the R&D jointly with each making a contribution and each free to enjoy any fruits of the R&D. This is collaborative research and each company would potentially be eligible for R&D relief on its share of the qualifying expenditure.
Where one company carrying out R&D pays another company for the provision of workers or materials this is not subcontracting of the R&D.
Where one company engages another company to carry out R&D activity on the first company’s behalf in exchange for payment then that is subcontracting of the R&D to the second company.
Where, for example, a consultant simply provides expert advice and charges for their time, that does not amount to subcontracting of R&D.
Subcontracting - differences in rules for SMEs and large companies
The rules in regard to qualifying expenditure for subcontracted R&D (CIRD84200) differ under the SME scheme and the large company scheme. Before considering mounting any arguments you should consider the appropriate tax treatment, so as to better focus attention on those areas where tax is at risk.
CIRD84250 - R&D tax relief: categories of qualifying expenditure: subcontracted activities - meaning of subcontracted [as at 20 April 2021]
Subcontracted R&D activities
Where there is a contract between persons for R&D activities to be carried out by one for the other, then the R&D activities have been subcontracted. A contract to provide services rather than to undertake a specific part of the activities is not subcontracted R&D. Nor is a contract of personal employment.
There are obviously a considerable variety of possible contractual arrangements. Some examples are:
Where a company carries out R&D on its own account (retaining use of the intellectual property in the work) and simply receives a subsidy from another entity, this is not subcontracting - it is subsidised expenditure.
Where two companies are both carrying out R&D on the same subject they may decide to pursue the R&D jointly with each making a contribution and each free to enjoy any fruits of the R&D. This is collaborative research and each company would potentially be eligible for R&D relief on its share of the qualifying expenditure.
Where one company carrying out R&D pays another company for the provision of workers, or materials this is not subcontracting of the R&D.
Where one company engages another company to carry out R&D activity on the first company’s behalf in exchange for payment, with the first company having rights to the intellectual property resulting from the R&D then that is subcontracting of the R&D to the second company.
The above examples illustrate a range of situations. But each case will need to be judged on its particular facts. As part of any examination it may be useful to examine the degree of autonomy enjoyed by the person engaged, the ownership of intellectual property, and the economic risk in any arrangements. Where for example a consultant simply provides expert advice and charges for his time that does not amount to subcontracting of the R&D.
Subcontracting - differences in rules for SMEs and large companies
The rules in regard to qualifying expenditure for subcontracted R&D (CIRD84200) differ under the SME scheme and the large company scheme. Before considering mounting any arguments you should consider the appropriate tax treatment, so as to better focus attention on those areas where tax is at risk.
2 November 2022