Lords R&D inquiry: Business calls for broader R&D definition

Background

The House of Lords Economic Affairs Committee sets up an annual Finance Bill Sub-committee to consider aspects of the Finance Bill from the point of view of technical issues of tax administration, clarification and simplification.

The sub-committee is this year made up of six members:

• Lord Leigh of Hurley (Conservative) – sub-committee chair, a chartered tax adviser and a former Treasurer of the Conservative Party
• Viscount Chandos (Labour) – who lost his hereditary seat in the Lords in 1999 but was given a life peerage the following year
• Lord Monks (Labour) – a former general secretary of the Trades Union Congress and European Trade Union Confederation
• Baroness Noakes (Conservative) – a former partner at Peat Marwick Mitchell & Co and the first female President of the ICAEW
• Lord Palmer of Childs Hill (Lib Dem) – a chartered accountant, former councillor (London Borough of Barnet) and a current Deputy Speaker of the House of Lords
• Lord Turnbull (Crossbencher) – a former Cabinet Secretary and Permanent Secretary at the Treasury and Department of the Environment

This year the sub-committee has decided to focus on the reforms to Research and Development (R&D) Tax Relief in the draft Bill, including whether how effective the changes will be and whether there will be adverse consequences. In addition to taking oral evidence from invited witnesses, the sub-committee invited companies which claim R&D relief, their advisers, business and trade/sectoral organisations, and other interested parties to submit written evidence to the inquiry. This can be read here.

The inquiry will produce a report containing conclusions and recommendations. Based on previous inquiries we anticipate this will be published in December or January.

In its first evidence session the sub-committee heard from witnesses from a number of tax representative bodies, including CIOT. You can read our report on this session here.

This report covers three panel hearings –

Monday 7 November, 4pm - Business bodies

Chris McDonald, Policy Chair for Innovation and Enterprise, FSB (Federation of Small Businesses)/Chief Executive Officer at the Materials Processing Institute

Alice Jeffries, Head of Tax Policy, CBI (Confederation of British Industry)

Kitty Ussher, Chief Economist, IoD (Institute of Directors)

Monday 14 November, 4pm – R&D heavy sectors

Neil Ross, Associate Director, techUK

Colin Hailey, Chair, Finance and Tax Advisory Committee, BioIndustry Association (BIA)

Dr Joe Marshall, CEO, National Centre for Universities and Business (NCUB).

Monday 14 November, 4.45pm – R&D specialist advisers

Jenny Tragner, Director and Head of Policy at ForrestBrown Limited

Nigel Holmes, Director of Tax at Catax

You can find links to watch the sessions and read the transcripts here.

Monday 7 November, 4pm - Business bodies

Representatives of business groups suggested that broader definition of R&D including allowing it to apply to ‘new-to-firm’ research.

Alice Jeffries told the committee that, overall, the CBI think that R&D relief is hugely effective in increasing private business investment.

Chris McDonald of the FSB said R&D tax credits were responsive and flexible to business need. “There is a big difference between other innovation interventions, such as grants, and R&D tax credits, which reward success, which is very consistent with small business culture. Entrepreneurs like incentives that reward success. They are responsive and flexible to business need, whereas grant programmes tend to be much more top driven.”

Kitty Ussher of the IoD said we should consider whether capital allowances are being used most effectively, particularly for digital adoption of modern, 21st-century processes and cloud computing. “Certainly, our evidence shows that many of our firms think that would be transformational; it is just about having the incentives to firmly prioritise it.”

Jeffries said there are a number of things that you could do in the R&D tax credit scheme to make the UK stack up and be as generous as those elsewhere. “The one around the definition is key because a lot of the other countries use the broad OECD definition, which is called the Frascati definition. It includes applications of available knowledge in new ways, so that would cover those new-use or new-to-firm cases. It would also cover certain models that are becoming increasingly common and which most of us would consider innovative, but which are not necessarily captured by the current UK definition in tech and AI.”

McDonald said he had worked in multinationals doing R&D and in small businesses as well. “There is a clear cultural split. To generalise, people who are entrepreneurs, who are running small businesses, in general believe that it is right that they will be rewarded for their success and it is wrong to subsidise failure… Among the small business community, an R&D tax credit is seen as a reward for success, and if a competitor receives a grant for something, “Why have they been given a subsidy?” is essentially the response.” For this reason, R&D tax credits have a greater level of acceptance.

Lord Turnbull challenged the premise that this was wholly a ‘reward for success’. McDonald acknowledged that yes, you can cash in tax credits at a lower rate against losses and historical losses.

Lord Monks said the committee had heard evidence “from the world of accountancy and agents that there is a lot of concern about the complications in accessing the tax credits”. Do you have any ideas about how the whole thing might be simplified, he asked.

McDonald replied that HMRC can be “quite an intimidating organisation”. Even when businesses hear about how they could gain from R&D credits “they can be very wary about engaging with it for fear of ending up on the wrong side of a discussion with HMRC”. There are others who feel “that if this scheme is so complex that the only way they can engage with it is through some third-party agency, then they do not want to be involved with it at all”.

He suggested HMRC could “engage differently around this”. “We have seen some good examples of where this is applied in other countries. There is an intellectual capability around innovation located within the tax body that understands innovation and how innovation works in business and is able to engage in that way. Having had experience of filling in R&D tax credit applications, this is not a tick-box exercise. You need to carefully go through each project that you have undertaken, identify the innovation potential of that project, which is naturally subjective, and then agree that with HMRC. To do this effectively, HMRC needs to have capability within the organisation that can engage in that way directly with businesses.” 

Jeffries agreed. “On simplification, our larger businesses tend to have a good relationship with HMRC. They tend to have a personal compliance manager who they engage with, and they have that early engagement and a good relationship. It is smaller businesses and the people who advise them who find themselves in the position where they are unsure what the applications will be.”

An advanced assurance system would be helpful, said Jeffries. “HMRC technically has one of these for small businesses, but it allows you to use it only once. If you do multiple projects as a small business and you have used advanced assurance once, you are not allowed to use it again. We do not understand why that is the case if HMRC wants more engagement with taxpayers to understand their projects and whether they fit within the rules.” She said there was a pilot in 2019-20 to do this for large companies, but it has not yet reported.

Ussher said there is “a very general high-level point of principle here, which is that if you are running a small business, you should not have to engage an intermediary in order to deal with government.” 

Lord Leigh asked the panel what they thought of the proposed requirement in the draft legislation for companies to give advance notice of their intention to claim R&D. Do they think it will be effective in deterring fraudulent and abusive claims?

Jeffries said it was “highly unlikely to make any difference to HMRC’s understanding of what the projects are or the business’s understanding of whether their claim is valid or not. We do not understand its purpose in the form that it has been introduced.” Ussher and McDonald agreed.

McDonald added that he noticed “that the requirement will not exist for companies that have made three successive claims. It presents a barrier to entry for firms that have not engaged with the scheme previously. When we look at the data, one of the things that we would like to do is to encourage more schemes that currently are not innovating to innovate through the use of such an incentive, and this would certainly be an additional barrier to that.”

Baroness Noakes asked whether having two R&D credit schemes leads to inefficiencies.

Ussher said the IoD thought “that in the companies that use it, there is quite good knowledge that there are two schemes. It might actually complicate things more if there was an attempt to merge them. We did pick up some evidence that sometimes, even though people knew there were two, they were not quite sure which one they were eligible for.” We are broadly content with having two schemes, she concluded.

Jeffries said that, when merging the two schemes had been floated by government, the CBI had taken the position “that if it were overall a simplification and the benefits of both schemes were retained… then a merging of the two schemes might be sensible.” However, “when we speak to SMEs in our membership, they prefer the SME scheme as it is. It has been in place for so long that they fully understand it, where they are using it, and they do not necessarily think that rejigging the entire system could be done in a way that was genuinely beneficial to them.”

Lord Palmer asked Chris McDonald: “If you had the chance to advise HMRC on making the scheme less complex to some of your compatriots, is there one thing that you would suggest?” McDonald said his three top things would be to allow new-to-firm innovation, do not add any more new and complex rules, and engage in a collaborative way with businesses.

Monday 14 November, 4pm – R&D heavy sectors

Representatives from the tech and bioindustry sectors told peers that R&D credits pay an important role in attracting those sectors to the UK and that broad definitions of R&D are beneficial. There was concern that the R&D adviser sector is an ‘absolute wild west’.

Neil Ross said the R&D tax credit system was “a very important part of the network of different incentives that attract tech companies to operate in the UK”. When techuk has asked its members what they would like to see the Government do to help them advance or expand their R&D operations, improving and expanding the incentives has usually been one of the top two or three asks of members, he said. Techuk is very keen on the expansion to cover cloud data and other computing costs, he added, saying that, “often, some of the biggest expenditure is the staff and talent costs of operating in that area, such as software development engineers and other software engineers. Claiming the credit back against those costs is very important for the sector.”

Colin Hailey said R&D credits are essential to UK biotechnology companies. “Basically, most of these companies have no product until they have finished their R&D. It is an essential consideration for companies being founded and for companies growing in the UK. There is a competitive international landscape, so they have been very widely used by the sector, which has invested huge amounts in R&D since it was established in 2000.” He is sure that the UK gets value for money from the scheme: “the ability to claim R&D tax credits is one reason why people set up, found and grow companies here”.

Joe Marshall, from NCUB, said it feels like the UK has one system focused on tax relief and another focused on grants. “What we do not have is a way to bring those discussions together so that we get the net benefits of both those schemes, rather than operating them in complete isolation.”

Hailey said that applying for a grant was always a lottery. “You apply for a grant, you might write a good application or you might not, you might hit favour with what the call for applications is addressed to. The great thing about R&D tax credits is that if you meet the criteria, you will get the R&D tax credit. That is very valuable for companies, rather than spending money on grants report writers, hoping that you will be one of the successful applicants.”

Hailey told the peers that there are “claims going in for all sorts of things that should not qualify, but they are simply not being looked at by HMRC. During Covid, no inquiries were running at all; HMRC just let everything through. You are just asking for a refund on your tax return, you get it. We are only just starting to see inquiry activity coming back in. The measures in the Finance Bill, from my point of view, do not go anywhere near far enough to clamp down on spurious claims.”

Lord Turnbull, the former permanent secretary, suggested that the measures in the Finance Bill would do nothing to correct this.

Hailey agreed. The Bioindustry Association has raised this with the Treasury a number of times, citing DOTAS rules. “In general, my experience is that almost everything is not even getting ticked through by HMRC. No one picks up the pen at HMRC; they just go through and get picked up at random. The measures in the Finance Bill are trying to deal with spurious claims without incurring more headcount in HMRC.”

Hailey agreed that pre-registration would not be effective in tackling this. “There are already software products out there that will write your R&D claim for you. You put in a few words, and it will generate the report for you to send into HMRC. It will not take those firms long to work out how to write an automatic notification piece of software. It will not address the problem at all.”

Lord Palmer asked whether the changes to the definition of R&D improved things.

Marshall said that the OECD’s Frascati definition (see above) has very good working definitions of what is and is not included. 

Hailey said that “the main thing exercising BioIndustry Association members at the moment is the exclusion of overseas expenditure.” “If you are in a new area of medicine and there are a handful of subject matter experts worldwide but none of them are in the UK, why should you be precluded from putting the cost of engaging that person in your R&D tax credit wherever they are in the world?”

Ross said that there is a scheme in the Netherlands called the innovation box which provides discounts at payroll level for more intangible, non-patented innovations, so a broader range of IP rights are encompassed. “It is seen as a particularly good model for the tech sector, where innovation is a lot more iterative. For example, if you build a very good machine-learning algorithm or AI system, the benefits of that accrue over time, as it learns and develops. It is not a one-off cost, like buying a piece of fancy kit. It gets more advanced and smarter, and delivers better benefits over time, particularly as it is trained. The innovation box allows you to continue to claim a discount on payroll as that innovation is used, rather than just at the point where it is purchased.”

Lord Turnbull offered the view that the Government’s review is not reviewing the right thing. “What needs to be reviewed is the way in which HMRC reviews claims. It is a tax authority. What locus does it have to make judgments about whether this R&D is ground-breaking, or whatever? The big question, which is not being reviewed, is whether it is really within HMRC’s capability to do this work.”

Hailey said he thought HMRC was “perfectly able to ask the questions and understand what it gets told by companies, but it is not asking the questions and reviewing enough claims.” He added that he did not see what the notification process was trying to achieve.

Ross said that some techuk members, particularly in the software development space, “keep running up against HMRC when it comes to making claims. Clearer guidance and a better approach would probably be welcome on their side.”

Lord Palmer asked whether the advantage of having an outside adviser was that they know “how the computer is going to answer”? Hailey replied that it is “literally all automated: you put some numbers in and get a repayment. There is no review going on. Outside advisers cold-call companies all the time saying, “We have a special relationship with HMRC. Some 99% of our claims are accepted by HMRC. It’s free money from HMRC”. The Treasury has said to me that it is very frustrating that, if you google “R&D tax credits”, you go through four pages of R&D tax credit firms before you get to anything from GOV.UK. It is an absolute wild west out there.”

Monday 14 November, 4.45pm – R&D specialist advisers

A representative of R&D specialist advisory firm ForrestBrown made the case for compulsory professional body membership for those providing paid-for tax advisory services and suggested HMRC could imprive their risk assessment of claims on submission. A representative of another R&D firm, Catax, told the peers that HMRC needs to take a more focused approach, targeting rogue agents.

The session began with the witnesses introducing themselves, Jenny Tragner of ForrestBrown telling the peers that she is a member of ICAS and the ATT.

The sub-committee began its questioning by asking Nigel Holmes about a statement on Catax’s website “that something like £84 billion is owed by the British Government to small and medium-sized firms”. Lord Monks wondered whether a claim like this might encourage spurious claims as well as genuine ones. Holmes agreed that this figure seemed very high and agreed to look into it and write to the sub-committee. He said Catax would not make any spurious claims.

On the Finance Bill measures Holmes thought, like the previous panel, that the inclusion of data and cloud computing and pure mathematics was a positive step but disagreed with the exclusion of overseas activity. “[W]here that R&D is exploited is more important than where it takes place,” he argued. “If you use overseas activity but it ends up benefiting the UK economy, to me that is more important.”

Tragner said that, in her experience, “the corporates’ approach to corporate tax is now about getting it right and not abusing it or being seen to be aggressive in any way. Some of those behaviours might be more directed towards some of the agent community, which has had success in a particular type of claim and then perhaps tried to roll that out across a sector. Some of that was potentially happening, but my experience with businesses is that they want to get it right, which is why a lot of our recommendations have been around making sure that the definition is accessible and that we are educating businesses. If the pubs, the blueberry muffin companies and the launderettes understand that this incentive is not directed at them, fewer of them will end up making claims.”

Lord Palmer asked how HMRC can reduce error and abuse. Holmes said the two need to be looked at separately. “From an abuse point of view, HMRC should be targeting the advisers who abuse the system rather than the claimants — the advisers are leading claimants up the garden path if they are saying, to take the example from the Times, that a blueberry croissant qualifies for R&D.” Beyond this, guidance needs to be ‘clearer and simpler’, and he had praise for the R&D units HMRC used to run. “They had officers who, although they were not scientists, engineers or chemists, had really good knowledge. You could pick up the phone and have conversations with them, and it worked. Now I just feel that it is lots of people pressing a button to churn out a letter, without any attention given to whether it is the right company to target.”

Tragner said that companies providing the name of any agent who has supported a claim preparation will give HMRC a lot more data on where claims are coming from and who has supported them. “We do not yet know how it will use that data, but one assumes it will enable it to target compliance activities or engage directly with agents and take action about behaviours, which in my experience they do very little of at the moment.” Compulsory professional body membership for those providing paid-for tax advisory services would, she said, mean that businesses can be more confident that their advice is coming from a member of a professional body which has technical competence and some oversight over how they behave.

Holmes said that you used to get a letter from HMRC, after it had looked at the R&D report you submitted, saying, “Tell us more about this and explain that in a bit more detail”. The letters now being sent use 12 standard questions, “and they disregard everything we have already spent a lot of time on — telling HMRC what the R&D is and why we think it qualifies. It is just a standard template letter; in my opinion, that wastes both our time and HMRC’s time.”

Tragner said the units Holmes had mentioned had had an enabling, educational role as well as a compliance one. “HMRC’s activities are now very much focused on compliance… in large part due to the volume of claims it has to deal with… However, there is an interesting question as to whether we should expect it to wear both hats and whether it is best placed to do that”.

In terms of further improvements to the R&D compliance regime Holmes repeated that the key was making it more focused, as well as increasing the skill set of HMRC officers. Tragner said she would like to see us review the definition of R&D, make it clearer, and provide better guidance and examples to educate businesses.

Lord Palmer asked about HMRC’s ‘process now, check later’ approach. Tragner said that if money has been paid out in error or in an abusive scenario, paying it out and then trying to get it back is ‘obviously not ideal’. “HMRC used to have a commitment or KPI that it would try to risk-assess a claim and decide whether it is likely to open an enquiry before processing the money. It recognised that, even if it ultimately finds nothing wrong with the claim, having the money and then having HMRC ask questions over the validity of the claim could be quite stressful for a business, and businesses need certainty so that they can reinvest that funding into more R&D.” She wondered if more risk-assessing of claims when they are submitted and before HMRC processes them could lead to a situation where getting the money and then several months later having an enquiry that challenges the claim would be fairly rare.

Lord Turnbull asked about contingency fees. Holmes said Catax charges them: “That is the commercial model we choose, which is driven by the markets, because competitors are charging them as well.” Neither he nor Tragner thought the contingency fees model should be banned. “[T]he type of agents we see behave poorly almost exclusively work on that fee basis,” acknowledged Tragner. However, “[a]s a professional body member, I have to make sure that my firm has safeguards in place to manage that threat. A non-professional body member obviously does not. For me, it is about the agent behaviour.”

Tragner thought there was potentially a stronger role for the professional bodies to play. “They have guidance on the objectivity threat of offering contingency fees and the safeguards to have in place. They have an oversight role over members, but obviously they can inform only the behaviour of their members, hence the recommendation that, if you are charging clients for tax advice, you should be a member of a professional body.”

By George Crozier, CIOT Head of External Relations