Non-compliance in SME R&D claims and the proposed future of the SME R&D Tax Relief

HMRC’s latest analysis on the scale and shape of non-compliance in R&D tax relief schemes for the 2020-2021 period was published on 17^th July 2023. The findings indicate a higher than anticipated level of error and fraud (“E&F”) within the SME scheme and a clear statement of intent that HMRC will continue to significantly increase the level of scrutiny it applies to R&D claims.

Some of the key findings include:

1. Customer Behaviour: 25% of claims were disallowed because no qualifying R&D activity took place, although HMRC had no specific indication that the claimants were attempting to commit fraud. Less than 10% of claims had indicators of fraud.
2. Size of Expenditure: Smaller R&D claims were more likely be non-compliant. 75% of claims with under £10,000 of R&D expenditure were deemed non-compliant. In contrast, 75% of claims that had over £1 million of R&D expenditure were more likely to be fully compliant.
3. Sector Analysis: R&D claims within “Professional, Scientific & Technical Activities” and “Manufacturing” sectors had the lowest levels of non-compliance (highest levels of compliance) at 9% and 17% respectively. In contrast, Companies within “Education” and “Arts, Entertainment & Recreation” sectors saw the highest levels of non-compliance at 87% and 61% respectively.
4. First Time Claimants: First-time claimers were more likely to have had non-compliant R&D claims (38%) compared with previous claimers that had non-compliant R&D claims (22%).
   
5. Agents: Whilst HMRC believe that 90% of claims submitted by companies are supported in some capacity by an agent, non-compliance still exists within claims that do have an identified agent involved as well as in claims that do not have an identified agent involved.

The findings are largely based on extrapolated sample data of 500 claims investigated as part of HMRC’s mandatory random enquiry programme (“MREP”) for SME’s that was launched in 2021.

The popularity of R&D tax relief becoming an increasingly utilised tool for companies is evident with nearly 90,000 claims being made in the 2020-21 year, an increase of 7% from the previous year. The rise in the volume of claims, coupled with the generosity of SME tax relief, meant that the scheme was potentially being targeted by spurious and fraudulent opportunists. A high-profile case that saw three men jailed in 2020, after trying to fraudulently claim nearly £30 million in R&D tax relief, fuelled concern about possible vulnerabilities within the R&D schemes.

In recent years, HMRC has progressively developed its compliance approach toward R&D tax relief schemes. This approach has included an increase in HMRC agents working on R&D compliance, the creation of an R&D Anti-Abuse Unit, and a focus on “upstream” compliance that aims to provide education and intervention for companies to prevent non-compliance. This heightened approach has led HMRC to estimate that it has blocked £85 million in fraudulent claims, challenged 2,500 suspected claims and arrested 9 people.

Despite this compliance-driven approach, HMRC’s new methodology for estimating the level of non-compliance (based on the MREP data) indicates the level of error and fraud for both SME and RDEC reliefs for 2020-2021 is 16.7% (£1.13 billion), which is significantly higher than the previously published estimate for 2020-2021 of 3.6% (£336 million).

The findings from HMRC’s report suggest non-compliance is higher within the SME scheme at 24.4% (£1.04 billion) than in the RDEC scheme available for larger businesses at 3.6% (£90 million). Previously published estimates of non-compliance were 5.5% (£303 million) and 0.9% (£33 million) for the SME and RDEC schemes respectively.

A raft of legislative changes has been phased in to try and prevent further non-compliance within R&D tax relief.

As of April 2023, the SME enhancement rate that is applied to qualifying R&D expenditure and summarily deducted from the company’s taxable trading profits has been reduced from 130% to 86%. For loss-making SMEs the tax credit rate at which it can surrender taxable trading losses for cash has also been reduced from 14.5% to 10%. Furthermore, a PAYE/NIC cap has been previously introduced to limit the available cash credit for loss-making SMEs to 300% of a company’s annual PAYE/NIC liability plus a £20,000 buffer. The PAYE/NIC cap seeks to prevent companies with a limited UK presence from obtaining extensive R&D tax relief, whilst the reduction in the enhancement and tax credit rates may deter companies from claiming altogether.

As of August 2023, HMRC will introduce mandatory additional information requirements to be provided in support of R&D claims. Some of the measures include:

• Requiring all R&D claims to be made digitally,
• Requiring each claim to be supported by a named officer of the claiming company,
• Requiring details of any agent associated with a claim to be provided,
• Increasing the level of technical information required for R&D projects included in the claim

HMRC hopes that its compliance-driven approach, the new legislative changes, and its ongoing consultative work with stakeholders will reduce the level of non-compliance in 2022-2023 by £250 million across SME claims.

In addition to the above changes that are collectively aimed at preventing non-compliance and poor advice for companies looking to make R&D claims, consultations in early 2023 between HMRC, HMT and other key stakeholders (professional bodies, agents, trade bodies and taxpayers) have looked at how to apply best practice to the shape and structure of R&D tax relief.

Draft legislation published on 18^th July 2023 has outlined a proposed “merging” of the SME and RDEC R&D tax relief schemes to further prevent non-compliance, offer simplicity and continue the re-balancing of SME & RDEC R&D tax reliefs.

The draft legislation sets out a single R&D relief, delivered in a similar way to the existing RDEC. This merged scheme differs from the current RDEC however in several respects; most notably that companies will generally be able to claim for expenditure incurred on subcontractors, as is currently possible in the SME scheme but not in the existing RDEC scheme. The draft legislation also uses the more generous version of the PAYE/ NIC cap for calculating the available tax credit payment included in the current SME scheme. However, the proposed merged scheme plans to uphold restrictions on relief for overseas expenditure which will come into effect from April 2024.

A final decision on whether to merge schemes will be made at a future fiscal event. HMRC also plans to share a further update on this its approach to improving compliance with R&D tax relief in late 2023.

The key trends identified around customer behaviour, claim expenditure, sectoral analysis, first-time claimants and the use of R&D tax agents provide thoughtful insight on what HMRC are evaluating and how this intrinsically links to the direction of travel.

It remains more important than ever for companies to understand the rules and guidance surrounding R&D tax relief to prevent them falling into the estimated 25% of claimers with no qualifying R&D activity. The estimated high-levels of non-compliance within low-value R&D claims should also serve to remind claimants that claims of all sizes are subject to HMRC scrutiny. The analysis of a variety of sectors suggest that certain sectors may be less likely to yield qualifying R&D activity than others, so it remains essential to understand the boundaries and definition of R&D for tax purposes, though HMRC admit that providing updated and current examples will better inform companies looking to make claims. It is also evident that whether a company is a first-time or long-time claimer, it should regularly assess the quality of advice provided by its R&D agent to ensure it is has the appropriate level of support and professional scepticism applied when making a claim for R&D tax relief .

The potential of a merged scheme also presents additional consideration for claimants on how this revised structure would apply to companies traditionally used to claiming under the SME scheme. This deviation from the traditional SME structure, combined with the return of potential marginal rates of corporation tax, could mean that companies are not fully equipped with current information to help forecast and prepare their R&D claims.

We are pleased to continue to support companies with their R&D claims and if you would like to speak with one of our specialist advisers, please do get in touch.