It all started when the head of business development forwarded me an email that suggested that the sender got cash from a UK government program that reimbursed your coders’ salary spend.
As a tech start-up that is going through the classic growing pains any opportunity for financial assistance is like catnip. You have to follow it. This was the start of a journey that unearthed a cottage industry generating almost £1bn a year, with almost pretty much no liability to its clients which could well be costing the UK taxpayer multi billions in wrongly paid out funds.
In responding to this magic pill for getting money back, I ask the team to set up a call to get under the bonnet of what seemed a too good to be true program that by some magic could get our money back for a good chunk of our business costs. Not to cast any aspersions, but it is fair to say that however innovative and creative one’s technological development team are, they don’t tend to come cheap. Yes, it is true that you get what you pay for and in pretty much all cases on the technology development side of things in our experience we received value for money. Still the idea of getting these costs back is incredible.
So, the guys get tasked with setting up a call to find out more and this is where the fun really begins. It turns out that the UK government program being marketed and sold as a place where the streets are paved with gold for tech start-ups is the Research & Development Tax Credits scheme.
A Tax Credit Scheme that is sold as getting money back
Some background. The UK Government created the UK R&D Tax Credit scheme in 2000. The government at the time recognised the UK was lagging in various innovation rankings and wished to provide an incentive or set of incentives that would stimulate innovation, creativity, and experimentation.
R&D tax credits are designed as a tax relief to encourage greater R&D spending and innovation. It works in a couple of ways by either reducing a company’s tax bill by an additional amount depending on the company’s allowable R&D expenditure or if a company is loss making over a period directly reimbursing a portion of the allowable R&D expenditure. This second option is known as the Research and Development Expenditure Credit (RDEC) scheme. RDEC was introduced in the Finance Act 2013 and enables companies with no Corporate Tax liability to benefit through a cash payment or a reduction of tax or other duties due.
For tax purposes, R&D takes place when a project seeks to achieve an advance in overall knowledge or capability in a field of science or technology. This is an important definition and one which is actually more difficult to meet than saying that you developed a new coloured something or other.
When you get into the details R&D relief allows companies that carry out qualifying R&D related to their trade to claim an extra Corporation Tax deduction for certain qualifying expenditure. The level of relief available depends upon which scheme the company uses.
The R&D relief is also available to large companies but when you consider a couple of things over the life of the program only 15% of claims are made by large companies, and typically the paperwork is done using their own internal financial and technical expertise and therefore there wouldn’t be a recipient of an email promising rebates on coder salary spend. It should also be acknowledged that the army of specialist agencies, consultants, accountants and lawyers to these large enterprises wouldn’t let this opportunity to sell services to them pass them by. This is particularly true for the more complex arrangements where there are examples of global enterprises establishing UK subsidiaries in order to claim support for R&D activities completed outside of the UK.
So, what type of innovation qualifies? The answer to this is taken from the R&D guide provided by the government tax office. “Work that advances overall knowledge or capability in a field of science or technology, and projects and activities that help resolve scientific or technological uncertainties”. When you unpack this it is a pretty high benchmark to meet. In fact, the guide goes on to say that “R&D has a specific statutory definition for the purposes of R&D tax relief which is not the same as the commercial, engineering or accounting definitions”. To qualify companies must be carrying out research and development work in the field of science or technology.
It is fair to say that the relief is not just for ‘white coat’ scientific research but also for ‘brown coat’ development work in design and engineering that involves overcoming difficult technological problems. In the case of TFSMC this would be us. The image of my tech guys coding away with next generation software and algorithms sitting in brown coats is fairly odd, but in a strange way it says a lot of what we did.
According to the description referred to above, it can include creating new processes, products or services, making appreciable improvements to existing ones and even using science and technology to duplicate existing processes, products and services in a new way.
But pure product development in itself does not qualify. Some examples of qualifying activities include software development, engineering design, new construction techniques, bio-energy, cleantech, agri-food and life and health sciences. So, plenty of scope to push the boundaries of innovation.
The main questions to consider are:
- Are you looking to advance a field of science or technology?
- Does the advance extend the overall knowledge or capability in the field of science or technology and not just the company’s own state of knowledge or capability?
- Does the project involve an uncertainty that competent professionals can’t readily resolve and where solutions aren’t common knowledge?
Judging which projects and activities will qualify for R&D tax relief is usually the area where most people seek help. Answering these questions in the appropriate way has given birth to a cottage industry worth almost £1 billion a year. The beauty for the players in this thriving sector is that whether by accident or design, they have access to multi-year annuity revenues for a service they typically don’t have any liability for.
Getting into the numbers
Back in 2000 the scheme was initially designed to solely support SMEs. In the first year the scheme processed 1,860 claims for a total of £70m pounds worth of eligible credits. Fast forward almost 20 years, 2018 – 2019 (the data available at present, considering that this is still provisional and partial as claims are still being received). The latest results show that there have been over 50,000 SME claims for a total of £2.985bn and over 7,000 large business claims for a further £2.360bn.
Take a step back a moment. What we are saying is that for SME’s over the last 20 years the innovation landscape has shifted to such an extent that almost 30 times as many SME’s can claim and are eligible for R&D support.
Just as another flag, over the lifecycle of the program it has paid out over £15bn to SMEs and £18bn to large enterprises. A different way of dissecting the number of annual claims for SME’s is to consider that it breaks down into over 4000 claims per month or over 220 claims per working day.
At this sort of volume, you are inevitably going to have workflow management issues. Reported problems have been lack of expertise on the process, lack of expertise on the field of innovation (very difficult to verify the actual innovation), even the online portal through which a firm submits its supporting words, doesn’t work.
This rise in claims has proved challenging for HMRC and companies applying for R&D tax relief have experienced significant delays in the processing of claims, sometimes up to nine months. Back in 2019, HMRC reported that new advisers and resources had been brought in and that the backlog had been cleared. From 1 October 2019, the processing of claims has moved to a larger team in Cardiff which should be better able to cope with the fluctuations in demand. Prompt processing is crucial to help reduce the time lag between R&D spend and receiving the relief. This is particularly important for early stage businesses where cash flow is often an issue. When you dive into the data an interesting takeaway is that over 40 percent of claims are made by companies less than 10 years old. This suggests that businesses still perceive R&D tax credits to be predominantly for young companies.
This pressure on meeting the requirements, processing in a timely manner and perception that the scheme is designed for young companies has created perfect storm conditions for third party advisers to feed off the claimants.
The market for 3rd party advisers offering this service has ballooned in recent years. Applicants don’t need to be accredited to a professional body to provide the service. Twenty years ago, when the scheme was designed, a fair expectation was that if the entities were not doing it themselves, they would be working with their professionally qualified accountants. The commercial arrangement being that your accountant charged you a fee for the service independent of the claim outcome. Nowadays, it is not uncommon for these services to be offered on a no win, no fee basis. Always attractive for an early stage company where cashflow is typically tight. The challenges come when the typical contracts offered for this type of ambulance chasing approach are that the advisor signs the claimant up for a multi-year agreement, normally for four years or more. The idea of not having to worry about it every year may be attractive for a small innovative start-up that is just focused on building their value proposition, but it’s rare that these firms have a sufficiently robust roadmap that projects out beyond 18 months. Tying yourself into a contract of this sort of length where the 3rd party can farm you for up to 40% of the value of the return without any liability on the 3rd party seems highly questionable.
If the argument was that 3rd party services provided compelling insight that warranted the difference between a successful claimant and not, you may have a good case for this type of proposition. If that were the case, one might expect to see a delta between the number of claims and the number of returns (claims that are successfully paid) but looking at the HMRC data the percentage of successful returns to claims is 99.7%. At a fail rate of three out of 1000 applicants you can pretty much be assured you’ll get a result. Not a bad business model if you can get it.
Equally one may argue that the 3rd party advisers are able to bring valuable expertise in answering the main questions on the field of science or technology, the uncertainty faced and how the advancements were measured. Ultimately, in order to do this a 3rd party adviser will need to interview a member of the company, write it up and play it back in the format that will meet the exam questions. Keep in mind that your innovation can be in any field of science and technology so finding an expert that is potentially more knowledgeable than the members of the firm will be very rare, but not impossible.
So, going back to the HMRC data for 2017-18, 54,005 claims were made by SME’s for a total of £2.76bn giving an average claim value at £51,106 of which over £15,000 goes to the 3rd party. Add it all back up and you have £828m going to service providers for playing back your innovation words and numbers to a process that fails 3 in a 1000. Fantastic odds for the service providers. The ultimate question is, is the potential fee of £15,000 worth more to the innovative start-up that is typically under cash flow pressure? Only the start-up management team will know the answer to this but when someone comes to you with something that seems too good to be true, it usually is. Future parts of this investigation will be explored over the coming days.
Read the follow-on piece entitled “Cooking the R&D books” here.