Tax avoidance could be argued is an unfortunate by-product of government policy. Boiling it down to the basics, tax avoidance refers to folks applying the tax rules and regulations in a way that wasn’t planned or designed for by the creators and implementers of the tax policy.
It is the practices of tax avoidance at the global corporate level and particularly those undertaken by the Big Tech players that the recent G7 summit in Cornwall looked to tackle.
The governments of the wealthiest countries in the world signed a historic tax agreement to put in place a minimum global corporate tax rate for the first time. A very attractive mechanism for avoiding tax comes from over 1000 different tax reliefs and allowances offered by the UK tax system. The straightforward idea behind a tax relief is to reduce the amount of tax owed by a company or person based on a set of criteria. However, when you get into the history, and our friends at Taxwatch have, tax reliefs are increasingly being used as a tool to support and stimulate economic policy. The logic being to reverse engineer an incentive and take less rather than give out loans, grants and state aid to directly support your economic aspirations. Tax reliefs have been introduced to encourage a wide variety of things including, the production of films, music, video games, and spending on R&D to name a few. These schemes work by allowing companies to make additional deductions from their tax bills for spending money on the desired activities.
As you might well expect, any policy or relief to lower one’s tax is a crowd-pleaser for the folks getting the intended benefit. These types of tax relief are also open to misuse. It is fair to say that the application of a scheme’s rules for a tax relief may not be ruled to be in the wrong for some time after its creation. As in the case of Icebreaker which purported to invest in the music industry, taking advantage of tax reliefs that were set up by the UK government to encourage the creative industries. The Icebreaker scheme ran for years before a judge ruled it a tax avoidance scheme catching out several famous names some of which ended up paying back millions.
It almost seems an inevitable result but history shows us that as soon as a government designs and implements an initiative to provide targeted support for a sector, management consultants, accountants and lawyers will be all over it with creative ways in claiming and selling it as a service.
Research and Development as a Tax Credit
One such tax relief, where there is very clear evidence of exploitation is the research and development tax credit program. These tax credits work by awarding companies based on the amount of money they spend on research and development activities. It should be noted that for the purposes of the tax program R&D takes place when a project seeks to achieve an advance in overall knowledge or capability in a field of science or technology. These credits can then be offset against their tax bills. If the company has no tax liability, they can receive money back from the government.
Twenty years ago, when the scheme was first introduced the government received 1,860 claims and paid out £70m. Last year this had risen to almost 60,000 claims for the year at a value of over £5,3bn, a rise of over 75 times.
In 2016-7, the last year where figures are complete, HMRC awarded credits to companies claiming that they spent a total of £32.3 billion in spending on R&D. However, the Office of National Statistics (ONS) recorded just £22.6bn of spending on UK R&D activities in 2017. The following extract comes from our friends at Tax Watch commenting on this oddity when considering the 2020 budget.
It is unheard of for any tax relief to get anywhere near 100% take up, never mind more than 100%! The ONS data and the HMRC data are different and not directly comparable. They cover slightly different time periods, with the ONS looking at a calendar year whilst HMRC looks at the financial year. The HMRC data also counts some non-UK spending, which can be claimed under the R&D tax credit scheme (for example if a company subcontracts some R&D work to a non-UK company). The ONS data looks at UK spend only. However, the difference is very large, with the ONS data suggesting that R&D expenditure for tax purposes is 143% of UK R&D spend. This can’t simply be explained by differences in methodology, even the inclusion of non-UK spending. In fact, HMRC has identified the practice of some companies opening up UK subsidiaries with the sole purpose of routing payments through the UK to collect tax credits as an abuse of the system. The data suggests a worrying level of abuse.
The UK government recognised at those sorts of numbers that there was a problem. A high-profile catalyst to this occurred in 2016, when HMRC arrested three men in connection with attempting to fraudulently claiming £300 million in Research and Development (R&D) tax credits even though they had no R&D activity. Between 2018 and 2020 the government had two consultations with stakeholders in how to tackle the misuse and abuse of the scheme. The result being in that in the 2020 budget changes to constrain the amount small businesses can claim in cash under the R&D tax credit scheme based on their UK payroll were introduced. It seems that gross abuse of government innovation grants is rampant by non-UK based firms and related activities, a fact that will be investigated in future editions.
The new measures that came out of two consultations came into effect in April this year. However, as recently observed by the National Audit Office (NAO), even when the changes to R&D tax credits announced in the 2018 budget are made, companies will still have until 2022 to claim under the old rules. This means that tax will continue to be lost for years after serious fraud in the system was identified.
The principle change to curb misuse was to limit an SME’s claim to an annual cap of £20,000 plus three times the company’s total PAYE and national insurance contributions’ liability. At the same time, the scheme’s qualifying costs were revised to include data and cloud computing costs.
The cap on SME R&D relief only deals with part of the problem. A significant amount of tax loss occurs from what HRMC generously term “poor quality” R&D tax relief claims. This is where companies and their agents make claims for expenditure which should not be allowed, and the claim is not picked up by HMRC compliance staff, leading to an incorrect payment being made. According to the NAO:
“Following the increased assessment of tax at risk in 2018, HMRC is also exploring opportunities to improve its systems and processes for risk-assessing claims and preventing incorrect payments, which is likely to require both legislative change and funding.”
Given there is a degree of uncertainty facing firms making claims for expenditure already incurred, and as R&D is a relatively specialist part of the corporate tax system, some companies understandably find it helpful to engage a specialist agent to advise on or help prepare the claim. These specialist agents come from the worlds of management consultants, lawyers and accountants who sell their time and expertise to assist their clients.
As the gains, potential revenues and limited risks have become more attractive with only 3 in 1000 claims not being paid out by HMRC, some of these agents have developed a no-win, no-fee business model which presents a risk of “boundary-pushing”. This “boundary-pushing” in the words of the UK government presents a situation where “HMRC is not always aware of who these agents are, or of their experience with R&D claims, and there have been instances of agents persuading companies to submit marginal claims or even to claim for activity which is not R&D”.
This highlights a serious problem with the tax relief system. Tax reliefs can be very difficult to change, even where there is clear evidence of fraud in the system. Given the attractiveness to stimulating economic activity through innovation and the use of R&D tax credits, it is important that this comes alongside more resources dedicated to tackling the abuse of the system.
Will the changes have an effect? Probably not.
The economic attractiveness of R&D tax credits are powerful. A study by HMRC in 2015 found that for every £1 of tax forgone, between £1.53 and £2.35 of additional R&D is stimulated. The UK government has also set itself the target of raising total investment in R&D to 2.4% of UK GDP by 2027. The current level is only 1.7% of GDP and would represent a further 40% increase in R&D activity over next 6 years.
Any scenarios of curtailing R&D and constraining the existing market practices look unlikely as the government is working through the responses to a further consultation on the use of R&D tax credits. One can expect further ambulance chasing type practices as the allure of innovation and R&D drive unscrupulous market behaviours. We have been warned.
Read the concluding piece on this story, called R&D musical chairs here.