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Could R&D tax reform have consequences for A&D supply chains?

Jenny Tragner, Director and Head of Policy at ForrestBrown, looks at why R&D tax reform could have unintended consequences for aerospace and defence (A&D) supply chains.

Image courtesy ForrestBrown
 
Since its introduction in 2000, R&D tax relief has been an effective tool in supporting business innovation in the UK. The most recent data from HM Revenue & Customs (HMRC) showed the amount paid out in R&D tax relief reached £7.6 billion in 2022, equating to £44 billion of business R&D expenditure and demonstrating the scale of R&D being undertaken by UK companies.

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The aerospace and defence (A&D) sector is R&D intensive and although not easily identified in HMRC’s sector analysis, is estimated to spend around £1.6 billion on R&D annually. It already plays an important role in the economy, with a turnover totalling more than £82 billion. Maintaining – and growing – this contribution in the face of fresh challenges such as decarbonisation and energy efficiency places increasing emphasis on government policies like R&D tax relief.

Understanding the status quo
The R&D tax incentive has been designed to provide tax relief to support businesses investing in R&D activities. The scheme was previously divided up to support smaller businesses through the SME scheme and larger companies through the Research and Development Expenditure Credit (RDEC) scheme – both of which operated on different rates of relief.

Rates for both schemes were ‘rebalanced’ in 2022, with misuse of the system prompting the government to reduce the generosity of relief for SMEs and HMRC to scale up its compliance activities substantially, leaving some genuinely innovative businesses on the back foot. At the same time, a higher rate of relief was introduced for RDEC, alongside a number of other changes and proposals, resulting in increased complexity for all.

A consultation into the design of R&D tax incentives was launched in 2021 and concluded in the Autumn Statement 2023, with the government announcing that the SME and RDEC incentives would be merged into one R&D tax relief vehicle (using the 20% RDEC rate), commencing in April 2024.

While this change is a welcome step towards streamlining the overall process for A&D businesses, the picture is not quite as clear as this announcement suggests, not least because an SME scheme will continue alongside the merged scheme for loss making R&D intensive SMEs.

Companies need to consider carefully the details of recent and forthcoming changes to ensure they are not caught out, given the tight timeframe of implementation. There will be winners and losers, but businesses that plan ahead will be best placed to navigate the change with the minimum disruption.  

Innovation incentives pivotal for A&D investment
The Aerospace Technology Institute (ATI) has predicted that if the UK maintains its leadership in net-zero technology innovation, it could secure up to 18% of the £4.3 trillion market for energy-efficient commercial aircrafts by 2050.

However, there are currently concerns regarding the funding environment for scaling up technologies in the sector and there is a need for urgency in developing the necessary infrastructure for a net zero economy. While the ATI has played an active role in supporting next-generation aviation R&D, with over £3.5 billion of investment since 2013, the industry continues to face financing hurdles that are slowing down the development of zero-carbon technologies.

With these challenges in mind, tax incentives can provide a vital boost for A&D firms investing heavily in sustainable technology. Alongside the primary benefit of lowering the cost of R&D, the process of identifying, documenting and reporting R&D efforts, whether or not they result in commercial success, can help to promote a culture of innovation that promotes talent retention and attraction, facilitates growth and contributes to spillover benefits for the industry, local communities and the country.

A single scheme in name only?
Although badged as a merged scheme, the more recently introduced enhanced rate for loss making R&D intensive businesses will continue to operate separately under the existing SME relief framework. This scheme offers an effective rate just lower than the previous SME scheme (27% compared to 33%) and is available to loss making SMEs where their R&D spend is a given proportion of overall expenditure.

The current 40% threshold to qualify for this enhanced rate means that it only applies to a small number of businesses – but the lowering of this threshold to 30% from April 2024 will see a greater proportion of R&D businesses being brought into scope of the more generous rate. This is a welcome step in the right direction, albeit there are already calls for the threshold to be lowered even further and for the relief mechanism to be brought into line with RDEC.

R&D and supply chains
The launch of the merged scheme in April 2024 will result in winners and losers, as well as some potential ‘grey areas’. Industry leaders have stressed the importance of a cohesive industrial strategy to support SMEs and promote growth, yet there remain concerns regarding a potential disconnect between top level policy commitments and the practical implementation of those policies. One example is the introduction of new provisions governing R&D relief in supply chains.

Recognising the complexity of this point, a policy paper was published alongside the Autumn Statement 2023. This note set out the intention to focus relief where the decision to carry out R&D is taken, ensuring that relief best fits with the policy intent to encourage innovation investment.

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However, the practical implication is that all companies will now need to navigate a legislative definition of contracted out R&D. Some will be getting up to speed with this concept for the first time, whereas many SMEs will approach the new rules following years of uncertainty which have plagued some SME R&D claims.

HMRC is in the process of producing guidance to support the new definition, which is expected to build on the policy paper and provide greater clarity on how it intends to interpret the law.

Deciding whether R&D has been contracted out – as opposed to contracts for the supply of goods and services which might incorporate some R&D – will be key in the merged scheme. In the A&D sector, R&D supply chains can be complex and this change could take some by surprise, particularly in cases where the right to claim relief will move from one entity to another.

An example of this would be where R&D is contracted from a prime to an SME supplier. Currently, the SME can usually claim relief under RDEC but in the future, the claim will sit with the prime, which could create unintended consequences for commercial relationships.

How can the uncertainty be resolved?
The merged scheme announcement at the 2023 Autumn Statement signals this government’s intention to bring to a close the long running consultation into R&D tax reliefs. While a period of stability will be widely welcomed, several questions remain over the practical implementation of the merged scheme, particularly for sectors which are R&D intensive, or where technology is set to have a substantial impact in coming years.

With such major changes now being implemented in an incredibly tight timeframe, companies must have access to clear, timely guidance from HMRC and the government, which has previously been criticised for short term thinking and putting its concerns about abuse above the positive policy impact of the relief, should be held to account in monitoring the impact on businesses.     

As the A&D industry looks to combat the challenges it faces, such as supply chain issues and the furthering of net zero ambitions among many others, there is no doubt that R&D investment will be critical if the UK is to compete with global competitors on cutting carbon emissions. However, understanding the detail is critical and organisations must familiarise themselves with these changes ahead of April 2024 to best protect their investment in R&D.

 

 

 

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