Rishi Sunak's government has received praise from the UK tech community for its fast response to the SVB UK debacle. UK ministers and the Bank of England worked over the weekend to secure a buyer for the UK subsidiary of the US bank, averting a crisis for hundreds of startups.
But the goodwill may not last for long. At stake this time? R&D tax credits.
Last week, over 250 startup founders urged Jeremy Hunt, the British chancellor, to reverse proposed cuts to R&D tax rebates for SMEs in his spring Budget on Wednesday.
They warned that the cuts would have a “seismic impact” on the UK’s startup ecosystem, and cost the average startup £100k a year. Startup founders, who got £4.2bn from the scheme in the year to April 2021, say they may even have to lay off staff without the support.
UK politicians say cuts are necessary to rein in government spending. But UK startup founders and investors say the proposal is one of a string of post-Brexit policy decisions that has them worried about the government’s seemingly mercurial commitment to domestic tech.
And it’s a change that affects some of the most strategically important sectors — think deeptech, climate tech and biotech — for the future of the UK economy.
What changes is the government proposing?
In 2000, the UK government established an R&D tax relief scheme that allows companies to claim back part of the money spent on R&D expenses — including payroll, contractors, software and prototype materials — as a tax relief or cash credit. It was all in the name of incentivising scientists to commercialise their research in the UK.
It’s split into two schemes: the R&D scheme for SMEs and the R&D expenditure credit (RDEC) scheme, which is primarily for larger companies. In 2020-21, the former claimed 64% of the total R&D tax credits claimed, while the latter claimed 36%.
Founders are frustrated because the changes — in effect from April 1, 2023 — involve cutting the support for SMEs, while upping the tax relief available for larger companies.
Currently, accountants say a typical loss-making SME (ie, most startups) receives up to a 33% payable tax credit on qualifying R&D expenses, meaning they receive cash back equal to 33% of the qualifying expenditure. However, from next month, the generosity of this credit will be reduced to 19%.
Meanwhile, the generosity of the R&D expenditure credit (RDEC) scheme for larger companies will go up, its rate increasing from 13% to 20%.
Why does the UK government want to cut the SME scheme?
Sunak came up with the idea of reforming the R&D scheme while chancellor in his spring Budget this time last year, claiming: “In spite of spending huge and rapidly growing sums, clearly it is not working as well as it should.”
According to numbers from the Office for Budget Responsibility (OBR), UK companies claimed £6.6bn such relief in 2020-21, up almost fivefold from £1.2bn in 2015-16. The government feared this could rise to £8.9bn by 2027-28, based on OBR forecasts. Those same forecasts say the proposed cuts will save the UK £1.3bn a year by 2027-28.
Hunt has also cited fraudulent claims and misuse of tax credits as the chief reason for making cuts. In the year to April 2022, fraud and error amounted was equivalent to almost 5% of R&D tax claims.
But several founders and investors tell Sifted that beyond a handful of cases making a big splash in the media, R&D tax claim fraud has been wildly overstated. Instead, they point to the "error" component as being more to blame.
One company that helps startups claim their tax credits, Claimer, has analysed a dataset of more than 750 claims with HMRC across approximately 400 companies.
Claimer’s CEO Adam McCann tells Sifted: “The reality is that there’s very little fraud in the system.”
He says the bulk of inefficiency instead relates to "incorrect" claims — or claims which do not meet the R&D guidelines but get paid anyway — through a lack of compliance at HMRC.
“It's been getting increasingly out of control for some 22 years — but now it's as if they're trying to slam on the brakes as fast as possible,” McCann says.
This hasty reaction, paired with stretched resources at HMRC and the Treasury, has resulted in what McCann deems “poor and deliberately anti-SME decisions”, with insufficient notice for the businesses most impacted.
SMEs could be wrong target
Without a sufficient way to measure the impact that SME R&D spending is having on UK growth versus larger companies’, many founders and investors say that the government is shooting in the dark, and cutting in the wrong place.
“There is huge global competition for investment in R&D sectors in the private sector,” says Anne Glover, CEO at Amadeus Capital Partners, who points out that numerous countries are chasing the same big companies.
“So the government's attempt at re-engineering the tax credits was to try and focus on larger companies, who they felt weren’t basing their research and development centres in the UK as much as they used to.”
This was all part of the government’s plan to become a “science superpower” — which UK startups welcomed.
“But the problem is they’ve taken support away from the small guys (the SMEs), to fund it, which doesn’t make economic sense long-term,” Glover says.
There hasn’t been much research into how much impact the scheme has had on the broader UK economy. An independent Cambridge University report from 2021 concluded that the long timescales involved in research made it “impossible to quantify the influence of R&D tax credits on UK productivity and growth”.
Cuts will stifle innovation and cause bankruptcies
Tax advisers tell Sifted that the majority of startups they work with on SME R&D claims choose to reinvest the money from the scheme on more R&D, hiring additional personnel or buying new equipment.
“This plays a pivotal role in the long-term growth strategies of companies, and a reduction in the amount available will undoubtedly have a detrimental effect on these activities, stifling innovation,” says R&D tax specialist Steve Collins.
Three quarters of respondents to a recent survey of 267 UK startup founders by tech lobby group Coadec said that they may not be able to pay staff or meet other business costs as a result of the cuts.
Meanwhile, the very R&D output at the heart of all this could also be threatened: four in five founders strongly agreed that their R&D activities would be slower and more difficult as a result of the cuts. In the same survey, Coadec found that 84% of startup founders were concerned they'd have to offshore more tech development if the cuts come into force.
“What’s misunderstood is that you have to demonstrate you’ve paid payroll tax in order to get the R&D tax credit, so it's a direct incentive for scientific jobs in the UK,” Glover says.
“Jobs are what the government wants — for a lot of these research-intensive industries, it’s not the capital or equipment, but the people that matter most for the future.”
All this comes as startup founders and research institutions were already dealing with a tougher hiring environment since Brexit. Changes to the UK’s visa system have made it more expensive to hire researchers on longer term contracts, and founders tell Sifted that they’ve also been battling an "unfriendly" perception of the UK among potential hires since it left the EU.
Falling behind on a global scale
Even when the tax rebate has been in full force, UK business investment in R&D remains well below the OECD average. But in 2017, the UK government set a target for reaching 2.4% by 2027, up from below 2% now. Private sector spending is vital for reaching this goal — but by de-incentivising SMEs to spend more in the UK, experts warn the government is shooting itself in the foot.
“If the cuts were implemented as a cost-saving measure, it may work against the government's aim of establishing an innovative economy,” says Collins.
“SMEs will no longer be motivated to innovate to the same degree,” says Collins. “If the UK desires to cultivate the next Google or Apple, its approach is counterproductive.”
Amy O’Brien is Sifted’s fintech reporter. She tweets from @Amy_EOBrien and writes our fintech newsletter — you can sign up here.
