UK Government Spells Out R & D Tax Credit Options

by Jason Gorringe, Tax-News.com, London

05 December 2001

As UK ministers with business responsibilities prepared to face manufacturers and unions at a hastily-convened "summit" in Birmingham, the Government published details of its research and development tax credit for large companies. Today's Birmingham meeting was called by Patricia Hewitt, the trade and industry secretary, although she is understood to have few proposals for the summit, beyond DTI help in spreading best practice to lagging manufacturers, and faster roll-out of a network of Manufacturing Advisory Centres.

Chancellor Gordon Brown said the three R & D tax credit proposals, on which the Inland Revenue is inviting consulotation, would play an important role in boosting R&D expenditure, which business leaders say is crucial to international competitiveness. The Treasury said it wanted to aim the scheme at companies that undertook R&D rather than those that financed it. It said collaboration between companies and universities and other institutions would qualify. The Confederation of British Industry (CBI) said it was very pleased that the government had abandoned earlier proposals for a tax credit based on incremental spending: "There are pluses and minuses with each of these proposals and we will be thinking carefully about which one is best for industry," said Tim Bradshaw, a CBI senior policy adviser.

The three options for an R&D tax credit are:

• Credit at a single rate on all R&D spending;
• Higher rate tax relief up to a threshold of £100m and a lower rate above that level - to target medium-sized companies;
• A complex, CBI-promoted scheme using specific company baselines above which a simple credit would be paid on all R&D spending.

The Government says that responses to previous consultation clearly indicate industry's preference for a volume-based scheme; hence all three options are of this type.

The following are extracts from the Inland Revenue's consultation document:

' The incremental option set out in the consultation document was seen as less attractive than a volume based scheme. The principal concerns centered around the fears that:

• it is too complex, especially the group rules, the rolling base and the debit bank;
• the amount of relief depends upon the total annual increase, so it is difficult to predict the extent of tax relief at the time that investment decisions are made;
• it does not reward companies that maintain high but relatively stable levels of R&D.

' In contrast, respondents were attracted to a volume based scheme because:

• it is simple and predictable. Respondents thought this would make a volume credit more effective in providing an incentive to increase R&D;
• it would be fairer to companies with a long record of sustained R&D effort; and
• it would fit better with the existing SME scheme, helping to smooth the transition for growing companies.

' As a result of the initial consultation the Government has also decided upon some common features that will be adopted by any of these three schemes:

• the definition of R&D will be the same as that for the SME R&D tax credit, as set out in guidelines issued by the Secretary of State for Trade and Industry;
• unlike the SME R&D tax credit, ownership of the intellectual property arising from the R&D will not be required;
• the credit will operate as a super-deduction against taxable profits. All credit rates refer to this rate of super deduction;
• the government is considering how it can ensure that it rewards companies for the R&D they carry on themselves. For example, within groups a company subcontracted to undertake R&D would be rewarded rather than the company financing the R&D; and
• an exception to the above will be made for R&D carried on in collaboration with universities, scientific research organisations or charities, recognising the important benefits that derive from collaborative research.
  

'To facilitate consultation we have laid out below what we perceive to be the relative advantages and disadvantages of each scheme. We welcome comments on these or any additional points.

OPTION 1: A SIMPLE VOLUME SCHEME

'A simple volume scheme rewards all R&D within each year using an R&D super-deduction. A super-deduction allows companies to deduct more than 100% of their R&D expenditure from taxable profits. The simple volume scheme has two main advantages:

• the simple volume scheme is the most transparent and predictable of the three options. Companies will be able to predict with certainty how much additional tax relief they will get as a result of each new R&D investment. The response from consultation suggests that this element of predictability is important for the success of any R&D tax credit. Evidence from the US supports this view; and
• this is also the simplest of the three schemes to operate, reducing compliance costs for companies.

'However, the two principal disadvantages are:

• this scheme offers a lower headline rate of credit than the baseline scheme and a lower rate of credit than the two-tier scheme for companies below the threshold; and
• much of the relief rewards existing R&D rather than new R&D.

OPTION 2: A TWO-TIERED VOLUME SCHEME

'A two-tiered scheme provides a higher rate of volume credit on R&D expenditure below a threshold, say £100m, and a lower rate on spending above this. Compared to the simple volume scheme, a two-tiered approach based on a £100m threshold can offer a rate of relief that is about 50% higher for the first £100 million of R&D and about 50% lower thereafter.

'The two-tiered scheme has one main advantage: it offers a better rate of R&D subsidy for the majority of companies that spend less than £100 million a year on R&D. This will provide support to medium and smaller qualifying companies who may face greater constraints when investing in R&D.

'However, the two-tiered system has two main disadvantages:

• the two-tiered scheme is more complex. In particular, it requires the relief to operate at the group level. The implications of a group basis computation were set out in detail in the consultation document "Increasing Innovation". Operating this scheme alongside an approach which grants the credit to the company that undertakes the R&D, rather than the one that finances it, is likely to introduce further complexity; and
• companies above the £100m upper tier will receive the lower rate of relief at the margin, but receive the higher rate for their first £100m of R&D. For these companies, the two-tier scheme is a less efficient way of providing a marginal incentive. Furthermore, much of the relief rewards existing R&D rather than new R&D.
  

OPTION 3: A BASELINE VOLUME SCHEME

'Under this option, which has recently been put to us by a business representative, a baseline level of R&D expenditure is determined by reference to the previous R&D expenditure levels of the specific company. The company would then be eligible for an R&D tax credit on all expenditure above this baseline. One example, which has been evaluated in Box 1, would assign a baseline of 50% of a company's R&D expenditure in its accounting period ending in the year 2000. A credit is then paid on all R&D expenditure above this base, which would be at least 50% higher than the simple volume credit rate. In this example the base is set at 50% of 2000 R&D for all companies, but this could be tapered so that large R&D spenders face a higher baseline percentage.

'his baseline scheme has two main advantages:

• it delivers the highest marginal rate of subsidy on additional R&D. Marginal rates of subsidy play an important role alongside average rates of subsidy in encouraging companies to increase their level of R&D expenditure; and
• the rate of relief will be predictable so long as companies' R&D expenditure is not close to their baseline and a baseline update is not anticipated.
  

' However, the baseline scheme has two main disadvantages:

• it is the most complex scheme. Like option 2, it requires a group basis of computation, requiring all of the special group rules that were set out in the "Increasing Innovation" consultation document. Operating this scheme alongside an approach which grants the credit to the company that undertakes the R&D, rather than the one that finances it, is likely to introduce further complexity. Additional rules would also be required: to determine the initial baseline; to index the R&D base; and to define an emergency base for new companies or those involved in mergers or disposals; and
• this option would require some mechanism for updating the baseline. A pre-announced update may create incentives for companies to reduce their R&D in the new baseline year. An alternative would be infrequent unannounced updates.

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