Understand the changes to R&D tax reliefs: overseas restrictions

The UK government has introduced significant reforms to the Research and Development (R&D) tax relief regime, particularly concerning overseas expenditure. These changes aim to ensure that the benefits of R&D tax reliefs are focused on activities that directly benefit the UK economy. This blog will explore the position under the old regime, the key enactment dates, the effects of the changes, and examples to illustrate their impact.

The old regime: a global approach to R&D expenditure (for claims under old RDEC and SME regimes)

Under the previous R&D tax relief regime, companies could claim relief on eligible R&D activities regardless of where the work was conducted. This meant that in many cases businesses could include costs incurred for R&D activities performed overseas, such as subcontracted work or payments in respect of externally provided workers (EPWs) based outside the UK. While this approach provided flexibility for businesses operating internationally, it also meant that UK taxpayers were indirectly subsidising R&D activities that might not benefit the UK economy.

Key enactment dates and legislative changes

The reforms to R&D tax reliefs were announced as part of the UK government’s broader strategy to modernise the tax system and ensure that public funds are used effectively. The key dates to note are:

1. Announcement of changes: the government first announced its intention to reform R&D tax reliefs in the 2021 Autumn Budget
2. Legislation: the changes were legislated in the Finance Act 2024
3. Implementation date: the new rules apply to accounting periods beginning on or after 1 April 2024 (and therefore claims under new RDEC and ERIS)

These changes introduce restrictions on claiming R&D tax relief for certain overseas costs, with a focus on encouraging businesses to conduct R&D activities within the UK.

The new regime: overseas restrictions (for claims under new RDEC and ERIS regimes)

Under the reformed regimes, expenditure on externally provided workers whose earnings are not subject wholly or in part to UK PAYE and on contracted out R&D that is conducted outside of the UK is excluded from R&D claims except in certain circumstances.

As is often the case, there are exceptions – where there are conditions necessary for the purposes of the R&D:

• that are not present in the UK;
• that are present in the location where the R&D is undertaken; and
• that it would be wholly unreasonable for the company to replicate in the UK

then the cost of the R&D activities undertaken overseas may be claimable.

In this context, ‘conditions; includes geographical, environmental or social conditions and legal or regulatory requirements (not an exhaustive list) but does not include the cost of the R&D or availability of workers to carry out the R&D (exhaustive list).

Whether it is wholly unreasonable for the company to replicate the conditions in the UK will depend upon the R&D, the circumstances of the company and the reason for undertaking the work abroad.

These changes aim to align the R&D tax relief system with the government’s goal of fostering innovation and economic growth within the UK.

Examples illustrating the changes

To better understand the impact of these changes, consider the following examples:

Example 1: overseas expertise

A UK-based pharmaceutical company conducts clinical trials in a country with a specific patient demographic unavailable in the UK. Under the new rules, the company may still claim R&D tax relief for this expenditure if it can demonstrate that conducting the trials in the UK would be ‘wholly unreasonable’.

Example 2: subcontracted work

A software development company outsources part of its R&D work to a team in India due to cost considerations. Under the new regime, this expenditure would no longer qualify for R&D tax relief, as the work could reasonably be conducted within the UK.

Example 3: Environmental Conditions

A renewable energy company conducts R&D on solar panel efficiency in a desert environment. If the specific environmental conditions required for the research are unavailable in the UK, the company may still claim relief for this overseas expenditure.

Implications for businesses

The introduction of overseas restrictions represents a significant shift in the R&D tax relief landscape. Businesses must carefully assess their R&D activities and expenditure to ensure compliance with the new rules. Key considerations include:

• Reviewing R&D projects: companies should evaluate their R&D projects to determine whether any overseas activities can be relocated to the UK.
• Documenting justifications: for overseas expenditure that may still qualify for relief, businesses must maintain robust documentation to demonstrate why conducting the work in the UK would be ‘wholly unreasonable’.
• Engaging with advisors: given the complexity of the new rules, businesses should seek professional advice to navigate the changes and optimise their R&D tax relief claims.

Conclusion

The reforms to R&D tax reliefs reflect the UK government’s commitment to fostering domestic innovation and ensuring that public funds are used effectively. While the new rules may pose challenges for businesses with international operations, they also present an opportunity to refocus R&D activities within the UK. By understanding the changes and planning accordingly, businesses can continue to benefit from R&D tax reliefs while supporting the UK’s economic growth.

For detailed guidance on the reformed R&D tax reliefs and overseas restrictions, visit the: HMRC Corporate Intangibles Research and Development Manual.