One seemingly straightforward sub clause in the current Finance Bill shows just how little our politicians actually understand about the technical detail behind the words.  Clause 43(6) states:

In section 1058 (amount of tax credit), in subsection (1)(a), for “14%” substitute “12.5%”.

What this will do is to reduce the rate of repayable R&D Credit from 14% to 12.5% of the enhanced expenditure.  Of course, sine the rate of enhancement has increased from 75% to 100%, the actual amount of credit (all other things being equal) has increased from 24.5% (ie 14% of 175%) to 25% (ie 12.5% of 200%).  Which, let’s be clear, is still good news for loss making SMEs.  However, it is the rationale behind this reduction in the Credit rate which concerns me.

First, we need to understand that the SME R&D regime is an EU State Aid and, as such, must comply with various EC regulations.  The relevant regulation in this case is 5.1.2 of Community Framework for State Aid for Research and Development and Innovation (2006/C 323) which requires that the Aid Intensity of any relief should not exceed 25%.  In simple terms, Aid Intensity in this case is the cash credit as a percentage of the qualifying expenditure.

An example: assume qualifying R&D expenditure of £100 by a loss making SME.  With the new rate of relief, that would give an R&D deduction of £200 (ie 100 x 200%) and a Credit amount of £25 (ie £200 x 12.5%).  The Aid Intensity is thus 25% (ie 25/100).

This seems straightforward enough but a closer look at how HMRC calculates Aid Intensity in non-Credit situations is enlightening.  If we assume that, in the example above, the company had actually been profitable, it would have had an extra tax deduction (in excess of the normal trading deduction for the qualifying expenditure) of £100.  In other words (at a CT rate of 26%) it would have paid £26 less tax than without the relief.  So, the Aid Intensity is 26/100 or 26%.  Greater than the EC’s limit of 25%.

Ah but, say HMRC, in looking at what “Aid” has been received, we should take account of what relief the company could have claimed under the Large Company R&D regime (which is not a State Aid).  The extra deduction for the Large Company relief is 30%, so the excess that the SME has obtained is only 70% (ie 100 – 30).  So, now the “Aid” is only £18.20 (ie £100 x 70% x 26%) and the Aid Intensity is 18.2% (ie 18.20/100).

Using the Large Company regime as a baseline seems quite reasonable but it does then beg the question as to why that isn’t applied in the case of the Credit.

All of which brings me back to my opening statement.  The Opposition tabled an amendment which sought to delete sub clause (6), ie leaving the Credit Rate at 14%.  In the Finance Bill Committee debate on this (24 May 2011), David Gauke (Exchequer Secretary to The Treasury) explained that the change was necessary to keep within the EC Aid Intensity limits, explaining that the amendment would result in an Aid Intensity of 28%!  The Opposition rather meekly accepted this explanation and the amendment was withdrawn.