Founder Series: Top Tips to Fund Your Innovation


11 minute read | June.28.2024

Orrick's Founder Series offers monthly top tips for UK startups on key considerations at each stage of their lifecycle, from incorporating a company through to possible exit strategies. The Series is written by members of our market-leading London Technology Companies Group (TCG), with contributions from other specialists. Our Band 1 ranked London TCG team closed over 200 growth financings and tech M&A deals totalling $3bn in 2023 and has dominated the European venture capital tech market for 33 quarters in a row (PitchBook, Q1 2024). View previous series instalments here.

Startups play a vital role in the UK economy but face challenges when it comes to raising capital to fund their innovation. A range of incentives are in place to encourage investment in Research and Development (R&D) but the rules around accessing these have changed significantly in recent years, with the introduction of a merged scheme for R&D tax relief. For the latest instalment of the Founder Series, we've teamed up with innovation tax specialists, ForrestBrown to explore the options available to founders and highlights key issues to be aware of.

1. Get to grips with new rules on contracting out R&D. With the merging of the SME and Research and Development Expenditure Credit (RDEC) schemes for R&D tax relief for accounting periods beginning on or after 1 April, new rules relating to contracting out R&D now apply. As these new rules will have far-reaching effects across innovation ecosystems, high growth SMEs need to be aware of the implications.

The new definition that has emerged effectively places the right to claim R&D tax relief with the company making the decision to undertake R&D. This recouples the incentive with the policy objective of driving behavior, namely the inherently risky decision to invest in innovation. 

The merged scheme introduces a three-step test. All three questions below need to be confirmed in the affirmative for R&D to be contracted out:

  1. Is there a contract between the companies to which the R&D relates?
  2. Was qualifying R&D undertaken to meet the obligations of the contract?
  3. Assuming the first two tests are met, was the relevant R&D intended or contemplated when entering the contract?

While at first glance it seems straightforward, there is quite significant scope for interpretation, so businesses need to review commercial arrangements with supply chain partners carefully. SME entities who have claimed correctly in prior periods could now find their large clients considering the R&D belongs to them, and they will need to be confident any intention to claim moving forward is backed up by contractual terms.

Understanding how these new rules will impact your R&D tax relief claim – positively or negatively – is vital to inform accurate financial planning.

2. Make R&D part of investment decision-making. The merged scheme changes the mechanism for SMEs claiming the R&D tax incentive, making the credit more visible in company accounts. This is particularly vital for SMEs (in particular, those with specified investment enterprise backing or other external stakeholders) and can be critical to decisions, ranging from access to wider financing to shareholder queries.

Under the old SME scheme, the credit was made via an enhancement to the Corporation Tax liability calculation. As the credit was not subject to a tax charge, it was shown 'below the line', solely as an adjustment to tax liability and the balance sheet, with no impact on the profit and loss statement.

However, the merged scheme adopts the previous 'above-the-line' RDEC-style credit, making it more visible and enabling businesses to forecast their cash flow and performance more accurately. In addition, as it is included in your income statement, it can help companies in respect of their EBITDA position. R&D impact on EBITDA will differ, but this key metric for how well the entity manages its day-to-day operations, will be more visible to PE, VCs, advisors and wider shareholders, therefore increasing the importance of reporting and forecasting the benefit effectively.

3. Assess eligibility for enhanced R&D intensive support (ERIS). Despite the introduction of a merged scheme, some SMEs will continue to sit outside the RDEC mechanism if they qualify as ‘R&D intensive’. Enhanced R&D intensive support (ERIS) is available for businesses investing at least 30% of total business expenditure in R&D (currently 40% for periods after 1 April 2023). Eligible businesses can claim R&D tax relief at a more generous rate.

What is more, with the removal of subsidy rules in the merged scheme, grant funded projects will be eligible to claim under ERIS, providing significant relief on R&D projects even if the company has not funded the projects themselves. This eliminates a potential barrier previously preventing some startups from accessing more generous R&D relief.

Awareness of whether you are within the ERIS scheme is key, as this is not something you will have had to calculate previously. Consideration should be given to forward planning and reporting to ensure access to the scheme is not impacted negatively by business decisions without awareness.

4. Submit an AIF in advance of your R&D tax relief claim. As explored further in section 7 below, HMRC expects companies to engage proactively with the rules. Companies will continue to need to do so in order to ensure that they meet the new requirements (introduced in August 2023) to file the R&D supporting information on HMRC’s Additional Information Form (AIF). This needs to be completed prior to filing your R&D claim numbers in the Tax Return. While the number of people who are not filling the AIF in advance is dropping, HMRC statistics still show 15% of claims are being rejected due to lack of an AIF. 

This form requires the inclusion of crucial supporting details that HMRC considers essential for backing the R&D claim. Significantly, businesses will no longer have the flexibility to select which technical reports to submit, as the project requirements are now firmly established.

Companies need to ensure that the technical reports supporting the claim, are highlighting how the R&D activities meet the DSIT Guidelines (which define R&D for tax purposes) and importantly are focusing on the advances in the underlying technology, and not discussing the commercial advantages of the product, process or service.

5. Formulate a strategy for R&D tax relief enquiries. Over the last 18 months, the R&D scheme has come under increased compliance scrutiny. In the main, this has been due to HMRC pointing a portion of the 9,000-strong Campaigns and Projects team towards reducing error and fraud within the R&D marketplace. This team, which forms part of the Individuals and Small Business Compliance (ISBC) unit, has increased the number of enquiries into R&D claims from 1% to over 20%. 

At the height of the increased compliance activity in the summer of 2023, the ISBC team were not only challenging erroneous claims from sectors unlikely to be carrying out R&D (such as care homes and pubs) but also catching genuinely innovative businesses in their net, as they focused on targeting certain industries. Fast forward to today and there are glimmers of light, but it is important that founders are aware that R&D tax claims remain subject to increased scrutiny and should plan accordingly for the possibility of a compliance check. 

Please be aware that these enquiries can be lengthy, often spanning multiple years and diverting valuable resources from daily operations. If you do find yourself involved in an enquiry, it is essential to approach it strategically and be clear about the resolution you aim to achieve. Seeking early advice is key to success. And remember, it is not just about the claim in question – the result of an enquiry could impact your ability to make future claims.

6. Understand enquiry timescales. A common mistake when considering an R&D claim is assuming that once it has been processed, it has been reviewed and accepted by HMRC. It is important to understand that R&D claims fall under Corporate Tax Self-Assessment, meaning the taxpayer is responsible for calculating the tax liability. The claim is processed when the tax return is filed. 

Despite the significant increase in compliance checks, HMRC aims to ensure that claimants still receive their Corporation Tax repayments and R&D credits promptly, typically within 40 days of submission. However, HMRC has a much longer period to review the claim documentation thoroughly. The enquiry window periods are: 

  • 12 months from filing the R&D claim if filed within the original return. 
  • If filed within an amended tax return, it is the quarter end following 12 months from filing (quarter ends being 31 January, 30 April, 31 July and 31 October).

This means that HMRC still has nearly a year after processing your R&D claim to open a compliance check into your claim.

HMRC has additional discovery powers to review claims from the past four years. If they suspect insufficient tax payment, this period can extend to six or even twenty years in cases of careless or deliberate behavior. 

Remember, the lens through which discovery will be viewed is your current claim, so getting this right – and being prepared to defend it – is especially important.

7. Take a proactive approach to record keeping. Many recent changes stem from HMRC's desire for companies making R&D claims to engage with the rules proactively. They want businesses to understand the regulations and seek quality advice before submitting their claims.

Another example of this is the publication of new guidance for R&D claimants, known as Guidelines for Compliance 3 (GfC3). This document aims to clarify HMRC's expectations for companies preparing R&D claims. 

The good news about GfC3 is that it aligns well with the processes that will be familiar to all of us. It covers the main areas that are often a focus in enquiries and provides many short practical examples, drawn from a broad range of sectors, to expand on common concepts.

Founders should note that the new guidance places a much greater emphasis on the evidence needed to support an R&D claim, highlighting the importance of maintaining thorough records during an R&D project. We are increasingly seeing R&D claims rejected during enquiries due to insufficient records.

Keep in mind that HMRC enquiries are retrospective – they may ask for records a year or more down the line and will use GfC3 to guide their expectations, even if the claim was submitted before its publication. 

8. Commercialise your IP with Patent Box. In today’s competitive business landscape, protecting an innovative idea holds as much importance as the idea itself. Competition is fierce, with technological advancements happening daily, in part thanks to the rapid rise of AI in most industries to improve efficiency and performance. Moving forward, protecting IP will be critical for innovative firms to remain competitive. Please see our instalment on Protecting Your Ideas.

IP protection can safeguard brand identity, ensuring innovation is rightfully recognised, and create additional revenue streams through licensing and partnerships. Brand identities will thus be shielded from competitors that may look to replicate ideas. 

The Patent Box regime was introduced in the UK in 2013 to encourage businesses to commercialise their patented inventions and locate high-value jobs associated with the development and manufacture of patents in the UK. The relief rewards innovation and applies a lower tax rate of 10% to profits attributable to patented products or processes (compared to the standard main rate of 25%). 

Consideration of whether to commercialise your patents and the timing of when to do so is increasingly important. Understanding your runway to profits and tax liabilities as a business will be key, as is the length of time to get a patent and the revenues that will sit behind it.

9. Explore grant funding opportunities. In addition to tax reliefs, there are other innovation incentives available to innovative businesses in the form of government grants. 

Regularly scanning for grant opportunities should be part of your routine, alongside frequent project reviews, to ensure readiness when new funds become available. This is especially pertinent for businesses in industries such as life sciences, agritech, and quantum computing, where the government has identified a need for strategic support (see point 10 for thoughts on how this could change in future). 

Businesses tend to be less aware of negotiated grants, which is funding that is not currently allocated towards projects but can be made available depending on the type of project. When considering plans around people, capital or innovation investments, it is worth reaching out and exploring whether there could be potential funding for your project.

10. Look out for further changes to come. Following such a period of upheaval, many businesses would welcome a period of stability, but the forthcoming general election could result in further change. Details are thin on the ground in the major parties’ manifestos, at least when it comes to R&D tax relief, but there are some pointers to the approach they might take in government.

The Conservatives are committed to maintaining R&D tax reliefs, while Labour has pledged to keep the UK at the forefront of global innovation – in part, through an industrial strategy which would take a more targeted sector approach, perhaps indicating a greater focus on direct funding through grants. Elsewhere, the Liberal Democrats would set a target for R&D investment – at least 3% of GDP by 2030, rising to 3.5% by 2024. 

Whoever has the keys to Number 10 following 4 July, it’s clear that innovation will be viewed as critical to driving economic growth. Innovation incentives offer various levers to encourage private sector investment, which could mean further funding opportunities for startups looking to scale.

ForrestBrown is a trusted adviser to many of the UK’s most innovative businesses, on matters relating to R&D tax credits. For advice on your R&D tax credit claims, please contact chartered tax adviser (CTA) Chris Alderson. For any legal advice relating to raising capital, please contact Jamie Moore.