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Effective relief?

Published on 03/10/03 at 11:24am

Are you aware that there are tax reliefs now fully in place that could cut the cost of your R&D programmes? Having recognised the importance of R&D to the UK economy, the Government has introduced three separate tax reliefs in order to encourage UK companies to spend more on generating improved products, processes and systems via the R&D function. In this article, we look at the benefits available to you through a claim, the rationale behind the tax relief including a more detailed (non-technical) exploration of tax reliefs, plus we look at the potential commercial impact relief may have whilst highlighting any practical issues a company needs to address to ensure it is taking full advantage of the Governments new found generosity!

What is the tax relief worth to me?

In simple terms, the potential tax savings could be worth between 7.5% and 15% of your R&D spend. Current estimates on the total cost of bringing a new drug to market vary, but it is probably in the region of $800 million. Consider taking 7.5% or more from a figure of this magnitude, and it becomes clear that this is worth looking at very carefully indeed. For those small companies in a loss-making position, a cash refund of 24% of qualifying R&D costs is available.

You would be right in thinking that many pharmaceutical activities will obviously qualify as R&D. What is crucial to maximising your claim, however, is understanding what is considered to be R&D for the specific purposes of the relief. That means considering all the activities of the company, not just those carried out in the R&D cost centre. This process will require cohesive input from the commercial, R&D and finance departments in order to get it right. How are you going to do that?

We will explore below how the reliefs work, what costs and activities will qualify and what steps to take to maximise the benefit to your company. You may say that tax savings do not directly impact on your R&D budget, so why should you care? But the potential for maximising cost reductions is not to be sniffed at and should interest executives whatever their position in the company.

What is the point of it all?

If we compare the R&D activities of the UK as a whole to our international competitors, we lag behind. The DTI has been tracking R&D activity in the UK for 12 years and has concluded that there are definite links between higher R&D intensity (ratio of R&D spend to sales) and sales growth, productivity and shareholder returns. These conclusions have led the Government to introduce legislation which gives greater tax relief to qualifying R&D activities and, for the first time, also recognises that loss-making companies require additional assistance in the form of cash repayments.

The estimated spend on R&D in the UK pharmaceutical sector for 2001 was in excess of £3 billion, with an estimated annual growth rate of some 8% (Source: CMR International profile of the UK pharmaceutical industry 2000 to 2002). Allowing for the fact that non-qualifying amounts may be included in this estimate, the potential benefit is still enormous. The UK pharmaceutical industry is consistently one of the top three industrial sectors in terms of trade surplus. A tax relief will play an important part in helping it address the challenges of an increasingly competitive international business environment.

One of the challenges the sector currently faces is a reduced supply of new chemical entities which  due to the long lead time of approximately 12 years for the development of most drugs  dates back to the early 90s. Any measures that encourage further R&D and pipeline development of new products will benefit not only the sector, but the general economy as well.

The reliefs

You will be relieved to know that we wont go into the details of the legislation from a tax perspective. The legislation, and its interpretation, is a complex area that, even as we write, is undergoing a process of synthesis and industry consultation. There are three different types of R&D Tax Relief. The first two reliefs for all R&D are dependent upon the companys size, in other words a small to medium size enterprise (SME) qualifies for SME relief, a large company qualifies for large company relief. Thirdly, there is relief specific to the pharmaceutical sector.

An SME may claim an additional 50% of the qualifying costs of R&D against its taxable profits. For a company paying tax at 30 %, this represents a cash benefit of 15% of the qualifying costs. For SMEs that are incurring a loss, a claim can be made for a cash refund of 16% of the enhanced loss.

A large company can claim an additional 25% of the qualifying costs of R&D against its taxable profits. At a 30% tax rate this equates to 7.5% tax saving on the underlying costs. The table is a basic summary of aspects of the SME and large company rules, though in practice the rules are much more complex.

Capital expenditure is not eligible for the enhanced relief but could be eligible for immediate deduction against taxable profits under the Research and Development Capital Allowances rules.

Of particular relevance to the Pharmaceutical sector, the Government has also introduced a Vaccine Research Relief (VRR). This is available in addition to the R&D Tax Relief. The VRR came into effect on 22 April 2003, and benefits companies who spend on R&D into human vaccines and medicines which prevent and treat tuberculosis and malaria, and also vaccines which prevent the infection of HIV. VRR is also available for research relating to vaccines and medicines for treating and preventing the onset of AIDS. As it only covers the clades commonly found in the developing world, however, VRR aims to tackle diseases primarily affecting such countries. The relief allows companies to claim an additional 50% relief, giving a total tax benefit of up to 30%. Where SMEs are loss-making, they can claim cash back, as above. Large companies may use the additional deductions in the normal way, but cannot claim any cash back.

Commercial issues

The subcontracting of activities is becoming more commonplace in the sector, perhaps as commercial pressures to create products outstrip the resources of the internal R&D function.

According to the Governments Budget 2003, companies can claim the cost of third party agency workers, albeit at only 65% of the invoice cost. A large company is not able to claim for work subcontracted out to commercial R&D providers. The change in the rules may lead to companies reconsidering subcontract arrangements, as the amount of claimable relief may be increased through the use of agency workers.

The potential to improve profitability and reduce cash outflows is now clear. Can board members afford to neglect the potential impact on shareholder value and cashflow, both of which are key commercial drivers these days?

Where is the R&D in my company?

Having dealt with the cost qualification, we can concentrate on the activities that qualify as R&D. This is the most complex area, having exercised the minds of tax authorities in every country in which similar relief has been introduced. The definition is still evolving in the UK.

As announced by Gordon Brown in this years budget, the Inland Revenue issued a consultative document in July to explore further clarification on the definition of R&D and the level of guidance to be given. Now is the time to stand up and be counted if you want guidance to take into account the specific circumstances of the pharmaceutical sector. Such guidance already exists in the US, Canada and Australia, where R&D relief has been available for a number of years. In keeping with our regular input into this evolving definition, Deloitte & Touche will be making representations and would be glad to incorporate your view in our submission if you would like to contact us.

The tax definition of R&D currently revolves around activities that involve an appreciable element of innovation, novelty and creativity in the fields of science and technology. Qualifying activities seek to achieve a scientific or technological advancement, resolving scientific or technological uncertainty in a systematic way. The challenge for your company will be to clearly demonstrate this to the Inland Revenue on a project-by-project basis. Many activities may be obvious qualifiers. Phases I to III of clinical research trials spring to mind as activities that have historically been accepted by the Inland Revenue as constituting R&D. The real challenge will be to expand your claim by identifying qualifying activities within Phase IV and also outside the phases of clinical research, such as those in manufacturing, quality assurance and control, regulations medical affairs et al.

You must then identify the associated qualifying costs, but this is not a project for the finance department alone. A task of this importance and size will need the input of tax specialists, accountants and most importantly, the scientists and managers involved in the wider R&D process. We say wider because the key to maximising the benefits of this relief is to identify not only the qualifying activities for new active substances, but also the line extensions and advances in systems and processes. These will occur not only in the lab cost centres but also through experimental development and early stages of production.

Our experience shows that qualifying R&D activities, based on the advancement and resolution of uncertainty principles set out above, occur in bubbles at various stages in the evolution of a product or process There is no standard end-point that can be identified and so each activity must be evaluated on its own. The opportunities that come with R&D tax relief are science and technology issues, just as much as they are financial.

John Moore (johnmoore@deloitte.co.uk) and David Cobb (dcobb@deloitte.co.uk) are director and head respectively of the UK R&D Tax Services Group at Deloitte & Touche.

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