The UK’s research and development (R&D) Tax Credit landscape underwent a seismic shift in April 2023 when the government decreased the uplift under the SME scheme for one year. Then, they subsequently merged the separate SME and Large Company schemes into a single Research and Development Expenditure Credit (RDEC) system. While presented as a simplification measure, the reality for small and medium-sized enterprises (SMEs) is that the effective R&D Tax Credit refund under the merged scheme requires the SME to make a significant investment in R&D. Even though the SME is carrying out R&D, many conclude that the R&D tax refund is so low that it is not worth making an R&D Tax Credit claim.

The Great R&D Tax Credit Restructure

Before April 2023, the UK operated two distinct R&D Tax Credit schemes:

• SME Scheme: the old SME scheme effectively offered an R&D Tax Credit of approximately 25% of eligible R&D spend for profitable companies and up to a 33% tax credit for SMEs in a tax loss position. The current effective after-tax R&D Tax Credit is 16% under the new merged scheme.
• Large Company Scheme (RDEC): the old RDEC provided a more modest 13% tax credit rate for larger enterprises. Which is now effectively a 15% R&D Tax Credit.

The 16% SME Reality Check – New Merged Scheme

For accounting periods starting on or after 1 April 2024, the new merged scheme is in effect. While the headline rate is 20%, the effective benefit for SMEs is significantly lower due to the interaction with corporation tax. The RDEC credit itself is subject to corporation tax up to 25% (the corporate tax rate ranges from 19% to 25% as profits increase), reducing the net benefit to approximately 16% for most SMEs.

This represents a dramatic reduction from the previous SME scheme’s effective rates. Under the old scheme an SME in a tax loss position could receive an R&D Tax Credit refund up to 33%, so on a £100,000 R&D spend, the SME would receive £33,000. Now that the same SME (other than an R&D intensive SME) receives only £16,000. A decrease of approximately 50%. Similarly, an SME that was profitable under the old scheme received an R&D Tax Credit of 25%. Now that SME receives an R&D Tax Credit of 16%, a decrease of 36%.

As most SME’s spend less than £150,000 on R&D, the merged R&D Tax Credit scheme arguably offers little assistance after considering the cost of filing an R&D Tax Credit claim and perhaps enduring a compliance check by HMRC. 

Abuse of the R&D Tax Credit Scheme

There is no question that under the old R&D Tax Credit scheme, the programme was abused. Many companies received refunds, whereas the related R&D Tax credit claim did not qualify. While there were unscrupulous advisors encouraging companies to make an R&D Tax Credit claim when the criteria were not met, HMRC has to take some responsibility. We have worked in other countries with R&D Tax Credit schemes, and whenever the tax authorities review less than 10% of R&D Tax Credit claims, many companies will take advantage. It appears that HMRC was reviewing less than 2% of R&D Tax Credits filed. When this happens, word gets out, and many companies will play the odds and file a claim knowing they have a 98% chance of receiving a refund without a compliance check by HMRC.

The Current Situation

Fortunately, this problem has now been corrected, and HMRC is now carrying out adequate compliance checks for R&D Tax Credit claims. The latest statistics reveal that the number of SME claims dropped from a high of almost 80,000 in 2021 to 36,000 in 2024. While part of the reason for this decrease is to weed out companies that do not qualify for R&D Tax Credit relief, certainly a major reason for the reduction in claimants is the significant decrease in the R&D tax credit rate. 

There is some additional relief for SMEs that are R&D intensive. To be R&D intensive an SME needs to spend more than 30% of its total expenses on eligible R&D spend. In 2024, this was roughly 3,900 SME’s, approximately 10% of all SMEs. For these SMEs, the benefit only applies if the SME is in a tax loss position and can surrender sufficient losses, in which case the R&D Tax Credit refund equates to 27.5%.

Beyond the Numbers: The Innovation Impact

The implications extend far beyond tax policy:

• Innovation Ecosystem Disruption
  • SMEs are traditionally the engine of innovation in the UK economy, often taking risks that larger companies avoid. The reduced incentive structure discourages the very experimental R&D activities that drive breakthrough innovations.
• Regional Economic Effects
  • R&D Tax Credits have been particularly valuable for supporting innovation hubs outside London and the Southeast. The scheme changes disproportionately affect smaller regional companies that were previously significant beneficiaries.
• Startup Funding Gap
  • Early-stage companies, which often rely heavily on R&D Tax Credits as a crucial funding source, now face a significant reduction in available capital during their most vulnerable growth phases.

Government Justifications vs. Market Reality

The government has defended the changes on several grounds:

1. Simplification: A single scheme reduces complexity
2. Anti-abuse measures: Tighter rules prevent fraudulent claims
3. Fiscal responsibility: Reduced cost to the taxpayer

However, these justifications ring hollow when examined against the practical impact:

• Complexity hasn’t decreased for SMEs—if anything, the new rules are more complex
• Legitimate claimants are being deterred alongside any potential fraudsters
• The fiscal saving comes at the expense of innovative investment

International Competitiveness Concerns

The UK’s R&D tax credit incentives now compare less favourably with international alternatives:

• Ireland: Now has a 35% refundable tax credit
• France: Provides the Crédit d’Impôt Recherche at 30% for the first €100m of expenditure
• Germany and Netherlands: now offer refundable tax credits of over 30%

There is now a stark difference between the UK and other countries with R&D Tax Credit schemes.

The Path Forward: Policy Recommendations

To address these concerns without completely reversing course, several targeted interventions could help:

1. SME Top-Up Mechanism

Introduce a supplementary tax credit specifically for companies below certain turnover or employee thresholds, bringing their effective rate closer to historical levels.

2. Loss-Making Company Enhancement

Permit loss-making SMEs to offset the inclusion of the R&D Tax Credit into income with these losses rather than having to immediately pay tax on the R&D Tax Credit. While the R&D Tax Credit can be taxable, if an SME has losses or expenses to offset the income inclusion, then this should be permitted so that the SME enjoys the full headline refundable R&D tax credit rate of 20%.

Conclusion: Innovation at a Crossroads

The evidence increasingly suggests that the merged R&D Tax Credit scheme has indeed created a significant barrier to SME participation. The combination of reduced effective rates, increased compliance burden, and proportionally higher administrative costs has created a perfect storm that favours larger companies while disadvantaging the SMEs that have historically driven UK innovation.

While the government’s desire to control costs and prevent abuse is understandable, the current approach risks throwing the baby out with the bathwater. The UK’s innovation ecosystem depends heavily on the risk-taking entrepreneurialism of smaller companies. If these businesses can no longer access meaningful R&D support, the long-term consequences for UK competitiveness could be severe. We are already seeing UK SMEs look to do R&D in neighbouring countries like Ireland.

If you want to find out more about how the UK SMEs are being shut out of R&D Tax Credits under the New Merged Scheme, then get in touch.