When companies pursue mergers or acquisitions (M&A), they typically focus on financial due diligence alongside a handful of other reviews. Yet R&D tax risks are often overlooked – a gap that can prove costly, writes Jayne Stokes, associate director at ForrestBrown.
R&D tax relief is a government incentive, aimed at reducing a company’s tax liability, or to provide a cash payment for investing in innovation relating to projects of national, scientific or technological importance. As the world faces a period of global uncertainty, that has taken on a new dimension of importance now – and investors must take note of that.
“R&D tax relief can have a meaningful impact on valuations, so it increasingly comes into focus during M&A and investments,” Stokes explains. “When a business has historically relied on the relief, investors will want to understand whether their claims were robust and sustainable, particularly given the heightened compliance landscape of recent years.
“Due diligence can bring a number of potential R&D tax risks to the surface. One is the assumption that the level of relief will continue at the same level going forward, which businesses can’t rely on. In today’s tougher compliance environment, HMRC enquiries are also more common, and if issues are identified, they can lead to discovery assessments reaching back into earlier years. In some cases, businesses identify errors themselves during due diligence and need to make voluntary disclosures to correct historic claims.”
“Investors also need clarity on whether a company will continue to qualify for relief in the future. If a business has historically been classed as ‘R&D intensive’, there may be questions about whether it can maintain that status and continue benefiting from the preferential rate of relief. The introduction of the merged R&D scheme adds further complexity, particularly for businesses operating in complex supply chains or those that previously included overseas costs in their claims.”
Practical steps
Taken together, these factors can materially influence how investors assess both risk and value during a transaction. But what practical steps should businesses and advisers take to avoid issues later in the deal cycle?
“From a deals perspective, it helps to approach historic R&D claims with a degree of caution – and perhaps a little scepticism,” says Stokes. “Certain patterns can raise questions, such as claims that look almost identical year after year, or where a very high proportion of staff are included despite not being directly involved in technical development.”
Another common red flag is when the supporting narrative focuses more on the commercial benefits of a project than the underlying scientific or technological challenges. “Misunderstanding the boundaries of an R&D project (as opposed to the wider commercial project it often relates to) is one of the most frequent mistakes we see in practice.”
Stokes continues, “The way a claim has been prepared also matters. Claims produced in-house or with the support of unregulated advisers can carry greater risk. The same goes for claims from sectors which aren’t typically associated with significant technological developments. That doesn’t mean genuine R&D isn’t taking place, but it does mean that investors and HMRC will have a close eye on the detail.”
“For businesses, the key issue is confidence. Do they truly understand what is being claimed, why it qualifies, and how the numbers have been calculated? Legal protections such as indemnities can help where historic claims turn out to be objectively wrong, but they aren’t a comprehensive safety net. R&D claims often rely on subjective technical judgments, so disputes can arise over how any potential liability should be valued.”
In essence, the ForrestBrown expert clarifies that indemnities are “useful”, but should be best seen as “a last line of defence rather than the primary safeguard.” Looking beyond that, it is important to understand what advanced assurance fix, and where it may fall short.
Advanced assurance
The associate director notes, “Advance assurance is designed to provide guidance about whether particular projects qualify as R&D or if a business is eligible to claim relief. We are still waiting to see exactly how the pilot will operate in practice, but confirmation from HMRC about these issues will naturally reassure investors considering a deal. Even the fact that a company has proactively engaged with HMRC sends a positive signal about its approach to tax governance and risk management.
“That said, advance assurance will have its limits. It won’t resolve every issue with an R&D claim. For example, it won’t address detailed methodology questions or confirm that all cost categories have been treated correctly. Another important point is that the final claim must align with the facts presented during the assurance process. This means that where advance assurance has been obtained, buyers will still need to carry out careful due diligence to ensure that the claim actually reflects the position agreed with HMRC. If there is any divergence, the reasons for that will need to be understood.”
With so many factors at play, it might seem that there is a risk of a two-tier system – where only the best-resourced, most prepared, well-advised businesses will benefit from advance assurance. According to Stokes, however, it is important to remember that advanced assurance is not the only way to go.
“In reality, many companies may decide not to rely on advance assurance, at least initially. For that reason, it would be a mistake to view advance assurance as the only indicator of a well-advised or well-run business. A lot will depend on how HMRC ultimately operates the scheme. While advance assurance offers potential benefits, it also introduces certain risks, which may make some well-advised businesses cautious about participating until the process becomes clearer.”
“In the meantime, companies need to do their own due diligence on the same principles. The fundamentals are relatively straightforward – to understand the basis of the claim, ask the right questions, and check whether any warning signs are present. If a business cannot clearly explain how its R&D claim works, that is usually the moment when further investigation is needed, regardless of whether advance assurance is in place or not.”
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