Capitalising on R&D tax credits in the defence sector

16 September 2019 (Last Updated September 4th, 2019 12:17)

R&D tax credits can offer a funding boost to defence suppliers, but claiming them involves navigating a number of regulatory challenges. William Garvey, MD of innovation funding consultancy Leyton UK, tells us how companies can capitalise on tax credits to offset some of their R&D costs.

Capitalising on R&D tax credits in the defence sector

During the Conservative leadership battle and the various spending commitments made, the right level of defence spending was once again thrust into the spotlight.

In 2006 when NATO allies set a target to spend of 2% of GDP on defence, they also set a second target to devote 20% of defence spending to research, development and acquisition of equipment. However, despite the evolving nature of global threats, in relative terms, the industry spends far less on R&D than other critical sectors.

Looking at the UK specifically, now representing around 2.1% of GDP, the defence industry is comprised of a small number of large contractors and a substantial secondary tier of smaller, more niche companies. In 2017, the aerospace, defence, security and space sector contributed a £74bn turnover, £41bn of exports, over 380,000 direct jobs and 12,000 apprentices.

In terms of UK research and development, in 2017 R&D for defence purposes accounted for 5% (£1.8bn) of the UK’s total R&D expenditure, rising 2.1% from the previous year. However, business expenditure on R&D performed in the defence sector has fallen by 47.6% since 1990 in constant prices, while R&D in the civil sector grew by 99.9%, according to ONS Figures.

The government’s push for defence R&D

A key contributing factor to this shrinkage is the defence supply chain not taking advantage of the government funding and grants available to them as has been the case in other industries. To address the shortfall, in October 2018, it was confirmed that the Ministry of Defence (MOD) will be allocated an additional £200m during fiscal year 2018/19 and a further £800m for 2019/20. This significant budget increase has the potential to reinvigorate the defence supply chain, allowing new players to surface.

The UK Government documented the importance of innovation in the defence sector through its ‘Advantage through Innovation’ initiative in 2016. This report recognised that constant R&D is required to maintain the UK’s position as one the leading innovators globally. As the nature of the global security landscape constantly evolves, innovation supports the maintenance of the UK’s military advantage in the future.

Pushing technological boundaries is second nature to many defence suppliers, and much of the activity carried out by businesses throughout the supply chain is likely to qualify for government R&D Tax credits.

R&D tax credits: how it works

Developed to boost spending in research and development, R&D tax credits create a pool of resource that can be further invested. While many larger businesses within the defence sector are already claiming, there are undoubtedly more opportunities, and a higher number of claims from smaller suppliers would provide financial support for the future and bolster the sector’s development.

There are a number of stumbling blocks which are preventing defence suppliers from successfully claiming to their maximum potential. These challenges often surround the differentiation between routine and non-routine project elements. According to HMRC guidelines, businesses can claim R&D tax relief, for a proportion of the build cost of an item and salary costs, but not the entire cost.

Many defence projects include a significant level of innovative qualifying activity. Exploring topical innovation in defence more closely, there are several areas of the sector where a proportion of the associated costs could qualify for R&D tax credits.

How the defence sector can benefit from R&D tax credits

SMEs in the defence and security sector often have the freedom to be more agile and dynamic in their innovation, with many job roles directly or indirectly related to the development and testing of cutting-edge software and products.

For many suppliers, the development process involves rigorous design and testing elements, and due to the constantly evolving nature of the sector, high-end R&D can require a considerable amount of trial and error prior to market release.

As weapon and munition effectiveness increases, equipment and transport suppliers are using R&D to mature their product offering to reflect this development and remain competitive. In some cases, this has necessitated the building of facilities dedicated entirely to the durability testing of products, a key area where businesses can claim tax credits for a percentage of employee salaries and running costs.

Electronics in defence is a fast-moving sector, with companies developing new software or products for the MoD as often as every three to six months. Military software and electronics development require substantial experience, intelligence and a highly controlled development process.

The operational environments of electronic military applications are often extremely severe, and as such they require solutions with specific design and extensive testing to ensure faultless operation. The manufacturing and development processes are rigorous, and the time between the development of new products is short, making this a very R&D intensive area.

Defence and security software is subjected to high levels of scrutiny to ensure it is consistently reliable and safe during operation. The R&D in this area is often focussed on testing, as it is vital to continually develop and refine products to meet exacting standards. These products also require hostile environment testing to ensure they are reliable when needed; this can be both costly and time consuming. Software businesses who supply the defence sector spend considerable funds ensuring they reach the required standard on a regular basis.

How to meet evolving MOD requirements

The defence industry is rife with diverse R&D, ranging from research and design to manufacturing, operations and maintenance. Producing new software and equipment for the defence sector is challenging for a number of reasons, including constantly evolving MoD requirements, difficulty predicting the operating environment and balancing durability with ergonomics and weight.

It is clear that capability development and testing activities are key areas of eligibility for R&D tax credits. Challenges surrounding unpredictability in the testing environment and carrying out non-destructive testing on new components are areas which have huge claims potential.

In order to capitalise on the funding available to them, companies should seek to identify which elements of their product and software development qualify as eligible expenditure. A detailed scoping process can identify how much money a business would receive for government funding, grants or tax credits. Due to rigorous qualification criteria, working with a specialist R&D tax relief consultancy is likely to be the best method of maximising the potential of a claim.