How HMRC could give Scots AI sector a valuable boost

Every £1 of tax relief granted through the initiative has generated upwards of £2.70 of extra R&D spending amongst the nation’s large companies. That figure sits at £1.58 of extra R&D spending for every pound of relief secured by smaller businesses through the SME scheme.

While these are encouraging statistics which underline the historical effectiveness of R&D Tax Relief over the past quarter century, there are emerging questions over whether the scheme is appropriately structured to support the UK’s AI sector which has the potential to be a driving force in generating future economic growth.

In Scotland alone, AI’s economic potential is huge. The Scottish Government’s latest AI strategy estimates the sector could contribute £23bn annually to the nation’s economy by 2035, with cumulative gains above £140bn over the current decade.

While small compared to the US or even London, Scotland’s AI sector carries strong long-term growth potential in becoming a specialised European hub focused on energy, fintech, healthcare, robotics, and ‘responsible AI.’

While this is hugely encouraging, both Scottish and rUK AI companies are currently struggling to secure R&D Tax Relief to help them further innovate and potentially become world leading in this sector.

The key reason for this is that existing R&D Tax Relief rules require companies to advance an existing ‘technological baseline’ to qualify for this exemption. While this is a sensible approach for most sectors, the baseline for AI is constantly progressing making it difficult for those companies to qualify.

Major breakthroughs are published globally and adopted almost immediately meaning the baseline for which HMRC measures advancement is constantly rising. Scottish as well as rUK AI companies are often building on top of, rather than beyond, globally available techniques. This makes it extremely difficult for many such businesses to demonstrate they were faced with genuine technological uncertainty within their R&D activities, a key requirement to secure relief through our tax system.

Progress in the AI sector often comes through incremental improvements to accuracy, robustness, speed, bias mitigation or cost efficiency which are extremely valuable commercially but harder to frame as a clear advance in the technological baseline.

Combined with these issues facing Scottish and rUK AI companies, HMRC’s recent strategy on reviewing R&D Tax Relief claims and enquiries has also been off putting in terms of wider sectoral investment into innovation. There are also concerns that the reduction in the level of relief on offer through the scheme is acting as a disincentive to companies here and driving more investment towards places like Ireland, which offers more attractive tax incentives to promote R&D activity.

If we want to build a world-leading AI sector, the UK Government needs to adopt some flexibility in its R&D Tax Relief structure. While HMRC’s guidance for qualification was recently updated, it needs to go further and introduce sector-specific guidance that encourages more AI companies to invest in innovation. This includes greater flexibility in how a technological baseline is defined, or a reconsideration of what costs can be claimed. Clear, updated guidance could, for example, acknowledge the fine-tuning of existing technology as an activity which qualifies for tax exemption.

Putting in place a specific AI team within HMRC would be a sensible move that would support inspectors in interpreting legitimate R&D Tax Relief claims. This approach along with a quicker turnaround for claims and a more generous tax credit for companies that invest in genuine innovation could give our AI sector a much-needed boost in making it a global leader.

Dave Philp, Head of R&D Tax at accountants CT