Research And Development Tax Regimes
A brief introduction to R&D tax, identifying what it is and how it works for small and medium enterprises
The Research and Development Tax Regime was introduced for small and medium-sized companies in 2000. It was followed two years later by the corresponding large company regime but given that most groups with fewer than 500 employees will generally qualify under the far more beneficial small and medium enterprises regime, most practitioners will be more familiar with the latter although the two do interact as detailed further below.
When first introduced, the small and medium enterprises regime provided a 50% uplift in qualifying R&D expenditure. Over the years, the rate of uplift has been improved: from April 2012, it now stands at an impressive 125%. By contrast, the credit available for loss making companies has remained consistent at approximately 25%. This ever increasing rate of uplift does mean that careful consideration should be given to whether it is appropriate to encash such losses up-front. Indeed, the carry forward of such losses can more than double the ultimate tax benefit compared to the amounts available under the credit.
Improvements to the Regime
But it is not just the rate of uplift that has improved over the years, the following other changes should also be noted:
- From 1 April 2012 the aforementioned tax credit is no longer capped by reference to the company’s total PAYE and NIC contributions made in the year.
- The requirement that the claimant company must own the intellectual property (IP) rights arising from the R&D project was abolished in 2009. This therefore gives much greater flexibility in considering where the IP should be held. In the past, consideration was often given to holding such IP rights offshore. Today, with the general availability of amortisation relief on such costs and the 10% corporation tax rate available under the patent box, the UK has become an attractive holding location
- The R&D regime sets out specific heads of expenditure which qualify for relief such as salary cost and sub-contracted expenditure. There have however been two important additions to this list, namely the cost of externally provided workers which typically allows companies to claim for staff employed on R&D projects via an external employment agency and also the cost of power used up in the R&D process, as discussed further below.
Of course if hasn’t all been good news: HMRC did not appreciate having to give R&D tax credits to failed companies and therefore it is now a requirement that the claimant company must be a going concern, per section 1046 CTA2009.
What is Meant by “R&D”?
HMRC have over the years made various attempts to define and subsequently refine what projects qualify for these significant tax benefits. Broadly, it must be necessary to demonstrate that the company has been undertaking a project which seeks to achieve an advance in the field of science and technology through the resolution of fundamental uncertainties. The full guidelines can be found at CIRD81900.
However, the “man in the street test” is broadly whether a competent professional in the relevant field would be readily able to ascertain a solution to the problem that the company is seeking to overcome. If not, then it is likely that the project will be qualifying for these purposes.
In seeking to clarify this definition, HMRC have published specific guidance for two industries only, namely pharmaceuticals and software development. It is our experience that the majority of R&D claims relate to the latter and this presents particular difficulties insofar as there is no physical product which HMRC can verify. HMRC’s guidance at CIRD81960 specifies the sort of work which may qualify, for example projects seeking to develop new languages, algorithms or encryption techniques. It should however be noted that this guidance is not meant to raise additional thresholds to qualify for R&D, merely to quantify exactly what is meant by R & D in the context of software development.
Best Practice for Submitting Claims
Despite the formation of specialist R&D units, HMRC do not claim to be experts in every scientific or technological area. Whereas strictly a claim can be made by simply inserting the total qualifying expenditure in the tax return, it is recommended that any such claim is supported by both a narrative setting out why the project is qualifying and a breakdown of the qualifying loss which should include the costs of each relevant employee. Not only should such an approach avoid unnecessary HMRC enquiries but it also minimises the risk of HMRC seeking to charge penalties should they reject any such claim.
How Can I Increase the Value of a Claim?
The main item of qualifying expenditure relates to salary costs. Here the company’s policy in respect of expenses is of particular relevance. Whereas travel costs for example are not a qualifying head of expenditure, if such costs are incurred by the employee and reimbursed by the company then strictly they form part of the relevant individual’s gross taxable remuneration, albeit offset by corresponding deduction for such expenditure wholly and exclusively incurred for the purposes of his/her employment. Such expenditure incurred by the employee can then be included in the individual’s qualifying salary costs for these purposes. For this reason, a company that incurs significant travel costs or similar may wish to ensure that the employee incurs these costs (rather than them being paid directly the company).
HMRC have also confirmed that so called qualifying indirect activities also qualify for relief: these include expenditure on items such as training, research and equipment maintenance. Further details can be found at CIRD83000.
As referred to above, it is also now possible to include the cost of power consumed as part of the R&D project in any claim. It was originally understood that this included power directly used up in the R&D process, for example in the case of a company seeking to develop new materials, the production of which required large consumption of gas or electricity. However, as is made clear at CIRD82300, it is possible to include within an R&D claim the cost of any power used up by way of an overhead for example in lighting and heating a building where an R&D process is being carried on. Indeed, HMRC state that they will accept any reasonable apportionment of such costs incurred by a company.
Finally, one should also be mindful of avoiding generalisations in tax. It is of course normally beneficial for shareholder-directors to remunerate themselves by way of dividends as opposed to salaries given the lower overall tax burden generally incurred thereon. However, where the directors directly contribution to the R&D process, then their salaries qualify for these enhanced R&D reliefs. Dividends by contrast can never be included in the R&D pot. This may therefore tip the scales towards remuneration by way of salaries notwithstanding conventional wisdom.
However there are pitfalls: in particular, it should be noted that R&D tax credits are a so-called notified state aid. Under EU Law, a company is precluded from claiming two such aids. Thus should a company also be in receipt of for example a SMART Award, no matter how small, then this would completely preclude the company from claiming the benefits of the R&D regime under the small company regime for that project. Relief would only then be available under the far less generous large company regime.
The ever improving R&D tax credit regime provides significant incentives for companies to carry on R&D in the UK. As always the devil is in the detail and practitioners should speak to their clients upfront so as to identify qualifying projects and ensure that the correct documentation is retained in support of any such claim in the future.
By Anthony Newgrosh of BKL Tax, member firm of UK200Group Tax Panel