Staff and contractor costs qualifying for R&D claims
We provided an overview of tax relief on R&D expenditure previously, however in this post, we'll now focus on staff and contractor costs qualifying for R&D claims,
Perhaps one of the most important points to make is that qualifying staff costs are the same for Small and Medium-sized Enterprises (SMEs) and Large companies. This includes up to 100% of expenditure for directors and employees and 65% for external contractors.
With regard to employees (though not necessarily directors) working on R&D, they must have a direct contract of employment to qualify as part of your company's R&D claim. Typically the following costs can be included in your claim:
Costs which specifically cannot be included as staff and contractor costs qualifying for R&D claims are as follows:
These costs that qualify should be apportioned where your staff are not wholly engaged in qualifying R&D activities. In the case of a director's time for example this can only be claimed where their time directly relates to R&D and not other supervisory or managerial time on the company's affairs.
Reimbursed staff costs
It's possible for your company to reimburse expenses incurred by your employees as indicated here in the taxes legislation. However these are only allowable in the following circumstances:
We would mention that HMRC will challenge a claim which includes reimbursed expenditure in circumstances where they consider it doesn't relate specifically to the requirements of an employee's role working on R&D - see here.
Subcontractor costs and externally provided workers
There are essentially three different rules to consider, which are as follows:
Large company claims
Generally speaking where R&D has been contracted to other parties it is not an allowable cost and therefore subcontractor costs cannot be included in a Large Company claim.
However expenditure can potentially be claimed where R&D is subcontracted to an individual, a partnership consisting entirely of individuals and certain qualifying bodies for example charities, universities and health service bodies.
Provided they qualify, then 100% of those costs can be included in the claim. Although relief is not available under the Large Company Scheme where a company has subcontracted R&D to another limited company.
SME claims with connected subcontractors
If your company and the subcontractor are connected then your subcontractor must carry out the work themselves and can't subcontract to a third party. Your company can then claim R&D tax relief on the lower of:
Relevant expenditure is not capital in nature or subsidised. The expenditure must relate to staffing costs, externally provided workers (see below), consumables and software.
There are circumstances when it might be more beneficial for unconnected companies to be treated for the purposes of an R&D claim as if they were connected. If that's the case your company and your subcontractor may jointly elect to be treated as connected. Both you and your subcontractor would then be treated as connected for all payments made under the same contract or arrangement.
This election must be made within two years of the end of your company's accounting period in which the contract is made. So for example if you subcontracted work during your company's financial year ended 31st March 2023, an election must be submitted by 31 March 2025
SME claims with unconnected subcontractors
Unlike connected subcontractors, relief is potentially available where your company has subcontracted R&D to other limited companies in addition to, individuals, partnerships (consisting of individuals) and qualifying bodies.
Your subcontractor does not have to be UK resident and subcontracted work does not need to be performed in the UK. If your company and your subcontractor are not connected, your company can claim R&D tax relief on 65% of the payment it makes to the subcontractor.
Additionally your subcontractor does not have to carry out the work itself but may subcontract the work to a third party. This is not the case where they are connected (see above).
Externally provided workers
These costs are possibly more relevant to a large organisation who employs staff via an agency. The rules were introduced by HMRC in 2012 in recognition of the fact that more and more companies were employing staff via an agency rather than directly themselves,
Where these rules apply only 65% of the payment for the services of an Externally Provided Worker ('EPW') may be claimed under The Small or Medium-sized Enterprise (SME) Scheme and The Repayable Credit Large Company Scheme or R&D Expenditure Credit (RDEC).
To be regarded as an EPW a worker must be an individual personally providing services to your company and be under the supervision, direct and control of your company.
Where a large company is concerned it is important to establish that the worker is in fact an EPW and not a subcontractor. This is because subcontractor costs cannot be claimed as part of an R&D Large Company Scheme claim (see above).
The impact of dividends and salary for directors undertaking R&D
Directors and shareholders frequently structure the profit extraction from their company so as to mitigate any income tax and National Insurance liabilities. Typically this might consist of a low salary with the balance paid as dividends.
Employee and contractor costs are usually as key component of any R&D claim made by a company. However it should be noted that dividends are NOT a qualifying cost for R&D tax purposes. The impact of this is best illustrated in these simple examples below.
Example: low salary/high dividends
Michael is a director and shareholder in his company Cutter L&O Ltd and he is fairly heavily involved in the qualifying R&D work. His earnings of £100,000 for the year is structured as £9,500 salary and £90,500 as dividends. Michael has spent 80% of his time on the qualifying R&D work and the rest of his time on existing admin, client and strategy.
Unfortunately, Michael is unable to claim 80% of his total package of £100,000. He is therefore limited to applying the 80% to the £9,500 salary element only.
Example: high salary/low dividends
Jack who is director and shareholder of his company McCoy DA Ltd, structures his £100k earnings as £98,000 salary and £2,000 as dividends (tax free £2,000 dividend allowance). Like Michael, he has spent 80% of his time on the qualifying R&D work and the rest of his time on existing admin, client and strategy.
As a result, 80% of the £98k salary results in £78,400 of costs qualifying for an enhanced R&D claim . Although, the higher salary would incur significantly higher income tax and national insurance contributions, the relevant apportionment of employer's NIC could be included in the R&D claim).
Future developments for R&D claims involving staff and contractors
The government is proposing to reposition support towards innovation in the UK. As part of this initiative they will impose restrictions to those claims involving subcontracted work and EPW's where work is not carried out in the UK.
HMRC published their draft guidance on 20 December 2022 (timing is everything eh?) which details the conditions which will potentially apply from 1 April 2023 onwards.
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