Tax relief on R&D expenditure

In this post we provide an overview of the rules for claiming tax relief on R&D expenditure. This is primarily aimed at start ups in the tech sector though in theory the rules can be applied to any small/medium sized business operating as a limited company.

Tax relief on R&D expenditure

Overview: Tax relief on R&D expenditure 

There are two schemes available for claiming relief. The Small or Medium-sized Enterprise (SME) Scheme and The Repayable Credit Large Company Scheme or R&D Expenditure Credit (RDEC). Which one applies to your business, depends on the size of the company involved.

We're focussing on relief for SMEs in the article, although in some cases the large company scheme applies to SMEs. This might occur for example where your business has been subcontracted to carry out work on behalf of a large company.

What is an SME?

Essentially a SME is defined as a company with fewer than 500 employees and a turnover limit of €100 million or a balance sheet total not exceeding €86 million. If the SME is part of a group or is 'linked' to another company or set of companies by way of control, the above limits are applied to the aggregate of the whole of the linked companies.

What is defined as R&D expenditure?

The definition of R&D for tax purposes is set out in HMRC's internal guidance. therefore in order for a company to claim tax relief on R&D expenditure it must possess those defining characteristics which are as follows::

  • Generally speaking, there must be uncertainty in achieving the  final objective. However, there must be an advance in science or technology through the resolution of scientific or technological uncertainty.
  • This could include an appreciable improvement to a process, material, device, product or service
  • Any potential advance does not need to be achieved or fully realised in order for R&D to take place.
  • The knowledge being sought must not be already available in the public domain.

What expenditure qualifies as R&D?

Your company must have incurred qualifying expenditure on R&D projects. It should also be noted that Government grant funding provided for R&D projects must be excluded from any claim. However it is possible to claim under both the SME scheme and the large company scheme in a year where there is a mixture of qualifying projects, some of which are not receiving state aid.

An SME may claim enhanced relief under the large company R&D scheme, currently at 130%. Where other grants or subsidies have been received, the SME relief may be claimed on the net amount. Relief under the large company scheme may be claimed on the subsidised expenditure, provided it qualifies as tax-deductible in the normal way.

Qualifying costs must have been incurred and cannot be capital in nature. However it may be possible to claim an enhanced deduction for equipment expenditure using the super-deduction allowance. 

Additionally certain capital costs relating to R&D work might qualify for Research and Development Allowance at 100%. This allowance can potentially be claimed on those capital items that would not otherwise qualify for Capital Allowances (see above).

The main qualifying costs (this list is not exhaustive) are as follows:

  • Employee costs. Though these must be apportioned to reflect the time spent actively engaged in R&D activities. These costs include salaries, Employers National Insurance Contributions and pension contributions, but not Benefits in Kind. 
  • Materials consumed or transformed in the R&D process. However restrictions apply where your company sells products of it's R&D activity as part of it's business activities.
  • Water and fuel.
  • Specially commissioned parts for prototypes.
  • Software bought specifically for R&D work. Details of the rules surrounding R&D software development plus any modifications involved can be found in HMRC's internal guidance here.
  • Subcontractor costs to connected and unconnected parties. However you should be mindful of the restrictions involved.  
  • A proportion of variable overheads

How does the relief operate?

If your company has incurred costs on qualifying R&D projects it can obtain an uplift on these costs of 230%. So for example it means that if a company spends £100, it will receive tax relief as if it had spent £230. 

Where your company has unrelieved trading losses you can instead surrender the R&D tax relief in exchange for a repayable tax credit. The amount that can be surrendered is the lower of the actual tax-adjusted loss or the total qualifying expenditure (i.e. the qualifying costs plus the uplift). 

It is possible to make a 'combination claim', where the R&D tax credit can be used to bring the tax payable to zero, and surrender the balance of the relief for a repayable tax credit.

The rate of repayable credit is 14.5% (i.e. lower than the rate of corporation tax relief if the loss is claimed. However if future profitability is uncertain, claiming the credit (as opposed to the loss) may be the more attractive option from a cash flow perspective.  

Tax Relief on R&D expenditure recent changes

PAYE cap

For accounting periods beginning on or after 1 April 2021, the payable credit (see above) will be subject to a cap. Essentially the amount of payable credit that a qualifying loss-making company can receive through R&D relief in any one year will be capped.

There will be a £20,000 minimum claim threshold below which the cap will not apply.

The cap is as follows:

  • £20,000, plus
  • Three times the company’s total PAYE and NICs liability plus
  • Three times any PAYE and NICs of Externally Provided Workers from connected companies or of staff used in work contracted out to a connected company

You can see examples of how this PAYE cap might apply to the new restrictions in HMRC's published guidance here.

Cloud computing

It is proposed that R&D relief will be extended to include cloud computing and data costs. This has evolved as part of a consultation announced in the  Autumn 2021 Budget. It is The Government's aim to refocus support towards innovation in the UK.  

Effective From 1 April 2023, the costs of purchasing data for R&D activities or using cloud computing services will qualify. On a practical level this may prove challenging where you are using the same cloud services throughout your operations As a result, some form of apportionment may be required. We would expect there to be further clarification from HMRC on these new rules in due course. 

R&D activities overseas

As previously suggested in this consultative document, from April 2023, the costs of overseas workers are unlikely to qualify for UK R&D relief going forward. With these new rules, R&D activity must potentially be located in the UK for the costs to be considered allowable.

However The Government has also suggested it does not want to be unfairly prejudicial against organisations that are unable to conduct R&D in the UK for practical reasons. Therefore potentially expenditure on overseas R&D activities may potentially still qualify where:

  • Material factors (for example environment, geography, population) are not present in the UK and are necessary for the research.
  • Regulatory or legal requirements stipulate that it must take place outside of the UK, such as clinical trials

 It may therefore be necessary to re-evaluate any future potential R&D claims if your company maintains all or part of it's research overseas. 

Anti abuse action by HMRC

HMRC are proposing to reduce new measures to deter what HMRC consider to be speculative or fraudulent claims. There is growing concern by HMRC that the R&D tax relief system is being abused.

These new measures will include a digital claims system, additional supporting details with claims which must be endorsed by a senior officer of the company. Additionally HMRC have indicated they will require advance notification of a company's intentions to submit a claim and details of any adviser involved in providing advice on that claim. 

Obtaining an advance assurance from HMRC.

HMRC provide a voluntary Advance Assurance service for companies looking to claim R&D. If an advance assurance is sanctioned, HMRC will not enquire into R&D tax claims made in the company's first three accounting periods. You can see here the circumstances where a company can qualify for Advance Assurance .

After requesting any additional information they need, or discussing the company's activities in more detail with an individual nominated by the company, HMRC will either send an letter confirming the claim is accepted or advise the reasons why Advance Assurance is not being granted. Obtaining an Advance Assurance provides certainty that a company R&D costs qualify and can be especially helpful for a start-up business which is looking to manage cashflows.  

For more useful information, check out our Ebooks here.

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