R&D Tax Reliefs for small businesses

12 mins

It goes without question that the R&D tax schemes introduced by the Government in the early 2000s has been one of the more successful tax incentives for entrepreneurial businesses.

Nevertheless, there are numerous business owners who are still unsure as to how they can both access and benefit from the schemes. There are two main schemes available to businesses, 1) SME R&D Relief for small and medium sized businesses and 2) Research and Development Expenditure Credit (RDEC) scheme for large businesses. The core elements of both reliefs are very similar, however the difference occurs in how they are applied. In this article, we focus on the SME R&D relief scheme.

The key to qualifying for R&D reliefs is proving that the business has undertaken a project that is seeking an advance in the field of science or technology, and must relate to your existing trade, or one you intend to start as a result of the R&D undertaken. A few key terms to breakdown:

  • The ‘advance’ must be to the benefit of the business’ industry as a whole, and not just for the company itself. The yard stick in the common tongue is whether or not a competent professional in your industry could reasonably solve the ‘uncertainty’.
  • ‘Uncertainty’, in broad terms, is not knowing whether you can achieve what you’ve set out to develop. That is the starting point and will help set the parameters of your project and, ultimately, your claim (i.e. it may be that part of the project involves practices or tools that are already known, and therefore, your R&D claim can only include the costs that contribute to solving the uncertainty).
  • ‘Science’ is defined as “the systematic study of the nature and behaviour of the physical and material Universe.” Meaning works in the arts, humanities, social sciences and economics fall outside of this definition. Mathematical advances only qualify if they benefit the physical and material Universe.

SME R&D Relief benefits

SME R&D relief allows companies to:

  1. Deduct an extra 1.3x the value of their qualifying costs from their yearly profits, as well as the normal 1x deduction. This means that a total deduction of 2.3x the value of qualifying costs from the company’s profits, from which corporation tax is charged at 19%*.
  2. If the company is loss making (or through the deductions from profit, crosses the break-even line) then the business can either:
    1. If they think they are likely to make a profit in the following year/period, carry it forward and deduct it from the profits in the following year/period, taxed at 19%, or;
    2. Claim a tax credit in the current year, worth up to 14.5% of the surrenderable loss.

It is worth noting that R&D tax credits classify as state aid, therefore, if a company has received a grant or any kind of subsidy that constitutes as state aid, it will take the project out of the SME R&D scheme. However, it may be that the particular project that you wish to make a claim against will fall under the criteria of the RDEC scheme.

A worked example:

*current rate of corporation tax as at April 2020

Qualifying expenditure

In regard to the costs that qualify for a claim, the guidance is dictated by legislation, and therefore, not open to too much interpretation!

  • Staff costs – Staff costs are the appropriate proportion of the per employee staff costs paid through payroll. They need to be genuine employees and need to be those involved in the project. In this we can include a proportion of gross salary, PAYE, NI and pension contributions.
  • Externally provided workers – Generally speaking this is an agency arrangement where an external provider is supplying the business with a member of staff.
  • Consumable items – In this, HMRC are looking for items that are genuinely consumed as part of the R&D process, and not sold as part of the end commercial product.
  • Subcontracting costs – Businesses have to be careful about who the subcontractor is, but the key bit is to understand whether the subcontracted process is genuinely part of the R&D project. Further detail on the subcontracting rules set out below.
  • Software – The cost of software that is used in the R&D process. Similarly to Consumable items, this does not include any software that is intended as the end commercial product.
  • Payments to subjects of clinical trials.

Businesses can only claim for revenue expenditure, and not capital expenditure. It could be argued that if you are in a position to capitalise the relevant cost then the ‘uncertainty’ has been reasonably removed. Therefore, the treatment of certain costs in your accounts will be a fact that needs to be considered.

If there are costs that businesses believe were incurred as part of the R&D project that don’t classify into any of the items above, unfortunately they are unlikely to qualify for a claim. Given the prescriptive nature of the definitions, Price Bailey work with businesses to understand exactly what can and cannot go into a claim in order to maximise the reliefs available, and avoid having the claim queried or rejected by HMRC. Businesses will often encounter HMRC interest in claims.

There are also categories of qualifying indirect expenditure that connect to the R&D project – this is ordinarily something your advisor will explore in detail when looking at the specifics of a claim.

Proportionality

Once expenditure is identified, the business will then need to ascertain the qualifying element of the spend. Once again, the definition of ‘proportionality’ is prescriptive and only includes the proportion of costs that are ‘relating to activities that directly contribute to R&D and therefore resolving uncertainties’.

In an ideal world, for example with staff costs, a business will have timesheets through which they can apportion an individuals’ time spent on R&D as opposed to other activities. However, in most circumstances those perfect records aren’t kept, and businesses have to make a reasoned approximation based on the proportionality rules.

Subcontractors

It is fairly common that part of a business’ R&D projected is subcontracted where they either do not have the skills or the equipment in house. When considering the proportionality of subcontractors, under the SME scheme, the following is the general rule of thumb:

  • Connected subcontractor (other companies under common control/ group holding) – look at the underlying spend of the connected company and identify what part of its underlying expenditure related to R&D staff costs;
  • Unconnected subcontractors – 65% of payments to them, but both parties can jointly elect to have connected treatment when all of the costs are directly associated to R&D;
  • Externally provided workers – 65% of payments to them, but also can jointly elect to have connected treatment.

It is therefore important to ensure we have appropriately identified the nature of subcontracted work.
The below table provides a useful guide to the subcontracting rules and the associated regime under which the relevant party can make a claim:

Contractor Subcontractor  Who can claim Under which regime
SME SME Contractor (SME) SME
SME Large company Contractor (SME) SME
Large company SME Subcontractor (SME) RDEC
Large company Large company Subcontractor (large) RDEC
Large company Qualifying body  Contractor (large) RDEC
Person other than in course of trade SME Subcontractor (SME) RDEC
Person other than in course of trade  Large company Subcontractor (large) RDEC

How to make a claim

Firstly, there is mounting confusion over whether you can make a claim under certain conditions. We have listed a few ‘myth busters’ below to help those who are worried about whether they can claim or not:

  1. The business must be a going concern in order to be able to make a claim. The point of the reliefs is to encourage entrepreneurial, advancing businesses to succeed.
  2. Expenditure has to already have been incurred when the claim is made (this is particularly relevant for people costs).
  3. The business must make a claim in the period/year the costs have been incurred, and certainly within 12 months of them occurring. There is an extended deadline that can be utilised which provides a business with 24 months in which to make the claim. This is then included in the accounts as a post-year-end adjustment.
  4. The business can make a claim for a R&D project that failed, providing the necessary criteria are met.
  5. It is not only large claims that undergo HMRC scrutiny. Whilst it is reasonable to expect that more valuable work is more likely to be subject to enquiry, HMRC can conduct routine enquiries on any claim, so ensure the business is adequately prepared for any queries made on the details of a claim. Some of the areas that are commonly open for challenge by HMRC include:
    1. Proportionality of costs;
    2. Whether there is a genuine advance in science or technology (this includes whether the advance has already been made in another industry and the business claiming has only been able to apply this advance to their industry, or, if another business is working on the same advancement);
    3. The parameters of the project, in particular, the start and end of the R&D project; and,
    4. It is also worth watching out for any changes by HMRC to qualifying expenditure and how that may impact your claim. If you are uncertain of whether any changes impact you claim or not, get in touch.

Businesses have a right to appeal a decision made by HMRC and have 30 days from receiving the decision, in which to do so.

As part of our typical process for R&D tax credits we recommend clients use our tax investigation service which provides them with assurance that we will be able to represent them without further cost in the case of lengthy HMRC enquiries. R&D tax credit claims can increase the risk of enquiry dramatically given HMRCs stated position that there are aggressive claims and flouting of the rules made in some cases.

In order to make a claim, a business will need to be prepared to answer the following 4 key questions and provide adequate evidence to support their answers:

  1. What was the advance in science or technology solved by the project?
  2. What was the uncertainties involved in the project?
  3. How and when were these uncertainty overcome?
  4. Why weren’t the uncertainties and advances readily deducible by a competent professional working in the field?

Beyond that, what we would recommend is addressed in any claim document is:

  • An overview of the company and what it does,
  • In the context of the projects:
    • Explain the R&D process involved;
    • Explain the types of costs involved in the process and where they sit in the process, to give useful context; and,
    • Describe the activities involved in the project, and which of these activities are qualifying, and therefore, the basis for which the costs associated with these activities have been included.

We would also advise that your claim is written in plain English and free of technical jargon that could restrict HMRC’s ability to appropriately review whether the claim is suitable.

Software Businesses

65% of R&D claims are for software businesses. Consequently, there are a specific set of guidelines that sit alongside the general guidelines for software businesses that any software company should make sure they understand before making a claim, particularly in regards to in-house software development

Further information on these guidelines will soon be available.

This post was written by Steven Butcher, Senior Tax Manager at Price Bailey. If you have any questions on the above or are considering making a claim please contact us using the form below. 

We always recommend that you seek advice from a suitably qualified adviser before taking any action. The information in this article only serves as a guide and no responsibility for loss occasioned by any person acting or refraining from action as a result of this material can be accepted by the authors or the firm.

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