Tax Deductions:
Research & Development

Claim an extra business tax deduction

CAN I claim an extra tax deduction, or even cash back, for some of my research and development (‘R&D’) expenditure? The answer is yes – as long as you fit the qualifying conditions!

The SME Scheme
There are various conditions which must be met in order to qualify for this relief, with the main condition being that your business must be liable for Corporation Tax – normally a company. There are two different types of relief available if you fall into the Small and Medium-size Enterprise (‘SME’) scheme – a reduction in your Corporation Tax bill, or an effective ‘cashback’ where your tax bill is not large enough to cover the relief obtained.

To qualify for the SME scheme, your company must:

1. Be a going concern
2. Have fewer than 500 employees
3. And either

i) Have annual turnover not exceeding 100 million Euros, or
ii) Have gross assets not exceeding 86 million Euros.

If your company is a member of a group then, broadly speaking, the group as a whole must meet these conditions.

Double Your Money
What’s so special about the relief for R&D expenditure is the fact that, under the SME scheme, you get relief at a rate of 200%: in other words, for every £1 of qualifying expenditure, you get a tax deduction of £2!

The 200% rate applies from 1st April 2011, subject to state aid approval from the European Commission (increased from the previous rate of 175%). Better still, the Government proposes to further increase this rate to 225% from 1st April 2012; once again, subject to state aid approval.

Converting Credits into Cash
A few years ago, the Government recognised that an enhanced tax deduction was only any use to companies which were actually paying tax. Many companies undertaking R&D make a loss, especially after deducting their enhanced R&D credit.

Under the cashback facility, any excess relief may currently be set off against your total PAYE liability for the same accounting period: not just the PAYE arising on employees involved in the R&D project. Under current Government proposals, the facility will be further extended from 1st April 2012 and will no longer be limited to the company’s PAYE liability for the period.

Where the credit is converted into ‘cash’ in this way, relief is currently given at a rate of 12.5% (14% prior to April 2011).

Example
Westminster Limited makes a profit of £50,000 for the year ending 31st March 2012 before deducting qualifying R&D expenditure of £30,000.

The company’s R&D expenditure is enhanced at the rate of 200%, giving it a deduction of £60,000. This gives the company an allowable trading loss of £10,000. This loss can be relieved in all the usual ways: group relief (where applicable), carry back, or carry forward – or it can be converted into ‘cash’ at the rate of 12.5%.

Hence, assuming that the other forms of relief are not available in this case, the company can choose between carrying forward a loss of £10,000, or claiming a payable tax credit of £1,250 as a deduction against its PAYE liability.

This can be a tricky decision, as carrying the loss forward could yield future tax savings of between £2,000 and £2,625.

On the other hand, for many struggling small companies with a large R&D budget, a tax refund of £1,250 today may be more important than a potential future saving: it could be a case of ‘a bird in the hand is worth two in the bush’.

Large Companies
Companies which fail to meet tests (b) or (c) above may claim under the ‘Large Company’ scheme, which provides a tax deduction equal to 130% of the qualifying expenditure. There is no cashback facility under the Large Company scheme: any loss arising is treated the same as a normal trading loss.

Expenditure Limits
The maximum qualifying spend under the SME scheme is £7.5 million in each 12-month accounting period. It is possible, however, for a qualifying company to claim under the SME scheme for one project and under the Large Company Scheme for one or more other projects. There is no maximum limit for qualifying expenditure under the Large Company Scheme.

There is also currently a minimum expenditure limit of £10,000 per annum under both schemes, although the Government proposes to abolish this limit from 1st April 2012.

But What Is R&D?
So, now you know how the relief works, what exactly is ‘R&D’?

HMRC has guidelines as to what does and does not constitute R&D expenditure. The relevant definitions can be found on the Department for Business, Innovation and Skills website

There is some good news, however, in that HMRC has specially dedicated teams who can assist you at any point in the process of making your claim. These specialist units are based on your company’s post code.

The Project
The first thing you will need to do is to identify your R&D ‘project’.

A qualifying R&D project is defined as a project, the aims of which are to ‘resolve scientific or technological uncertainty aimed at achieving an advance in science or technology’ and which must be related to your company’s trade or intended trade.  There must be particular scientific or technological uncertainties which you intend to research, where a discussion with other professionals cannot readily resolve the problem and, indeed, it cannot be known whether or not such an uncertainty can be resolved. It cannot just be research designed to further your company’s knowledge in a particular area, although ‘appreciable improvements’ to a technique, etc. can be covered by the relief.

In effect, in order to claim this relief, you need to ascertain: what is the scientific or technological advance which your project aims to achieve; what are the scientific or technological uncertainties involved; and how are these uncertainties to be resolved. You will also need to provide confirmation that this knowledge could not have been obtained from existing public sources.

Now we will take a look at the types of expenses which can be claimed.

Employees
The costs of employing staff directly involved in the R&D project can be claimed. If an employee’s time is split between the R&D project and other work, then an appropriate percentage of their employment costs should be claimed.

Other Staff
The costs of other staff directly involved with the project can sometimes also be claimed, such as agency workers, for example. There are some exceptions to watch out for, including the fact that the worker must be employed directly by the agency (i.e. not through their own company).

Materials
The cost of physical materials used in the project can be claimed. However, this does not extend to more indirect associated costs, such as telephone expenses, etc.
 
Utilities
Utilities such as water, electricity and fuel can be claimed where they are used in the project. Where there is mixed use, then an appropriate percentage can be claimed.

Computer Software
Computer Software used directly in the project can be claimed. Again Where there is mixed use, a suitable proportion can be claimed.

Sub-Contractors
The proportion of any sub-contractor expenses which can be claimed under the more generous SME scheme depends on the claimant company’s relationship with the sub-contractor.

Where the sub-contractor is connected to the claimant company, the claim is limited to the lower of:

1. The payment to the sub-contractor, or
2. The sub-contractor’s own qualifying expenditure.

Where the sub-contractor is not connected with the claimant company, then only 65% of the costs can be claimed. In this case, it is also possible for the sub-contractor to contract the work out further.

An election can be made so that the claimant company and the sub-contractor are treated as though they are connected for R&D credit purposes.

Claims for sub-contractor’s expenses under the Large Company Scheme may only be made in certain limited instances.

Capitalised Expenditure
Where tangible capital items, such as machinery, computers, or other equipment, are purchased for an R&D project, capital allowances are normally available instead and R&D credit relief cannot be claimed.

However, companies undertaking R&D sometimes capitalise other expenditure in their accounts in order to reflect the long-term benefits of that expenditure. This does not prevent the company from claiming R&D credit relief on that ‘capitalised’ expenditure if it would otherwise have qualified under the principles set out in this article.