Research and development (R&D) by UK companies has been actively encouraged by the government through a range of tax incentives. The government views investment in ‘R&D as a key to economic success. It is committed to driving innovation in the economy by encouraging more companies to claim R&D tax relief. Various incentives have been introduced including increased deductions for R&D spending and tax credits. Here we consider how the incentives work.
What is a Small or Medium-sized Enterprise (SME)?
An SME is a UK limited company subject to UK Corporation Tax (CT) where the company (or the group to which it belongs) employs 500 or fewer full time equivalent members of staff AND
- has a turnover of less than €100m or
- has balance sheet totals of less than €86m.
What are the tax reliefs available for SME companies?
A company can claim enhanced deductions against its taxable profits for expenditure which is qualifying R&D expenditure. The amount of the enhancement is currently 86% for expenditure incurred on or after 1 April 2023 (130% prior to April 2023). This amount is in addition to the actual expenditure (ie a 186% total deduction). R&D enhanced relief represents an additional corporation tax reduction of up to 22.79% of the expenditure incurred depending on the corporation tax rate.
If the R&D claim creates a tax loss, then the company may be able to surrender the loss for a cash repayment. This is currently calculated at 10% for expenditure incurred on or after 1 April 2023 (14.5% prior to April 2023). A surrendered loss could therefore give a repayment of up to 18.6% of the expenditure.
A higher rate of SME payable credit of 14.5% will apply to loss-making SMEs which are R&D intensive for expenditure incurred on or after 1 April 2023. To be R&D intensive the ratio of the company’s qualifying R&D expenditure must be 40% or above the company’s ‘total expenditure’ for the period. A surrendered loss could therefore give a repayment of up to 27% of the expenditure.
Where the company incurs qualifying R&D expenditure before it starts to trade, it can elect to treat 186% of that expenditure as a trading loss for that pre-trading period. The pre-trading loss created by the R&D relief can then be surrendered, as above, which could provide much needed cash flow for new companies.
Qualifying R&D capital expenditure incurred by a company would be eligible for 100% research and development allowance. Details of this allowance are not provided in this summary.
Example of R&D claim
A company has adjusted net profits of £50,000 before an R&D claim (after deducting allowable R&D expenditure of £70,000).
The enhanced claim is therefore £70,000 x 86% = £60,200.
Deducting this from the adjusted profits gives a loss of £10,200.
The company decides to surrender this loss for a cash repayment. The amount they would receive is £10,200 x 10% = £1,020.
Cap on R&D tax credit
There is a cap on the amount of R&D tax credit which can be paid to a loss-making small or medium-sized enterprise (SME). The payable tax credit is restricted to £20,000 plus three times the company's relevant expenditure on workers.
Relevant expenditure on workers is the company's PAYE and NICs for the period and importantly this is the company's whole PAYE and NIC liability. In addition, if the company is supplied with workers by a connected company the relevant workers' expenditure is extended to include a proportion of those worker costs.
Some companies which create or manage intellectual property and spend less than 15% with connected persons on R&D qualifying expenditure will be exempt from this cap.
Research and Development Expenditure Credit scheme (RDEC)
The SME scheme is not available if the R&D project has had the benefit of a grant or subsidy or if the company (or group) does not meet the SME criteria above. There may, however, be an alternative claim available to the company. This is known as the Research and Development Expenditure Credit scheme (RDEC). RDEC allows the company to claim a taxable credit of 20% for expenditure incurred on or after 1 April 2023 (13% prior to 1 April 2023) of eligible expenditure. As this amount is taxable it is known as an ‘above the line’ credit. The credit received may be used to settle corporation tax liabilities of the current, future or prior periods subject to certain limitations and calculations. Where there is no corporation tax due the amount can be used to settle other tax debts or can be repaid net of tax.
The RDEC relief is also available to an SME for expenditure incurred on R&D that is contracted to it by a large company.
Example of RDEC claim
A company has adjusted net profits of £1m before an RDEC claim (after deducting allowable R&D expenditure of £500,000).
The RDEC is £500,000 x 20% = £100,000
Taxable total profits (TTP) are increased to £1,100,000
CT on TTP is £1,100,000 x 25% = £275,000
The RDEC is deducted to give CT payable of £275,000 - £100,000 = £175,000
CT payable without the RDEC claim would be £1m x 25% = £250,000
The benefit of the RDEC is therefore £75,000 which equates to 15% of the R&D spend.
R&D relief can only be claimed by companies that have incurred expenditure on qualifying R&D projects that are relevant to the company's trade. A project should address an area of scientific or technological uncertainty and be innovative. The innovation needs to be an improvement in the overall knowledge in the relevant field of research, not just an advancement for the company. Qualifying projects could include those which:
- increase the life of a battery
- create a new type of material in an item of clothing
- develop new spark plugs for use in an existing engine.
An important point to appreciate is that the activity does not have to create something completely new from scratch. It could include:
- developing a product that exists but where there is some technological uncertainty which can be improved
- making an appreciable improvement to a product or process eg exploring new cost effective materials which will allow a product to perform better.
Companies should document the uncertainties and planned innovation at the start of a project to provide evidence to support an R&D claim.
Relevant activities on R&D
Once the company is comfortable that R&D is taking place, then the next step is to identify the activities of the business that relate to the R&D activity.
There are essentially two types of activities:
- those that contribute directly to achieving the advancement
- certain activities that indirectly contribute to achieving the advancement.
Examples of direct activities are:
- scientific or technological planning
- scientific or technological design, testing, and analysis
- activities which design or adapt software, materials or equipment.
Examples of indirect activities are:
- information services eg preparation of R&D reports
- indirect supporting services to the R&D project eg maintenance, security, clerical
- ancillary services eg leasing laboratories and equipment.
Indirect activities all have to be undertaken for the R&D project.
The R&D project begins when the work to resolve the scientific or technological uncertainty starts and ends when that uncertainty is resolved. It is therefore beneficial for companies to keep a timeline of activities and their purposes to detail when the business starts to move into the production phase to optimise their claims.
Types of expenditure
Qualifying expenditure which is incurred on activities which are either directly or indirectly related to the R&D project fall into different categories. These are as follows:
- staffing costs
- expenditure on consumable or transformable materials
- costs of work done by subcontractors and externally provided workers
- costs of clinical trial volunteers.
- data and cloud computing costs (for claims in accounting periods commencing after 1 April 2023)
To be eligible, expenditure must be revenue in nature and paid by the time that the R&D claim is made. This means any accruals for expenditure have to be monitored carefully after the year end to make sure that they are paid and not written back to profit.
Further detail on some of these categories is provided below.
The staff costs include employees and director staff costs ie salaries, employer pension contributions, employers’ NIC but not non-cash benefits-in-kind or dividends. Where an employee or director only spends part of their time on an R&D project then the costs are apportioned. The relevant staff are those involved in the directly and indirectly related activities highlighted above.
The indirect activity list included categories for ‘supporting’ and ‘ancillary’ services. The staff who perform these services should be providing supporting or ancillary services for the R&D project and not for the other people who are directly involved in the R&D project.
In addition, for accounting periods commencing on or after 1 April 2024, expenditure on payments to subcontractors must either be attributable to R&D undertaken in the UK or ‘qualifying overseas expenditure’. Overseas expenditure is qualifying broadly where there are conditions necessary overseas for the R&D which are not present in the UK and that it would be wholly unreasonable for the company to replicate in the UK.
- The salary costs of a maintenance worker working full time on maintaining laboratory equipment used for R&D can be claimed.
- The salary costs of an accountant keeping a record of the maintenance work done including the laboratory maintenance cannot be claimed.
If directors are taking dividends from the company rather than salaries it may be more beneficial to consider reviewing this for any directors substantially involved in R&D projects.
Consumable transformable materials
Materials that are consumed or transformed in the R&D activity are eligible expenditure. Items included would have to be items which were consumed or transformed so that they were no longer usable in their original form. This would therefore include:
- a chemical substance which is transformed
- an electrical component.
Any consumables or transformable materials that are included in a product that is sold, transferred or hired out will not be qualifying expenditure for R&D relief.
Costs of work subcontracted out and externally provided workers
Where the SME subcontracts qualifying R&D work to a subcontractor, the SME can claim a deduction for the cost of the subcontractor work. The amount that can be claimed depends on whether the SME is connected to the subcontractor but generally it is 65% of qualifying costs. Similar rules apply to externally provided workers.
Methods of claiming tax relief
Companies can claim R&D tax relief in the Corporation Tax (CT) return for the period when the expenditure is charged in the accounts of the company with a deadline of 2 years following the end of the accounting period in which the expenditure was incurred, to make any amendments to that CT return. This means for expenditure on a qualifying project identified after the CT return has been filed with HMRC there remains a window to make this claim.
Example of the R&D claim window
A company has an accounting period running from 1 April 2021 to 31 March 2022.
The CT return is filed by the due date of 31 March 2023.
Later a qualifying R&D project is identified as running from 1 June 2021 to 31 December 2022.
The previously filed CT return can be amended at any time up to 31 March 2024 to include the expenditure incurred in the accounts period ended 31 March 2022.
The expenditure incurred to the end of the project on 31 December 2022 is claimed as usual in the return for the accounting period to 31 March 2023.
HMRC has specialist offices which are able to offer advice on R&D claims. HMRC also offers an Advance Assurance Service for R&D.