Research and Development tax credits (R&D tax credits) are a part of a tax relief scheme that was first introduced in the UK in 2000. R&D tax credits work by supporting small to medium sized companies (those with no more than 500 employees and under €100 million turnover or €86 million on their balance sheet) by encouraging them to invest in developing or creating innovative business products or solutions through offering them tax relief. The figures which define what qualifies as an SME are in euros because the UK currently adopts the EU definition.
What are R&D tax credits?
R&D tax credits are issued either in the form of a cash pay-out, a corporation tax reduction, or a combination of both from HMRC. They can be claimed by companies who make qualifying expenditure on eligible R&D projects. In practice, R&D tax credits work for many SMEs by providing tax relief or cash so that the company is able to re-invest in the business and grow.
What are the different types of R&D tax credits?
The term ‘R&D tax credits’ is often broadly used, but it is important to understand that there are two different types which need to be distinguished.
- Small and medium sized enterprises (SME) R&D Relief
This scheme can only be used by small to medium sized businesses. Where your company falls within the scope of an SME (as defined above), you can make a claim for R&D tax credits that will allow for a total of 230% deduction on qualifying costs from your annual profits. This tax credit can therefore help reduce your corporation tax bill, reduce it completely, or even allow for any excess to be received in cash. It is an incredibly generous tax scheme and, as such, is considered a form of notifiable state aid. Not only that, but there are also different options of tax relief available for those R&D projects which are unsuccessful in order to minimise loss.
- Research and Development Expenditure Credit (RDEC)
RDEC is a similar tax relief scheme which is utilised by companies which exceed the SMEs size and value threshold. Again, it is offered to incentivise companies to invest in innovation. However, the difference between RDEC and SME R&D tax credits, is that the RDEC scheme offers a much less generous amount back in tax relief. The RDEC scheme allows for companies to claim tax relief of 13% of the qualifying R&D expenditure.
Although RDEC is predominantly geared towards larger enterprises, SMEs are not disqualified from using this scheme. Using RDEC is only recommended to SMEs that are unable to use the SME R&D tax credit scheme in such instances where they are subcontracted to do R&D work by a large company, or where they have received other forms of state aid such as innovation grants. You may want to read our other article to learn how to use R&D tax credits together with grants.
How do R&D tax credits work for SMEs?
To be able to claim for R&D tax credits, you must be undertaking at least one R&D project. The amount of money you invest in the project is the amount that your tax credit will be based on. It’s important to note that only qualifying expenditure will be included in the calculation of how much you will receive back. Some expenses do not qualify, even if they are genuine business expenses (genuine allowable businesses expenses remain deductible for corporation tax purposes).
The SME R&D tax relief scheme works by allowing profit-making companies to make a claim that will allow for a total of 230% deduction on qualifying costs from your annual profit. For every £1.00 spent on R&D, your profits for tax purposes are reduced by £2.30 (rather than just £1.00). Your R&D expenditure is enhanced by 130%. This deduction is usually offered as a corporation tax reduction, but if the enhanced expenditure total eliminates your corporation tax liability in its entirety and there is still an excess amount, this can be taken as a cash pay-out for you to further invest in future R&D projects.
R&D tax credits also work for SMEs if your company is loss-making and has no corporation tax to pay. You can choose to carry the loss back to the previous year if the company was profitable then and therefore receive a tax-rebate on the corporation tax you had paid. Alternatively, you may decide to carry it forwards to offset against any future profits. Your third option is to surrender the loss for group relief which is worth 14.5% of the surrenderable loss. This is issued as a cash pay-out.
Your surrenderable loss is the lower figure of either your qualifying R&D expenditure which has been enhanced by 230% or your net trading losses which have been enhanced by 130%. 14.5% is then calculated from the lower figure which is the amount you can then receive as cash. Although this may not have as much value as carrying forwards the loss, a cash pay-out can be a very necessary lifeline for an SME to continue operating.
What activities qualify as an R&D project?
An R&D project arises when a company is working to create or develop a new product, process or solution; or significantly improve an existing product, process or solution and is required to use science or technology to overcome the uncertainty in order to achieve the project goal. The scope of what qualifies as an R&D project is therefore vastly broad! The definitions and guidance provided by HMRC are intentionally vague to allow for as many industries to claim R&D tax credits as possible. Unfortunately, this explanation of what is an R&D project also often deters many SMEs who are considering claiming for the first time because they mistakenly believe it is only suitable for the tech and science sectors.
In general, HMRC will be satisfied that you are undertaking an R&D project where you can justify that the project meets 4 main criteria:
- The project “looked for an advance in science and technology”.
This does not mean that your project, business, or industry needs to be in the science or technology sector. Instead, you need to be able to demonstrate how your project aims to innovate a product, process, service, or solution that will amount to a discernible advancement in your own field of work. The advancement must be recognisable for your whole industry and cannot simply be improving your company’s own state of understanding or ability. An advance in science and technology will still be accepted even where it has already been developed so long as it was not public knowledge (such as trade secret).
- The project “had to overcome uncertainty”.
At the time of carrying out your R&D project, there has to be a level of uncertainty to the extent whereby you are unsure whether it is scientifically or technologically possible to achieve. Either you are trying to achieve something completely new and you are not sure it will even work, or you are sure it is possible however you are unsure as to how to make it a reality. For example, you may be working on a spray-on product that will extend the life of car tyres because it increases worn down tread depth. The idea seems likely to be feasible, but you’re unsure on how to create such a product. On the other hand, you may be designing a completely different shaped car tyre in the hope that it will run the car more efficiently and therefore reduce Co2 emissions. With this idea, you are unsure if it is feasible at all. In both examples, you can show that you have to overcome a technological uncertainty.
- The project “tried to overcome this uncertainty”.
It is not enough to come up with an innovative idea which you’re not sure will work or not. You must be able to show that during your R&D project, you actively tried to solve the uncertainty. Activity such as design, testing and analysis are all likely to qualify and be sufficient. On the other hand, assessing competitors in the market or maintaining research equipment as activity on its own may not be adequate to meet this criterion.
- The project “could not be easily worked out by a professional in the field”.
You need to be able to demonstrate that other professionals in your field would not be able to easily resolve issues, create the product or find the solutions you are aiming for. It cannot be the case that it is only the professions in your own company sector that found it difficult, but that others generally would find it challenging to realise the end outcome. This may be possible to ascertain through evidence of failed attempts or have other professionals explain the uncertainties involved. You can also demonstrate this by showing that you already have highly skilled professionals on your R&D team and that it is not simply a case of training your internal employees to a reasonable industry standard.
What costs can be claimed through R&D tax credits?
R&D tax credits work by allowing SMEs to claim an enhancement of 230% on qualifying expenditure. So, in order to calculate how much you can claim, you will first need to determine what costs count as qualifying expenditure. HMRC have provided clear guidance on this:
- Employee costs
For all staff working directly on the R&D project you can claim for their salary, their Class 1 National Insurance contributions and any pension fund contributions. You cannot claim for associated costs such as P11D benefits or directors’ dividends. Only employees who are working directly to support the project can be claimed for and so will not include any staff such as receptionists, cleaners, or security guards which you may be employing for the business anyway. If you use staff which have been provided by an agency, then you can claim 65% of payments made to the agency. Similarly, if you use subcontractors for your R&D activities, then you can claim 65% of the costs.
Should you need to purchase specific software or software licences in order to carry out your R&D project, then the full cost of this can be included as qualifying expenditure. However, software that is required as part of your usual business operations such as email or CRM cannot be claimed.
- Consumable items
By this, HMRC means utilities and materials. For utilities, you will be able to claim a relevant portion of the utilities that has been used directly for the purpose of carrying out the R&D activities. Utilities include electricity, gas, water, heat, and light. It does not however include services such as telecoms or broadband.
For materials, this refers to the materials you need to use for your R&D project. It can include the materials used to build a product, such as for a prototype, or for materials used to test your product on. For materials that are consumed for your R&D activities specifically, you can claim 100% of the costs.
- Clinical trials volunteers
If you work in the pharmaceutical industry, clinical trials may well be an essential part of your R&D project. Any payments made for volunteers who are involved can be claimed for in their entirety. When it comes to other industries, you may be able to make claims for costs of volunteers also. For example, if you work in catering and are creating an edible product, you may be able to claim for the cost of taste testers. The crucial part when it comes to making a claim for volunteers is that the costs are reasonable – which is measured by whether they are in line with industry expectations and are a sensible net cost to achieving the R&D project.
What costs cannot be claimed through R&D tax credits?
There are some costs which are commonly confused as costs that come under the above categories. However, these are not considered as qualifying expenditure:
- Rent for office, laboratory, or other workspaces, even where they are necessary for the R&D project or where the R&D activity takes place. Not only is rent not a qualifying expenditure, but neither is council tax nor business rates relating to the property.
- Production cost for sales or marketing. It’s important to distinguish between producing a product as a prototype, producing a product for testing (such as for clinical trials) and producing a product as a sample for potential buyers. The latter cannot be claimed as a qualifying expenditure because at this point it is seen that you have overcome the uncertainty and are only investigating how it will be received in the market.
- The cost for patents and trademarks as this is not part of the R&D activity but merely protects ownership of it.
- Capital expenditure such as office furniture or equipment, land, vehicles for staff etc.
What is the maximum I can claim from R&D Tax Credits?
Due to the incredibly generous amount companies can claim from R&D tax credits, whether they are successful or not, the Treasury are becoming increasingly concerned about fraud and abuse of the system. As such, from 1 April 2021 onwards, a new rule will be put in place to cap the maximum amount SMEs can claim from R&D tax credits.
The maximum you’ll be able to claim is 300% of your total qualifying expenditure for employee salaries which are on your PAYE system and their National Insurance contributions (but not their pension contributions), plus £20,000. Your company will be exempt from this cap if your employees are creating, preparing or managing intellectual property and if you do not spend more than 15% of your qualifying R&D expenditure on subcontractors or external agency supplied workers (also referred to as externally provided workers).
What are the benefits of claiming R&D tax credits for small businesses?
Despite the lucrative SME R&D tax credits scheme being aimed at small to medium sized enterprises, it is often the smallest businesses which lose out on the benefits. Many are unaware of their eligibility whilst others do not consider making an R&D claim at all, although they are carrying out qualifying R&D projects and are investing their own funds into them. However, in response to any misgivings, the benefits of claiming R&D tax credits far outweigh the effort it may take to claim them, and they are highly worthwhile. The benefits include:
- There is no minimum amount you need to spend on R&D projects. Prior to 2012, this was not the case and you needed to have spent at least £10,000 on qualifying expenditure to make a claim. Now however, even the smallest amounts can be eligible. In fact, there has been a growing number of small claims averaging £5,000 which shows you do not have to be spending significantly to receive tax relief.
- R&D tax credits are applicable to all industries. Although wording from HMRC may convince you that R&D is only for science and technology companies, some of the top claiming industries include the communications and telecoms sector, retail, and the food and beverage industry. Your chosen field of business will not prevent you from making an R&D tax credit claim so long as you can show you are aiming to innovate your industry.
- R&D tax credits allow you to invest in your small business and grow. Carrying out an R&D project can sound like a huge commitment for time and resources from your business, however it shouldn’t be seen as a separate demand. Rather, your R&D project should complement and advance your business. One of the biggest benefits of claiming R&D tax credits is that you receive government support in the form of tax relief or cash for investing in your own business.
- Benefit from R&D tax credits even if your project fails. Receiving tax relief or cash is not only available if you manage to achieve your R&D project successfully. Even where you can definitely confirm that your attempts will not work or are not feasible, you can still make a claim on all your qualifying expenditure. In fact, R&D tax credits can offer that vital boost of cash to help you continue your business after a failed investment.
If you’re considering making your first R&D tax credit claim, then we highly recommend you consider applying for Advance Assurance. Alternatively, to get help with making a claim or to discuss how we can help please get in touch today through the contact form below or on 01865 24 55 11.