How R&D tax credits support innovative SMEs

Launched more than 20 years ago, the UK government’s research and development (R&D) tax credit regimes offer companies undertaking innovation a way to reduce their tax bills. As firms starting out are often loss-making and do not pay corporation tax, many assume that making a claim isn’t an option or not worth their time, but increased losses can be carried forward or even claimed as cash back tax credit.

Wendy Smith, Senior Innovation and Growth Specialist at RTC North, advises innovative small businesses on how to commercialise their ideas in support of Innovate UK’s Edge scheme. She has many years of experience of advising on R&D tax credits and believes a lot of companies are missing out.

“When talking to SMEs about R&D tax credits, I’ve found there’s a real mix of responses,” says Smith. “Some don't know about the scheme, while others think it doesn't apply to them or think it is too much of a time investment which is a huge misconception. Finally, there are those that think they've got it covered, but the reality is they could missing out.”

What are R&D tax credits?

Under the R&D tax credit schemes, limited companies make a claim to HMRC detailing expenditure on projects that seek an advance in science or technology. Successful claims reduce taxable profits, or increase taxable losses, by enhancing the expenditure on a project by more than 100%, explains Smith.

For the SME scheme, which is open to businesses with less than 500 staff and a turnover of less than €100m or balance sheet total of less than €86m, the rate of relief can be as high as 230%. This means that SMEs can reduce their corporation tax liability by 44p for every £1 spent on R&D. If the business is not yet making a profit, it can either carry the enhanced losses forward or surrender them for a cash benefit worth up to 14.5% of the surrenderable loss.

“The scheme is all about encouraging us to find out whether there are better ways of doing things. It's a really great incentive for businesses to take risks to innovate,” says Smith.

Expenditure that can be claimed under the scheme includes that on software, materials, utilities and employee costs (salaries, pension contributions and national insurance contributions). Small business can also claim 65% of the costs of using an unconnected subcontractor and 65% of payments to an external agency which provided staff for the project.

Costs that can’t be claimed include the purchase of land, patents and trademarks, the production and distribution of goods, rent or capital expenditure. Entrepreneurs and start ups should also note that dividends cannot be claimed, so when setting up a business, from a R&D credits perspective, it can be better for directors involved in the R&D work to pay themselves salary.

Eligibility and making a claim

To qualify for R&D tax credits, the business must have undertaken a project that meets HMRC’s definition of “research and development”. This means overcoming something that is technically difficult that advances science and technology, it cannot be simply applying existing technology in a new sector or field. The project doesn't have to be a new one, it can be something that the company has been doing in the past but are looking at it in a different way.

“It's all about the limitations to existing technology,” explains Smith. “The tried and tested ways don't work, so there’s a new way that the business wants to try. The motivation can be to improve a process or product – make it cheaper, faster, smaller or larger, for example.”

“Alternatively, it could be that legislation has changed and where previously you would use a certain chemical, now you're not allowed, so you have to look at new ways of doing what you were doing before.”

To be successful each claim has to demonstrate to HMRC what the challenges were in moving from existing technology, how the business attempted to overcome them (tests, trials or protypes, for example) and what was the technical improvement (such as avoiding a chemical, reducing waste, or using a virtual environment). This narrative has to be clear and not include too much technical information.

“When I first started working in this area, I remember speaking to accountants and they would have some clients who had written pages and pages, while others had a one pager for the same size claim and they wanted to know what was right,” recalls Smith. “The truth is neither. HMRC may either think that you that you've tried to bamboozle them with too much data, or that you aren’t giving them enough information.

“It’s all about writing the claim at the right level. Claimants have to remember that staff employed in HMRC’s R&D units are not technical people (although some do have backgrounds in the areas of R&D eligible for claims) and they have to be able to understand why the project was technically difficult.”

Smith suggests that in some ways the claim is similar to a grant application or pitching for venture capital funding in that the claimant has to demonstrate where the value is in the project. “What was the purpose of it? Why have you done it?” she says. “It can’t simply be that you fancied taking on a technical challenge.”

The hardest part of the process is often being confident that the problem was technically difficult in line with HMRC’s definition. While there are companies offering support on making R&D claims, Smith highlights that this is an unregulated market, and for those offering the advice there can be little risk if the claim is later subject to an HMRC enquiry.

Accountants on the other hand tend to be more cautious on saying what is and isn’t eligible, knowing the implications and consequences of an enquiry. If HMRC looks into a claim and decides it's not eligible, it can potentially go back and investigate all previous claims.

However, Smith says that firms shouldn’t be put off making a claim. “It’s not a very complicated thing to do, you can do it yourself,” she says. “What I do with our clients is give them coaching on what is technically eligible, so that they can feel more confident when they talk to their accountants about their projects. They’re able to say ‘Yes, this was technically difficult, because of these reasons…’ This means their accountants feel more comfortable and can support them on the expenditure part of the claim.”

Common misunderstandings

One of the most common misunderstandings about R&D tax credits is that because HMRC’s definition talks of “advances in science and technology” that means the regime is restricted to new technology sectors. If the project is technically difficult to achieve and involves a new way of doing something, it should be eligible. For example, a drinks manufacturer looking to find a way to remove sugar from one of its beverages could be eligible for credits, as much as a firm working on a new application of artificial intelligence.

Smith highlights her experiences of going into manufacturing businesses where engineers are spending significant amounts of time to solve problems, but not realising that the work qualifies for credits. “They think because they're not coming up with something brand new they aren’t undertaking R&D, so they’re missing out,” she says. 

On the other hand, she warns that companies in the software sector often can assume that they qualify for credits where this might not be the case. “Software is a definite danger zone,” says Smith. “People really need to know what they're doing when they're claiming for software projects because HMRC are focused on ensuring the work is eligible. Companies are at risk of overclaiming and opening themselves up to an enquiry.”

Another assumption that businesses make about claiming R&D credits is that the project has to be a success. “Companies can still claim for failures, because the regime is aimed at encouraging businesses to take risks,” Smith confirms. “The claim needs to detail what you were attempting to achieve and then the results of the tests. Explain that you made five prototypes and the reasons why they didn’t work.”

Meanwhile, for SMEs who have won a grant for a project then R&D claims have to be made through the large company R&D scheme (RDEC), were the levels of credits are reduced to 13% of expenditure. Some then assume it's not worth making a claim, but Smith says this isn’t the case.

“There's this confusion that if a business takes a grant, then everything goes through the large companies’ scheme, while actually they can ring fence it,” explains Smith. “As long as the grant is for a specific project and specific elements, they can ring fence that cost to put that through RDEC, and then the rest of their projects can still go through the SME scheme.”

Finally, there is an assumption that because claims have been paid by HMRC previously they are correct. Smith explains that the process is similar to submitting tax returns, in that HMRC doesn’t look at every claim. “You speak to some people and they say: ‘We’re happy with how much we get back every year, our claim is fine’. And it might be that the submission is incorrect, but that HMRC hasn’t reviewed your claims yet,” she says.

Firms need to be aware that if the project has moved on, then it may no longer be eligible for credits. “It could be that a project is valid only for a short time, such as when a new test has to have been developed to confirm a change in software is successful. Once it is confirmed that the new test works then the R&D is gone,” she says. “R&D is constantly evolving, and so companies must also make sure that the projects they are claiming for still qualify.”

Further support:

• HMRC support on claiming R&D tax credits.
• More HMRC information on R&D tax credits for SMEs.
• ICAEW support on R&D tax credits.