Research and development tax relief in the UK
Nigel Holmes of tax relief specialist Catax considers research and development tax relief in the UK, the effecting of claiming state funding, R&D expenditure credit and how SMEs can make the most of R&D tax relief and grants side by side
The future plans of this UK government might be shrouded in mystery, but the ability to claim research and development (R&D) tax relief and grants side by side shouldn’t be. What does this mean for companies investing in R&D?
The SME scheme
Most readers will be familiar with R&D tax relief, which was introduced over 17 years ago. As a quick recap, the scheme for small and medium-sized enterprises (SMEs) introduced on 1 April 2000 allows companies carrying out eligible R&D to claim an enhanced deduction against their profits for certain costs, mainly consumable items, staff costs and subcontracted services.
This relief has been amended many times since 2000, mostly to increase the amount that can be claimed and to simplify the relief. The enhancement rate is now 130%: in other words, £100,000 of qualifying R&D spend attracts a further £130,000 deduction against profits.
This scheme allows tax liabilities to be substantially reduced, creating large tax repayments where the tax has already been paid – a claim can be made for the previous two accounting periods. Where a loss is created or increased, the loss can be surrendered in return for a 14.5% cash repayment, even if the company has never paid any tax to HMRC.
This is not an aggressive tax avoidance scheme; it is a legitimate relief to encourage innovation in the UK. There are still many companies not making claims to which they are entitled.
Following the successful introduction of the SME scheme, in 2002 the large company scheme was introduced, offering a very similar relief to the SME scheme but with a much lower enhancement. Luckily, the definition of SME is very generous and many clients can claim the more generous SME relief.
Effect of claiming state funding
The SME scheme falls within the definition of EU state aid. Whether we have a soft Brexit, a hard Brexit or a somewhere-in-between Brexit, at some point R&D tax relief will no longer be a state aid – but I am sure it will be here to stay in some form to keep the UK competitive for innovation. Under current rules, though, in simple terms you cannot receive state aid for the same matter twice. Therefore, where an SME has received some form of grant or subsidy towards R&D, it cannot have the SME tax relief too. So, all is lost from a tax perspective?
Well, actually, no! HMRC has acknowledged this issue and introduced legislation (now found in s104A(b), Corporation Tax Act 2009) so that an SME in receipt of state aid could claim R&D tax relief under the (less generous) large company scheme. This was often overlooked and still is, even though the methodology of claiming has changed. However, one major difference between the SME scheme and the large company scheme is that the large company scheme did not offer a tax credit for losses. Hence SMEs with state funding and tax losses could not surrender the losses for cash.
For example, if a company spent £100,000 on qualifying R&D and received 50% EU state aid funding, the actual cost to the company, after the additional 30% tax relief available, would be only £20,000 (being £100,000 spent, less £50,000 funding, less £30,000 enhanced tax relief). There is often confusion here in that some think the enhanced relief only applies to the balance after the funding, but this is incorrect. If the funding is a state aid the enhancement applies to the total but at the large company scheme rate. Therefore, should the amount of funding be very small, many companies may have made their financial position worse by opting for the funding rather than the tax relief.
Unfortunately, many companies claim the grants then seek or become aware of the tax relief much later, by which time advice is too late. By grant providers and R&D tax advisers working more closely together, at the outset, the client can receive the best all-round funding advice.
Tips on R&D state funding
The first tip we can offer you is to ensure that companies seek appropriate joined-up advice to ensure they consider the best combination of EU state aid funding and tax relief at the outset before proceeding.
The next tip is to review the grant documentation. I have seen a case where the client thought they had an R&D-related grant, yet upon closer observation it was for marketing and web development post-R&D as opposed to the R&D itself. So, if the grant relates to capital expenditure or marketing then this does not prevent a claim for R&D tax relief at the superior SME rate.
Even if the funding does relate to R&D, is it so specific that the project can be broken down into specific R&D projects, to ensure the future R&D attracts the SME enhancement because the funding clearly only relates to a specific element of the R&D? Ensuring the funding documentation is clear on what it covers greatly assists in maximising the tax relief claim.
R&D expenditure credit
In 2013 the large company scheme was phased out to be replaced by research & development expenditure credit (RDEC). On 1 April 2016 RDEC became mandatory for large companies and SMEs in receipt of state aid. The major advantage of RDEC over the previous large company scheme is that credits, ie, payments, can result for loss-making companies.
For RDEC, the definitions of R&D and how qualifying costs are calculated remain the same. It is the methodology of the claim that differs significantly. The concept of RDEC was to make the relief more visible but it becomes a difficult concept to explain.
11% (10% prior to 1 April 2015) of the qualifying costs are treated as a taxable credit in the company accounts (which is why it was originally referred to as ‘above the line’ tax relief). However, I have seen many SMEs make this adjustment through the tax computation as a taxable amount rather than within the financial statements. This helps in the common situation where accounts are finalised before the tax position is finalised.
Let’s assume qualifying costs were £100,000. The credit will be an additional £11,000 (at 11%) of taxable ‘income’ (strictly, not income but a tax adjustment) which is taxed as normal to corporation tax (CT). Thereafter, this credit is deducted from the company’s tax liability. So let’s say the company’s tax liability was £50,000, the actual amount due is £39,000 (£50,000 original liability less the £11,000 credit) after deducting the RDEC. Based upon a 19% CT rate, the effective rate of RDEC is 8.91% (was 8.8% when the CT rate was 20%). Loss-making companies receive the RDEC as a repayment, after withholding the CT element of the credit.
As with many aspects of tax legislation, it is not quite as simple as that. The calculation involves a seven-stage process. The CT element of the credit is carried forward or surrendered through group relief and there is a cap linked to the PAYE and class 1 NIC in relation to R&D staff. HMRC will also offset the repayment against any other tax due to it, such as VAT, before making the repayment.
While in my opinion RDEC is probably more complex than it needs to be, it was introduced for large companies and SMEs only claim it due to the state aid issue. If, following Brexit, changes are to be made as to how R&D tax relief is given, we think it essential that SMEs and their advisers are consulted to ensure the system is kept as simple as possible. The 2017 Budget promised to simplify the R&D claim process, and RDEC for SMEs is an area that could benefit from such simplification.
That said, we now have a position where loss-making companies in receipt of state aid can receive an R&D repayment too. It’s “win-win”, or “having your cake and eating it”. Whichever saying you prefer, please remember that companies in receipt of R&D grants should also be seeking to make an R&D tax relief claim too.
Given the complexities highlighted here, some accountants are seeking expert advice to ensure their clients receive the benefits to which they are entitled.
About the author
Nigel Holmes FCA CTA is a senior R&D tax consultant at Catax and a nominee for Tax Writer of the Year in Tolley’s Tax Awards 2017
Catax are specialists in tax reliefs and an ICAEW business partner. For more information contact Catax on +44 (0)300 303 1903 or visit catax.com