Lee Sharpe looks at new restrictions for research and development tax relief for small and medium-sized companies, as proposed in Budget 2018.
Firstly, it is important to recognise that there are many businesses that undertake eligible research and development (R&D) expenditure but do not realise it; this is particularly the case for small businesses where take-up has historically been quite low.
Where R&D expenditure is eligible for the special tax treatment, then for small and medium-sized enterprises, currently:
• the qualifying expenditure is ‘supercharged’ for tax purposes, reducing taxable profits by an extra 130% of the qualifying cost; and
• to the extent that the expenditure results in a tax loss, this can be exchanged for a payable tax credit of up to 14.5% of that loss. This tax credit can help to further fund the R&D.
Critical conditions
Only companies are eligible for this enhanced R&D tax relief.
R&D does not have to involve laboratories or scientists. I have seen valid R&D in commercial dairy farms and bakeries. But to be eligible, it must seek to resolve a relevant ‘technological uncertainty’. This phrase is very important because it means the business must be trying to break new ground in an area where there is no tried and tested solution or application.
To put it another way, it becomes R&D if a competent professional in that particular field doesn’t know if it can be done. Even the costs of failed projects are eligible – and failure is good in this context, because it strongly suggests that the outcome was uncertain (trade secrets may also qualify, where techniques, etc., are not freely available within that sector).
A note of caution
Over the last couple of years, I have seen evidence of what I might generously term ‘hopeful’ claims made by small companies or recommended to them, where I could discern no basis for the claim, given the facts as presented.
While this may be understandable where a business has made a claim without the benefit of tax advice, I have also seen an example where an R&D specialist firm appeared to suggest that a company would be eligible simply because it had not been able to buy software ‘off the shelf’ to achieve its aims, with the implication being that merely tailoring a software package was sufficient for an R&D claim – without identifying the issue of technical uncertainty.
Companies should realise that, under the self-assessment regime, the onus is on the company to decide if it is eligible for the relief. Even if the corporation tax return is processed and a repayment is issued, this should not be taken to mean that HMRC has agreed the claim is valid.
Budget 2018 restriction
The government appears also to be concerned because Budget 2018 included an announcement that repayment claims for small and medium sized enterprises would be capped. The stated intention was to prevent abuse, with an emphasis on combatting outright fraud, but it will potentially affect ‘genuine’ businesses as well.
From April 2020, a cap will be placed on how much of a company’s R&D-attributable losses can be exchanged for the payable tax credit, and the repayment cannot exceed 300% of the company’s total PAYE/National Insurance contributions (NICs) liability for the year.
Implications
Readers may be aware that, until 1 April 2012, a company could not get back more in tax credits than the PAYE and NICs it had incurred in the year (the measure was abolished from 2012, ostensibly to encourage take-up by smaller businesses!). This very broadly ensured that the government was not ‘out of pocket’ in terms of direct taxes and it also reflected that a company’s largest R&D-eligible expenditure tends to be its salary costs for the personnel assigned to R&D work.
This replacement cap is significantly more generous (three times that of its predecessor), but it should act automatically to limit the more extreme claims without HMRC’s having to check the validity of each claim before approving repayment.
Example 1: Established company
Let’s take a medium-sized company with a claim to £20,000 of eligible salary cost (representing the relevant proportion of the gross wages cost of particular employees) identified as having been spent on R&D projects in a year.
The revised tax deduction would be:
£20,000 x 113.8% (don’t forget employers’ NICs!) = £22,760 x 230% = £52,348
Assuming this increases the company’s loss for tax purposes, then this can potentially be surrendered in full for a payable tax credit:
£52,348 x 14.5% = £7,590
If we assume for simplicity that the employees are all being taxed at 40% and paying 2% primary NICs, the total paid over to HMRC (including employer NICs) would be at least*:
£20,000 x (40% + 2% + 13.8%) = £11,160, and the new limit from 2020 will be at least*:
£11,160 x 3 = £33,480
Therefore, this company should have no problems with the proposed cap.
*The company’s actual PAYE/NICs liability may well be much larger because:
- The company will probably be paying PAYE and NICs on employees who have no R&D function;
- The employees who do have an R&D role will almost certainly not be spending 100% of their time on qualifying R&D activity, and their combined annual salaries (and the PAYE/NICs due thereon) may well be much more than £20,000.
Example 2: Start-up company
NewCo has one director/employee who takes a modest salary of £12,000 a year. The director, who has no other source of earnings, calculates that she spends 80% of her time on eligible R&D activity.
The company spends a lot more on utilities, on consumable materials, and on software, all used exclusively for the project, and on outsourced testing and analysis that the director cannot undertake herself. The company is occasionally able to sell some of its finished product but generates a negligible amount of income, such that the company is running at a loss (and will probably be so for the next two or three years – but not indefinitely as there is also an underlying viability test for R&D):
£ £ £
Salary 12,000
‘Ers NICs 465
12,465
R&D Element 80%
Exclusively for R&D: 9,972
Utilities 1,000
Software 3,000
Materials, internal testing 3,788
External testing, etc. 5,000
22,760
R&D multiplier @ 230%
Enhanced R&D cost for tax purposes 52,348
@ 14.5%
Surrenderable for tax credit: 7,590
Company's PAYE/NICs liability:
‘Ees NICs 465
‘Ers NICs 404
PAYE tax (code 1250L) -
869
New PAYE/NICs cap x 3
2,607
Maximum R&D credit (restricted by PAYE cap) 2,607
So, two different projects which just happen to have the same amount of qualifying expenditure, end up with significantly different tax credit entitlements.
Note that, whatever R&D-enhanced tax losses NewCo cannot exchange for real money as tax credits, these can still be kept to set against future profits.
Conclusion
The intended measure should prevent HM Treasury from losing too much money finding spurious (or worse) claims, but there is a risk that small start-ups that are self-funding will lose out on the significant cashflow benefit of R&D tax credits – particularly where salaries are modest and other R&D costs are substantial. Ideally, HMRC would have the resources to weed out poor claims to ensure that all businesses would receive their fair share of the credits; I suspect that the proposed re-working of the old cap is seen as the cheaper option.
