The new proposals discussed by Louise Rippon: Article published in the August 2002 issue of Tax Adviser. Louise Rippon, LLB (Hons) LLM (Lond.), is a barrister at 3 Temple Gardens, London.
Research and Development (R&D) Tax Credits were introduced in Finance Act 2000 (FA 2000) for small- and medium-sized enterprises (SMEs). The scheme was intended to complement the allowance for capital spending and boost the amount SMEs could deduct from current spending on R&D in the computation of their taxable profits from 100 per cent to 150 per cent. These businesses can also surrender their R&D losses to the Exchequer in return for a cash payment. In the Budget 2001 the Exchequer announced proposals to give a similar relief to large companies. After consultation the proposals were introduced in the Budget 2002.
The new provisions are brought into force by what are currently cl. 52 and 55, and Sch. 12 and 15 of the Finance Bill 2002 (the numbering may change before the provisions receive Royal Assent), and have effect for accounting periods ending on or after 1 April 2002. They are likely to affect companies who spend money on R&D including those which subcontract work to other institutions. The R&D tax credit for SMEs will continue, but with a new measure to give credit to all companies. Large companies, essentially those other than SMEs will be entitled to an additional deduction from their taxable income of 25 per cent of current spending on qualifying R&D in addition to the normal 100 per cent.
Definition of Research and Development
What then is ‘research and development’ for these purposes? The definition is the same as for the old credit and is contained in Income and Corporation Taxes Act 1988 (ICTA 1988), s. 837A, which provides:
'(2) 'Research and development' means activities that fall to be treated as research and development in accordance with normal accounting practice.'
It is not a legal question whether or not something qualifies as expenditure on R&D, but an accounting question to be answered by reference to Statement of Standard Accounting Practice (SSAP) 13. It is defined there as:
'(a) pure (or basic) research: Experimental or theoretical work undertaken primarily to acquire new scientific or technical knowledge for its own sake rather than directed towards a specific aim or application;
(b) applied research: Original or critical investigation undertaken in order to gain new scientific or technical knowledge and directed towards a specific practical aim or objective;
(c) development: Use of scientific or technical knowledge in order to produce new or substantially improved materials, devices, products or services, to install new processes or systems prior to the commencement of commercial production or commercial applications, or to improving substantially those already produced or installed.'
The new provisions
Schedule 12 introduces R&D tax credits for large companies as well as SMEs. The schedule is split into six parts: Pt. 1 sets out the entitlement to the relief for large companies; Pt. 2 covers the extended entitlement to relief for SMEs; Pt. 3 sets out how the relief is given; Pt. 4 contains a special provision concerning the treatment of Insurance Companies, and Pt. 5 and 6 contain supplementary and general provisions, including defining terms of the schedule.
Part 1: Entitlement to Relief for R&D Expenditure: Large Companies
This part extends the relief previously given to small companies and explains how a company qualifies for the relief. The conditions are that the company must be a large company throughout the accounting period and has qualifying R&D expenditure of at least £25,000 for either a 12 month accounting period or an amount that bears to £25,000 the same proportion as the accounting period bears to 12 months. For these purposes qualifying expenditure - for an accounting period - is such of it as is deductible in computing the profits for tax purposes for that period of a trade carried on by the company. A large company is defined by para. 2 to be one which is not an SME. Paragraph 3 then sets out what can constitute qualifying expenditure, it can be one of three things:
Qualifying expenditure on direct R&D
- expenditure on direct research and development;
- expenditure on sub-contracted research and development, or
- expenditure on contributions to independent research and development.
Paragraph 4 sets out the conditions to be satisfied in relation to this:
(1) the expenditure must be incurred on R&D undertaken by the company directly;
(2) it may be incurred on either staffing costs or consumable stores (as defined in FA 2000, Sch. 20, para. 5 and 6);
(3) it must be attributable to relevant R&D in relation to the company;
(4) it must not be of a capital nature; and
(5) if the expenditure is incurred in carrying on activities contracted out to the company they must be either contracted out by a large company or by a person otherwise than in the course of a trade, profession or vocation.
Expenditure on R&D directly undertaken on company’s behalf
The conditions that a company has to satisfy for its expenditure to qualify under this head are set down in para. 5. Again there are five conditions:
(1) the expenditure must be incurred by the making of payments to either a qualifying body (defined in para. 18 as a charity, institute of higher education, health service body, scientific research organisation or other body prescribed by the Treasury), an individual or a partnership in respect of the R&D contracted out to them by the company;
(2) the sub-contracted R&D is directly undertaken on behalf of the company by that body, individual or partnership;
(3) the expenditure is attributable to relevant R&D in relation to the company;
(4) it must not be of a capital nature, and
(5) if the sub-contracted R&D is itself contracted out to the company it must be by a large company or a person otherwise than in the course of a trade, profession or vocation.
Qualifying expenditure on contributions to independent R&D
The expenditure of a company on contributions to independent R&D qualifies if the conditions in para. 6 are satisfied.
(1) expenditure must be incurred in making payments to a qualifying body, individual or partnership for the purpose of funding R&D carried on by the body, individual or partnership concerned;
(2) it must be relevant R&D in relation to that company;
(3) the funded R&D must not be contracted out to the qualifying body, individual or partnership concerned by another person; and
(4) if the payment is made to an individual or a partnership the company must not be connected with the individual or any member of the partnership when the payment is made. Section 839 of ICTA 1988 (connected persons) applies for these purposes: para. 19.
Part 2: Entitlement to relief for R&D expenditure: work sub-contracted to SMEs
This part extends the relief already given to SMEs by FA 2000, Sch. 20. The relief is additional to that already provided by Sch. 20 subject to the modifications of this Sch. introduced by cl. 55 and Sch. 15 of Finance Bill 2002. It provides that where the SME has work subcontracted to it, it qualifies for the tax credit at 125 per cent if certain conditions apply. To qualify the 'aggregate expenditure', rather than the 'qualifying expenditure' which is used in Sch. 20 (although for periods after 1 April 2002 this is changed to 'aggregate expenditure' by Sch. 15 of the Finance Bill 2002), must be no less than £25,000 over a 12 month accounting period. The 'aggregate expenditure' is defined in para. 7(2) to be the aggregate of the SMEs qualifying sub-contracted R&D expenditure and its qualifying R&D expenditure within the meaning of to the FA 2000, Sch. 20.
Qualifying sub-contracted R&D expenditure
Small- and medium-sized enterprises qualifying sub-contracted expenditure, defined in para. 8, is that incurred by the SME on R&D that is contracted out to it where it is contracted out by a large company or someone who is not doing so in the course of carrying on a trade, profession or vocation and where the conditions of para. 9 and 10 apply. These conditions mirror those already contained in Sch. 20.
Expenditure on R&D directly undertaken by SME
Four conditions are set out in para: 9
(1) that the expenditure is incurred on R&D which is directly undertaken by SME.
(2) that it is incurred on staffing costs or consumable stores;
(3) expenditure must be attributable to relevant R&D expenditure in relation to the SME; and
(4) it must not be of a capital nature.
Expenditure on R&D directly undertaken on SME's behalf
The conditions in para. 10 are that first the expenditure is incurred on payments to a qualifying body, individual or partnership in respect of the R&D contracted out by the SME. The R&D must be directly undertaken on behalf of the SME by the body, individual or partnership. It must be attributable to relevant R&D in relation to the SME and must not be capital in nature.
Part 3: The relief
Part 3 sets out how the relief is given when a company is so entitled. Insofar as a company's qualifying expenditure for a period is deductible in computing for tax purposes the profits for any period of a trade carried on by the company, it is entitled to an additional deduction in computing the profits of the trade for that period of an amount equal to 25 per cent of the qualifying trade. The effect will be to reduce the after tax cost of the full amount of qualifying R&D by 7.5 per cent for a company paying corporation tax at the standard rate.
Part 4: Provision for giving relief to insurance companies
This section provides that an SME insurance company shall qualify as if it were a large company for the purpose of obtaining the relief under Pt. 3.
Part 5: Supplementary provisions
R&D expenditure of group companies
If a company is within a group and a member of that group contracts R&D activities to another member of the group, that other member shall be treated as if they had carried out the R&D activity directly. This allows them to sub-contract the work out to a party who is not a member of the group. For these purposes the companies qualify as members of the same group if they are members of the group for the purposes of ICTA 1988, Ch. 4, Pt. 10.
Refunds of contributions to independent research and development
Paragraph 15 provides that 25 per cent of any refunded payment in relation to R&D expenditure is treated as income and charged under Case I of Sch. D for the period when it is made, except if it is refunded to a life assurance company where any refund will be treated as if 25 per cent of it were income referable to Case VI of Sch. D.
Artificially inflated claims
Any transaction arising out of a scheme, agreement or understanding, whether or not legally enforceable, shall be disregarded if entered into for a disqualifying purpose by virtue of para. 16. This is so if its main object is to enable a company to obtain relief under Sch. 12 that it is otherwise not entitled to, or is greater than it is entitled to.
Schedule 15 amends FA 2000, Sch. 20 so as to bring it into line with the new rules so that the aggregate expenditure and its qualifying sub-contracted expenditure now falls to be considered in analysing if it has the relevant expenditure for periods after 1 April 2002. The schedule also provides that the following will not qualify as state aids in relation to subsidised expenditure which is not inclusive in computing qualifying expenditure:
- R&D tax relief and R&D tax credits;
- Tax relief under Schedule 12; and
- Tax relief and tax credits under Sch. 13 (expenditure on vaccine research).
Although in order to qualify for the tax credit all the provisions contain a condition that the R&D expenditure must not be of a capital nature – which at first may seem restrictive – in actual fact SSAP 13 provides that all expenditure incurred on pure and applied research and development will in effect be revenue and regarded as part of the continuing operation required to maintain the business of the company. Such expenditure can be written off as it is incurred. Although expenditure on new products or services is distinguished from this, in effect it still carries the same accounting treatment except that it can be carried forward against the life of the asset if certain criteria set out at para. 10 to 12 of SSAP13 are met. It would seem, therefore, that requiring the expenditure to be revenue in nature will not be restrictive as any expenditure which qualifies as R&S expenditure for the purposes of ICTA is not capitalised, but treated as revenue.
The new credit is just part of a package of reform to the business tax system introduced by Budget 2002. It is intended to help provide longer-term investment for business and a competitive business environment, promoting investment and innovation in the UK. The expectations of the government are that it will provide an additional £400m a year support for investment in new technology by UK industry. Whether or not the scheme will achieve this is highly speculative, although certainly it would appear that the effect of the scheme will be to encourage more spending in relation to R&D in order to qualify for a higher figure of tax relief and it may serve to suppress the profits of the large companies going forward, thus achieving a balancing effect.
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