Research and Development (R&D) expenditure relief is an established relief in the UK tax system and is available to all sizes of company. We tend to think of it as being for SMEs and non-SMEs although to some degree that is a little misleading, as the definition of a SME is different for R&D relief. The standard SME indicators – turnover, employees and assets are doubled for R&D purposes, so always be careful in an exam question if the examiner gives you the relevant figures. Your tax tables do however contain the relevant definitions so don’t forget to double check. This is especially important with effect from 1 April 2016 as, from that date forward, large companies can no longer claim the enhanced deductions that have been the basis for all specific R&D tax relief before the introduction of the R&D expenditure credit (RDEC).
It is often taken for granted that a company may be involved in R&D - indeed the accounts may explicitly state this but whilst a set of GAAP accounts can be useful as an indicator of R&D activities, we instead use government guidelines to identify whether or not qualifying R&D is actually taking place and once we are satisfied that it is, we then look to identify qualifying expenditure.
In an exam, you might have to decide whether or not something is qualifying R&D, or be asked to write an email/letter/report that explains this. It would be useful to have something to hand to help you with this.
Fortunately, this can be found within the pages of the incredibly useful Tolley Yellow Handbook Part 2b. I’m a great fan of this often overlooked book - especially the section called “Miscellaneous non-statutory material”. This section is full of extremely helpful guidance notes relating to lots of issues that an examiner might wish you to demonstrate knowledge of. For example – if you need to articulate the ins and outs of the statutory residence test, this section contains an easy to follow guidance paper. Similarly, if you can’t remember the “tests” for employed vs self-employed status, or need a reminder on how to calculate IR 35 deemed payments the book again comes to the rescue. I can’t emphasise enough just how useful this material is, and, being written in plain English (by HMRC standards) you can quickly locate what you are looking for and insert it into your answer – thus hopefully accumulating lots of marks.
The relevant section for R&D is on page 1,683 and is called ““Misc VIII - Guidelines on the meaning of Research and Development for tax purposes.” It contains some very helpful basic statements and definitions. For example:
“The definition of Research and Development
R&D for tax purposes takes place when a project seeks to achieve an advance in science or technology. The activities which directly contribute to achieving this advance in science or technology through the resolution of scientific or technological uncertainty are R&D.”
Having stated this, the notes then go onto explain what is meant by an ‘Advance in science or technology’
“An advance in science or technology means an advance in overall knowledge or capability in a field of science or technology (not a company's own state of knowledge or capability alone). This includes the adaptation of knowledge or capability from another field of science or technology in order to make such an advance where this adaptation was not readily deducible.”
Hopefully you can see how helpful it is to have a “shopping list” of what is needed to qualify as R&D, and the examiner may set short-form questions which require such knowledge, or give marks in a long-form question for a clear articulation of R&D. How much easier is it to calmly copy from the Yellow Handbook than to sit in the exam hall straining to remember a page from a study pack read months before?
Once we have demonstrated to the examiner that our client is indeed pursuing qualifying R&D activities, we can then calculate either the enhanced deduction or the RDEC. This sounds a pretty simple task, and indeed it isn’t especially difficult, being largely a series of mechanical mathematical steps. In an exam question, however, there will almost certainly as many marks for identifying the correct qualifying expenditure as there will be for calculating the actual relief.
The bulk of qualifying expenditure will be staff costs. This is logical because outside of expensive items of capital kit (which will presumably be on the balance sheet and will qualify for scientific research allowances of 100%) the R&D will be performed by people who will expect to be paid! Identifying staff costs is relatively easy, but it should be remembered that only those staff who are directly and actively involved in pursuing the R&D will qualify. General staff such as HR or the finance department won’t qualify. That said, a few years ago HMRC began to allow the inclusion of the costs relating to those staff involved in “qualifying indirect” activities. Hence the staff costs of a maintenance worker who sets up the equipment everyday could qualify along with any special security guards for the R&D department. This would contrast with a general security guard who patrols the whole building – his costs would not qualify as they would not be sufficiently linked to the R&D.
Remember not all of the costs of qualifying staff qualify. We include wages and salaries, pension contributions, secondary class 1 NIC but not expenses or benefits such as cars. So be careful of an examiner inserting information about benefits in an attempt to trick the unwary.
Other qualifying costs include: software or consumables; relevant payments to the subjects of clinical trials; subcontracted R&D; or externally provided workers. Each of these categories would be worthy of an article in themselves but I want to spend a little time talking about sub-contracted R&D as this can sometimes be confusing.
Why might a company either subcontract R&D work out or take on work for another company? If we think of a typical SME there may be a time during its R&D work where it requires the specific skills of an individual or access to a specific piece of equipment – for example, an electron microscope. Such kit might be prohibitively expensive to buy and may only be used infrequently – so it is far more efficient to subcontract out that work to a relevant specialist.
SMEs can claim relief for the costs of doing this – but the treatment of these costs is somewhat complicated. If the payment is to a connected party, then the expenditure qualifies for the conventional 130% uplift. In all other cases only 65% of the payment qualifies, although an election can be made for connected party treatment. This is the sort of ‘fiddly’ aspect of the law that could prove highly tempting to an examiner looking to see if candidates have correctly understood the rules! Similar rules apply for the costs of externally provided workers.
Payments made to subcontractors by large companies do not qualify and must therefore be excluded from the calculation of qualifying expenditure for the RDEC.
What about payments received for sub-contracting, i.e. where the company that we are looking at is undertaking R&D on behalf of another company? Why might this be done? Again, think of the economics of running a small or medium sized company. In an ideal world one project would finish on the Friday and the next commence on the Monday, but even in ‘exam-land’ we seldom encounter such efficiency. Instead it is likely that a company may agree to do work for others in order to keep staff and machinery as fully occupied as possible.
Such payments, when received by a SME are eligible for enhanced deductions (when made by a SME) or rather confusingly for the RDEC when made by a large company. Hence it is possible (although possibly unlikely in an exam) for a SME to claim a degree of RDEC.
If the payments are received by a large company, they only qualify for the RDEC if the payment has been made by another large company. Payments made by a SME will qualify (as above) for enhanced deductions under the SME scheme.
R&D is a fascinating area as it contains lots of rules and has a “fork in the road” in terms of whether the entity carrying out the R&D is a SME or a large company. Hence it is an area attractive to examiners. Furthermore, there is a quite a lot of legislation - Part 13 CTA 2009 for SMEs and Part 3 Chapter 6A CTA 2009 for the RDEC. Although there is a lot of overlap between the two schemes in terms of the rules for qualifying expenditure, if you are going to quote a section number, make sure it is for the correct scheme! Having said that, if you take the time to carefully highlight your legislation, and have your secret weapon in the form of Yellow Handbook 2b to hand, there is no reason why you cannot accumulate lots of marks when presented with an R&D question and use it as a good springboard to exam success!
Duncan Harvey ATT, CTA, ADIT
Senior Tutor and Head of Birmingham Centre
Tolley Exam Training