r&d tax credits guide by @granttree
TRANSCRIPT
Hello, we are GrantTree. Here is all you ever wanted to know about R&D Tax Credits.
Table of Contents
1. What are R&D Tax Credits? 2. What is an SME?
a. Smart Grant SME b. R&D Tax Credit SME
3. Tax Credits and State Aid 4. What costs qualify
a. The Four Categories b. Other costs which also qualify c. Dividends, travel, subsistence costs
5. Technical Uncertainty 6. Who can claim
a. Unprofitable AND profitable companies b. Company ownership and its impact on R&D Tax Credits
I. Linked Enterprise II. Partner Enterprise
7. Lengthening or shortening your accounting period 8. R&D Tax Credits Capital Expenditure 9. HMRC Audit 10. Our Process
What are R&D Tax Credits?
R&D Tax credits are an HMRC initiative incentivising UK companies to invest more in the development of innovative technology products. As a result, companies can get up to 32% of their direct product development costs back in the form of tax relief. R&D Tax credits are accessible whether you are profitable or not: it can either be claimed as a reduction or refund of Corporation Tax, or as an additional tax loss which can be surrendered for cash. A company can claim retrospectively for the last two financial years, as well as an ongoing basis.
The thinking behind this is that most of the UK’s economic advantage and growth is likely to come from its ability to deliver technological innovation, and the theory is that proper tax incentives can help encourage more investment in this critical kind of innovation.
R&D Tax Credits work by reducing your taxable profit (perhaps all the way into a tax loss) and thereby dropping your Corporation Tax. However, even if you don’t owe any Corporation Tax (or don’t owe much), the scheme can still provide you with cash in exchange for “surrendering” some of the tax loss that has been created. In other words, R&D Tax Credits can help whether you’re profitable or not.
How much can you get? Up to about 32% of your “qualifying costs” can be recovered. That can make a real difference to cash-strapped startups - and just as much difference to funded startups that are spending a lot of money on developing innovative products.
STIMULATING TECHNOLOGICAL INNOVATION
the UK invests £11.5 million per day on R&D
up to 32% of your spend as tax reduction or straight up cash for profitable AND not profitable businesses
What is an SME?
Smart Grant SME
What’s a “Medium Enterprise” for the purpose of SMART grants? Small versus Medium makes a difference in terms of what percentage of expenses you can claim in the Development of Prototype grant.
According to the EU guidance on company size, an SME is essentially:
• Micro companies have under 10 staff, and either under €2m (under £1.75m) of turnover, or under €2m of balance sheet total
• Small companies: under 50 staff, and either under €10m turnover (under £8.78m) or under €10m of balance sheet total
• Medium-sized companies: under 250 staff, under €50m turnover (€43.9m) or under €50m of balance sheet total
Interestingly, another related page on the EC site states the following interesting facts about SMEs:
• More than 99% of all European businesses are SMEs • Nine out of ten SMEs are micro enterprises
Hence, “the mainstay of Europe’s economy are micro firms, each providing work for two persons, on average.
What is an SME?
R&D Tax Credit SME Of course, this wouldn’t be a proper government definition if different parts of the government didn’t have different definitions. HMRC doesn’t use the same definition for Smart Grants and R&D Tax Credits. For R&D Tax Credits, they use the following:
An SME is a company or organisation with fewer than 500 employees and either of the following:
• an annual turnover not exceeding €100 million • a balance sheet not exceeding €86 million
Further info is here, but please note: This definition of a SME for R&D Relief purposes is not necessarily the same as that used by HMRC in relation to other areas of Corporation Tax or other tax areas such as PAYE, or by other government agencies.
One additional hitch is that HMRC also considers aggregation a factor. What this means is that an investor who is not an SME owns 25% or more of a company, then the company will probably not be considered an SME (instead, the whole “group” will be considered in aggregate.
Exceptions Of course, there’s no exception to the different rule without an exception to the exception to the different rule, and there are in fact circumstances where a company can be considered to be an SME even though 25% or more of it is owned by a larger company. The question rests on whether the company can be considered “autonomous”. It is considered autonomous and (potentially) an SME in the following circumstances:
• The investor(s) that own 25% or more are public investment corporations or VCs • The investors are business angels and have not invested more than €1.25m • The investors are university or non-profit research centres • The investors are institutional investors, including regional development funds • The investors are autonomous local authorities with annual budgets of less than €10m and fewer
than 5,000 inhabitants
The rules about this thorny topic can be found here. Our advice? If in doubt, ring up an HMRC agent and ask them.
Tax Credits and State Aid
It’s important to know that as R&D Tax Credits at the SME level are seen as notifiable State Aid, they can only be offered to companies not already receiving other notifiable State Aid for the R&D project in question. The reasoning behind this restriction is due to European rules on State Aid to prevent anti-competitive behaviour from member states.
So, for the costs of a project receiving aid it is only possible apply for tax credits under the large company scheme. (11% instead of 32%) The rule is very sensible and pragmatic here, because it doesn’t go and disqualify your company from claiming R&D Tax credits under the SME scheme altogether, but only for the particular projects that received aid. This is likely to “result in the expenditure qualifying for R&D tax relief partly under the SME scheme and partly under the large company scheme.” In short, this means that you shouldn’t give up on the thought of claiming R&D Tax Credits even if you are receiving some State Aid! If you are running several projects for example,, and only one of them receives state aid, the rest can still be eligible roof R&D Tax Credits under the SME scheme.
It’s also important to understand that not all grants or funding received necessarily count as notifiable State Aid. If you are a recipient of some state funding, it’s good to check with your provider whether the funding you are getting is defined as “notifiable State Aid”. Notified State Aids are usually government funded grants such as the Grant for Research and Development, or Innovate UK Smart Grants. These have by definition been “notified to, and approved by, the EC.”
Either way, if you have received some funding via the government be it notified State aid or not, it still could be possible to benefit from the R&D tax credit scheme.
What Costs Qualify?
The Four Categories HMRC defines only 4 categories of qualifying costs:
• Direct labour: that is, employees paid directly by the company (e.g. on the payroll, in the UK or elsewhere) to work on the project.
• External staff: staff hired from an external staff provider, but otherwise similar to employees - i.e. directly employed on the project.
• Subcontracted R&D: parts of the project that have been extracted and parcelled out to a subcontractor, typically with a specification for what needs to be delivered and a subcontractor agreement or contract.
• R&D Consumables: things that were consumed in the R&D.
What are R&D consumables? The original thinking behind R&D consumables is easily understood if you think of R&D for physical products. In the process of building a physical, technically complex product, you will create numerous prototypes to test the technology. These prototypes will not be sold to consumers - they are a clear R&D cost. After the R&D, you may keep some prototypes for sentimental reasons, but most of them will be scrapped. Labour to create those prototypes is already covered by the other types of costs, but the materials are covered in this category. For example, if you used £10k worth of aluminium to build your prototypes, and scrapped all those prototypes, your R&D claim should include the cost of that aluminium.
It’s important that the prototypes are actually scrapped. If you end up selling them to consumers after all, they would not be considered part of the R&D project.
Other costs which also qualify Other costs that qualify according to the HMRC web page: • software licences • utilities (power, fuel - but not data or telecommunications costs!) • payments to clinical trial volunteers (of relatively little relevance to startups)
Dividends, travel, subsistence costs With early startups and smaller companies, most of the costs of doing R&D are not payroll. Many small companies do part-time consulting to pay the bills, and pay themselves through the tax-efficient means of a basic, minimal salary plus dividends. Moreover, as they are very cost- and tax-conscious, they do their best to pass costs like subsistence and travel, where appropriate, through the company.
Since those same small companies tend to do a lot of qualifying R&D (usually, most of the technical uncertainty is dealt with by the time commercial scale is reached and more people are hired), the question naturally arises whether they can claim dividends, travel and subsistence costs, incurred while working on R&D projects, in the cost of the R&D projects, and therefore get R&D relief on it, in the form of some much needed cash back.
Unfortunately, the answer is no. You can’t claim dividends, subsistence, business entertainment, advertising, travel, rent, or any of a host of other categories that you might think could be argued to fit into the costs of an R&D project.
Technical Uncertainty
In R&D Tax Credits claims, HMRC is looking specifically for what they call “technical uncertainty”. If the outcome was uncertain only because of your own lack of experience in the field, or for commercial reasons, then that’s not R&D. The project should be uncertain because of technical reasons.
Who decides whether it’s uncertain? There, HMRC brings a mythical beast called a “competent professional”. There’s no agreed definition of a competent professional in this field, and there probably won’t be for many years to come. Levels of competency can vary by staggering amounts between people who are gainfully employed in the industry. So, it’s very difficult to pin down even this first point. What I would advise is to ask yourself: were there any aspects to the project where you weren’t sure if that component could be built to the required specification (requirements, performance, scalability, etc), or you weren’t sure what it might look like once built, because the technical constraints were unclear and had to be explored? If the answer is yes, you may have an R&D project there.
Innovation If your project achieved a technical feat that no other project has achieved, then it is likely to be R&D. If it achieved something which few others have achieved, and if the knowledge of how they did it is not commonplace knowledge that the mythical “competent professional” would be aware of, then it could still be R&D. On the other hand, if what you’ve done has been done a thousand times already and is common knowledge, then it’s probably not R&D.
For example, downloading Insoshi (a social networking engine in Ruby on Rails) and setting up your own social network is not R&D. On the other hand, taking Insoshi, which basically represents the state of the art of publicly available knowledge, and heavily customising it and redeveloping fundamental components to match your specific requirements and scale it up, is probably R&D.
So, the “thumb rule” there is that if you have smart and competent people with significant formal qualifications spending a lot of time on the project, then it’s another hint that it may be R&D. If you don’t, though, that’s not necessarily a negative signal.
Who Can Claim?
Unprofitable AND profitable companies A common misconception about tax credits is the idea that you have to be profitable for them to be worthwhile. In fact both profitable and unprofitable companies can get up to 32.5% return.
The way that tax credits are calculated is that first you add up the “Qualifying Expenditure”. This is the amount that you’re declaring has been spent on “qualifying R&D”.
This qualifying expense is then “enhanced”, which artificially increases your expenses for the year, and therefore reduces your taxable profit for the year, perhaps taking you into a loss (or increasing your loss if you were already loss-making).
The way that this helps profitable companies is obvious: instead of paying tax on their taxable profit, they pay less tax on a diminished (or eliminated) profit. However, the scheme also allows companies to do something with the loss that’s generated. They call it “surrendering” the loss. In effect, any loss generated by the scheme can be surrendered for cash. This means that the loss is not carried over to future years, and instead you get some cash for it right now. This is music to the ears of loss-making startups.
Company ownership and its impact on R&D Tax Credits One question that recurs, in the startup world, is how investments by VCs and other investment bodies affect whether you can claim tax credits under the SME scheme, which is considerably more lucrative than the large company scheme. There are basic rules for determining whether a company is an SME, but this topic is worthy of a bit more detail.
The key concept here is autonomy. The main consideration, when applying for tax credits on behalf of a business which has investors, is whether the business is autonomous. HMRC defines a business as clearly autonomous if no external, corporate entity owns 25% or more of its shares.
Private investors, e.g. angels that operate as individuals rather than using a company front, do not count towards this, unless, of course, they are somehow linked to the corporate investors. If Sequoia Capital owns 15% of your company, and Fred Destin (partner at Atlas Ventures) owns another 15% personally, your company is autonomous. On the other hand, if Atlas and Fred Destin each owned 15%, you would then be exceeding the 25% limit.
In this latter case, you would still count as autonomous, however, because Sequoia is a venture company. HMRC explicitly allows up to 50% ownership by:
• public investment corporations, and VCs, • individuals or groups of individuals with a regular venture capital
investment activity who invest equity capital in unquoted businesses (‘business angels’), provided the total investment of those business angels in the same enterprise is less than €1.25 million,
• universities or non-profit research centres, • institutional investors, including regional development funds, • autonomous local authorities with an annual budget of less than €10
million and fewer than 5,000 inhabitants.
So, up to 50% owned by a single group of connected professional investors, you’re still ok. If Autonomy (the company) owns 30% of your business, you are not considered autonomous. If Atlas Ventures owns the same amount, you are autonomous.
What if your company is 51% owned by such an investment corporation (or group thereof)?
Then, unfortunately, you are no longer considered autonomous. The question then becomes whether you are a linked enterprise, or a partner enterprise. That can determine whether you are still considered an SME for R&D Tax Credit purposes.
Linked Enterprise In short, your company is considered to be linked to the owner of your shares if one of the following is true:
• the other company owns more than 50% of the voting rights, • they can appoint or remove a majority of your management team, • they can exert a “dominant influence” over your company, • they can indirectly achieve the above via agreements with other shareholders. • Basically, if they control your company, you are “linked”.
It’s worth noting that the linkage can also happen via an individual, if you are in the same industry. If you run a really small SME airline, and Richard Branson personally owns 51% of your company, you are linked to any other companies which he owns 51% or more of (and potentially to Virgin Airlines).
What happens then? Well, your figures are considered in aggregate. So, if you’re linked to a VC fund that manages more than €50m, you’re no longer in the SME scheme, and your tax credits become less than appealing.
Partner Enterprise There is another case to consider - one where you’re not autonomous, but the other company is not considered linked. For example, if Autonomy owns 30% of your business, you’re a partner of Autonomy, but they don’t control you, so you’re not linked.
So what happens then? Well, you may have a chance. To figure it out, multiply the shareholding by the turnover, balance and staff count of the other company. For example, if you were 30% owned by Autonomy back when they only had €10m of balance, they would only add €3m to your own balance, for the purpose of figuring out whether you’re an SME. So if you had €1m of balance, adding the two together would result in €4m, well under the SME limit.
If you had €1m of balance, and 30% owned by Autonomy when they were worth €100m, your balance aggregate would be €31m - so you would still be an SME, even though Autonomy would not be. Finally, if you were 30% owned by Autonomy when they had €1b of balance, your aggregate would be €301m, so you would not be an SME. It works in reverse too!
As a final thought, it’s worth pointing out that this works both ways. If your company owns more than 25% of a large company, you are considered in aggregate with that company, so even if you have zero turnover, you will still not be considered an SME.
Lengthening or Shortening Your Accounting Period
Many of the R&D tax-credit claims we submit to HMRC cover accounting periods longer or shorter than the usual financial year. It is perfectly possible to adjust the length of the claim period. A common reason for doing this is to suit a company that wants to take advantage of the tax-credit scheme immediately after a significant investment in a project.
The crux of the matter is the CT600 – your corporation tax return. This form can account for a maximum of 12 months, so any accounting period longer than this will involve two CT600s covering a period of a maximum of 18 months. Extending an accounting period is allowed once every five years.
An alternative to extending the accounting period is shortening it. You can do this as many times as you like. If your accounting year usually follows the fiscal year, but you made large R&D investments in July, for example, it might make sense to claim for an eight-month accounting period in January. This would free up some capital to sustain the business until the beginning of the usual financial year in March, when sales pick up and profits can be realised.
R&D Tax Credits Capital Expenditure
Accounts vs Tax An important distinction which HMRC draws is between the P&L that’s presented in the company accounts, and the tax calculations submitted to HMRC (also known as CT600). The key take-away from all this HMRC text is that even if the expenditure is capitalised in the accounts, it could still qualify for tax credits if it can be deducted from the profits in the tax calculations.
This was discussed with HMRC directly and this is their answer in writing: “If the labour charge is not prevented from being an allowable deduction (unlikely) and it is capitalised in the accounts, then it can be included in the tax computation with an enhancement to calculate the profit/loss for tax purposes. If there is no adjustment in the CT computation, the relief is not due but the return could be amended.”
So, here it is, clearly enough: the expenditure can only obtain R&D Tax Credit relief if it really is deducted in the CT computations. If you capitalised your R&D expenditure for tax purposes, as opposed to doing so only in the management accounts, you can’t get relief on it.
But… But the return could be amended (for up to 2 years after it was filed). If you capitalised your R&D expenditure for tax purposes for the last couple of years, and have suddenly realised that actually, you’d like to get the R&D Tax Credit relief, please - you still can. In this case, the costs would need to be decapitalised to be included in the claim.
Of course, this makes capitalising software development a somewhat bizarre exercise. There are reasons (even good reasons) to capitalise software development, so if you’ve done that, R&D Tax Credit relief may not be enough of a carrot to get you to undo it. But at least it’s nice to have some clarity about it all, at last.
HMRC Audit
Getting audited by HMRC sounds really scary, of course, so waving the threat of an “audit” would be a great way to convince clients to sign up with a specialist firm - but we believe that our service is valuable even without the vague threat of an undefined “audit”, so here’s a clear outline of what typically happens when HMRC receives your R&D Tax Credit claim and have questions.
The default case: everything goes fine If the claim has been prepared competently, and doesn’t include any “attention-grabbing” mistakes (like claiming a percentage that’s unnaturally high for your industry), it will probably sail through. This happens to most of the claims that we’ve filed at GrantTree. It is relatively rare for HMRC to have questions about a well presented, well explained, clear and reasonable claim.
A likely case: “we have some questions” If there is anything unclear or slightly unusual about the claim, then what’s likely to happen is that an HMRC Inspector from an R&D Specialist Unit will get in touch with some questions. Those are usually either requests for clarification, or discussions about specific costs that were included in the claim and shouldn’t have (this happens even when using a specialist to handle your filing, as the line of what HMRC will accept and reject does shift over time). This is generally a friendly call, and doesn’t take too much time. It can be handled by email entirely, but in our experience, picking up the phone can resolve, in half an hour, something that would have taken weeks by email.
Less likely: “we’d like to meet you” The next step up, which happens more frequently with first-time claimants, is that HMRC wants to come and meet the company in person. This is, again, a friendly meeting - at least it’s supposed to be. When our clients end up meeting the inspectors, we always explain in detail what might happen if HMRC decides to dig their claws in (to use a gentle metaphor), so they are prepared and understand how the scheme works, what is R&D, what HMRC’s likely lines of questioning are, etc. However, usually this type of meeting should be very friendly and not concerned with pushing back on the claim. Unless they find out that you misfiled part of the claim, the result of this meeting should be that the claim is approved and paid. If part of the claim has indeed been incorrectly filed, then HMRC would expect a corrected version to be sent before they pay out the money.
Even less likely: the aspect enquiry If HMRC is quite certain that a substantial part of the claim is incorrect, then they are likely to launch into the next level up: an aspect enquiry. This sounds more scary, and it should - it is now an official enquiry into an aspect of the Corporation Tax filing: the R&D Tax Credit aspect, specifically. This will always involve a formal meeting, with specific questions that HMRC wants answered before the meeting and during it.
That said, it still sounds more scary than it is. There’s a number of reasons why. First of all, the meeting is not, should not be, need not be confrontational. In fact, it should always be seen as a collaborative effort. The claimant and the HMRC inspector are, together, trying to figure out what should have been claimed. Unless the claimed amount is patently ridiculous, HMRC will never walk into the meeting and start throwing accusations around. Strained arguments may (and do) occur in the course of the discussion, but they are not aimed at people, but at resolving the matter at hand.
Secondly, unless your claim really was completely spurious, the likely outcome will be that part of the amount will be accepted and part will be rejected. After all, you do have a valid R&D project, right? HMRC Inspectors are fairly pragmatic, and they will look to come to a reasonable conclusion (that fairly represents your project) within the duration of the meeting.
Finally, when they hear “HMRC Aspect Enquiry”, most people have visions of endless investigations, never-ending hassle, and HMRC progressively digging into every aspect of the company’s tax return. Actually, that is explicitly not the goal of the aspect enquiry - it is limited to a specific aspect. In the letter announcing the enquiry, HMRC do mention that they reserve the right to turn this into a full enquiry, of course, but unless your business is very shady indeed, that’s not going to happen. Obviously, if you’re running a money-laundering operation, misfiling a tax credit claim is a very, very bad idea - but I think that those few people insane enough to run money-laundering operations in the UK already know this.
Pragmatic HMRC It’s somewhat unexpected to see these two words together, but HMRC inspectors from the R&D specialist units are actually a very pragmatic bunch (as opposed to dogmatic and inflexible, as they are often perceived). They’re not looking to scare companies into not filing, but they have a duty to the government to do their best to ensure that claim amounts fairly represent the R&D that’s been going on, according to HMRC’s elaborate definition. So long as you take a similar view, and work with the inspector to dig out the truth, rather than against them, even an Aspect Enquiry need not be all that scary.
Our Process
How do we work?
Maximise the claim, while minimising the risk
We maximise your claim by analysing your accounts, making sure we include every eligible expenditure. Industry experts will write your technical narrative, the argument to HMRC about what you are developing and why this is deemed R&D. The combination of domain expertise and knowledge of HMRC’s preferences results in our 100% success rate. Any questions and queries coming from HMRC after filing the claim are handled by GrantTree. On rare occasions, the verification of the claim involves a face to face interview with HMRC; should that be the case we will come an hour early to your offices to prepare your case, and defend your claim with you.
Turning your claim around quickly, with minimal disruption to your business.
We understand that your priority is building your business. We have designed all our processes to require only the minimum amount of time and effort: it only takes a couple of hours from your team to go through the financials and development work. During our unique process, a team of several people with relevant expertise within your sector verifies each and every claim. This ensures a focused attention on every step of the way as well as a fast progress. The whole process from signing the contract to receiving the money typically takes 2-3 months and we could file your claim in less than that, providing we receive the financial and technical data speedily.
Ask a specialist!
We’ve done our best to explain the criteria, but ultimately, a final answer should be obtained from someone who knows these criteria inside out and deals with HMRC on a regular basis. Most specialist firms will tell you whether your project qualifies free of charge, so it’s definitely worth having a chat even if you plan to file by yourself. That can be us or somebody else, but the point is, it’s free, so you might as well take advantage of it. It’s an “I know it when I see it” type of thing, so it won’t take that long and we look forward to you getting some of your money back from HMRC in the near future!
