R&D costs: the tax perspective
In our recent article on capitalising research and development (R&D) costs, we mentioned the importance of considering the tax implications. In this article, we will examine the tax reliefs available and how they interact with the accounting treatment.
What is the qualifying expenditure?
The accounting rules distinguish between “research” and “development” and only allow for the second one to be capitalised i.e. those that are expected to lead to future economic benefits for the company. The tax rules do not have such a distinction, and focus on the impact on the field as a whole rather than the specific company.
In order to qualify for the generous R&D tax reliefs, your project must be looking to advance science and technology. There must also be an element of uncertainty which could not have been easily overcome by a competent professional in the relevant field. HMRC’s guidance specifically says that the project must represent an advance in the overall field, rather than simply applying existing technology to a new sector.
If we apply these tax rules to the two types of expenditure discussed in our previous article, we see that the tax and accounting treatments are almost mirror images. The research costs which are not allowed to be capitalised are the most likely to qualify for tax relief; the development costs are unlikely to qualify as it is probable that the uncertainty has been resolved at that stage in the project.
A further difference is the type of costs that qualify as R&D. For accounting purposes, any costs that contribute to the project can be included, and capitalised if the conditions are met.
Usually the tax rules follow the accounting rules with a few exceptions for specific items, but the R&D rules do not adhere to this custom. Instead they set out clear categories of costs which are qualifying expenditure for the purposes of R&D, and it is only these costs that can be included in the claim.
The categories are:
- staff costs
- subcontractor costs
- consumable items: materials and utilities that are “consumed” by the R&D process, i.e. water and electricity, but not data
- expenditure on so-called externally provided workers, typically agency staff
- contributions to independent research
- expenditure on clinical trial volunteers
Bear in mind that only 65% of subcontractor costs and expenditure on externally provided workers would normally qualify.
The accounting rules and the tax rules do have one key similarity: the need to be able to back up the R&D figures with supporting information such as developers’ timesheets. Thorough records of the work carried out will be crucial in identifying the costs that can be included in your R&D claim. They will also be helpful in the event of an HMRC enquiry into your claim.
What are the tax reliefs available?
You can claim R&D relief under two schemes. Although the types of costs which can be included are generally the same, the calculation is very different under each of the schemes.
The relevant scheme depends on the size of the company making the claim and whether the work is being carried out on behalf of another company, or is being funded by grants.
The size limits for the small and medium sized enterprises (SME) scheme are:
- less than 500 employees
- and an annual turnover not exceeding €100 million
- or gross assets on the balance sheet total not exceeding €86 million
These limits are applied to the worldwide group as appropriate.
The SME scheme gives an additional 130% tax deduction. Together with the expense already in the profit and loss (P&L), this results in a deduction of 230%. If your company has a taxable loss, you can claim a tax credit of 14.5% of the uplifted R&D expenditure.
If your company is unable to claim under the SME scheme, the Research and Development Expenditure Credit (RDEC) is available. It gives a tax credit of 11% of your qualifying expenditure. This refund is itself taxable.
Tax treatment of capitalised costs: a case study
It’s possible that some of the “development” costs which could be capitalised in the accounts would meet the criteria and so be eligible for tax relief. This would further complicate the tax calculation.
As we did in our previous article, we’ll take the example of a company developing software to eventually sell, lease or market to the general public.
The company has £500,000 of capitalised R&D costs, being amortised over five years. £200,000 of these costs meet the conditions for qualifying expenditure for tax purposes. In the first year the accounts will show an intangible asset with a net book value of £400,000 and an amortisation charge in the P&L of £100,000.
The tax legislation specifically permits a full deduction to be claimed in the year of expenditure for R&D costs which are capitalised as an intangible asset. So for tax purposes, the company is entitled to £200,000 deduction for the qualifying expenditure, a £260,000 enhanced deduction thereon and a £60,000 amortisation charge: £500,000 – £200,000 = £300,000 spread over five years.
In order to achieve this, we need to disallow the part of the amortisation charge that relates to the qualifying R&D expenditure. We then allow the qualifying expenditure and add the enhanced deduction.
What if the company chose not to capitalise? In this scenario, the only adjustment needed is to add in the enhanced deduction, but the overall R&D claim is the same.
As referred to in our example above, the amortisation on any capitalised R&D costs that do not qualify for R&D tax relief will be allowable for corporation tax purposes in the year that the amortisation goes through the P&L.
Any R&D costs that aren’t capitalised, and which don’t qualify for R&D tax relief, will be allowable for corporation tax purposes in the year they are incurred.
How can BKL help?
Our tax specialists have generated significant tax refunds and savings for tech and digital clients investing in R&D.
There are pitfalls in the legislation and there are time limits for making claims. But by addressing these issues early, we have succeeded in obtaining HMRC’s agreement to the vast majority of claims submitted.
For more information, please get in touch with your usual BKL contact or use our enquiry form.
You can also download our guide to R&D tax incentives.