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UK R&D Tax Relief Regime

By Caroline Keenan

By Caroline Keenan

In this article Caroline Keenan provides an overview of the UK R&D tax relief regime, highlights the key features of the legislation and looks at some of the recent developments in this area.

The UK Government has recognised that encouraging innovation is a vital component in a strategy for improving the UK's productivity, performance and competitiveness. The UK Research & Development (R&D) Tax Relief Regime was introduced from 1 April 2000 for SMEs (Small and Medium Sized Enterprises) and was extended two years later from 1 April 2002 for Large Companies. The Regime exists to incentivise and motivate companies to invest in innovation and R&D both indigenous companies and existing foreign direct investment businesses already located here. Additionally the R&D tax relief regime is seen as a valuable tool in attracting further foreign direct investment to the UK, particularly where the mobile project involves significant R&D.

Key Features of the Legislation

Since the introduction of the regime over ten years ago, there have been a number of amendments to the rules introduced through a number of successive Pre-Budget and Budget Reports over the years, and through consultation between HM Revenue & Customs and relevant interest groups.

R&D tax relief allows limited companies, who carry out qualifying R&D of at least £10,000 per annum related to their trade, to claim an extra corporation tax deduction for certain qualifying revenue expenditure. The time limit to make an R&D tax relief claim is within two years of the end of the accounting period in which the expenditure has been incurred, for example a company with a 30 June accounting year end must make a R&D tax relief claim for the year ended 30 June 2008 by 30 June 2010.

The level of relief available depends upon which scheme the company falls into – either the SME Scheme or the Large Company Scheme.

The SME Scheme

The key features of the SME Scheme are:

  • A company can get relief of 175% (150% before 1 August 2008) on their qualifying R&D costs
  • Loss-making companies can in certain circumstances surrender the losses arising in return for a payable tax credit. This is limited to the PAYE and NICs payable for payment periods ending in the accounting period and where accounts are prepared on a going concern basis
  • From 1 August 2008 the SME threshold limits doubled for R&D tax relief purposes only

For R&D tax relief purposes only, Finance Act 2008 extended the SME relief to larger companies. It introduced the concept of a “larger SME” for expenditure incurred on or after 1 August 2008, by doubling the limits for determining if a company is a SME. A “larger SME” is entitled to R&D Relief under the SME Scheme. A “larger SME” is defined as an undertaking with fewer than 500 employees and having either:

  • Worldwide sales of less than €100m; or
  • Balance sheet gross assets of not more than €86m.

The Large Company Scheme

For companies that do not meet the above size definition, and therefore do not fall into the category of “larger SME” the rules of the Large Company Scheme apply. The key features of the Large Company Scheme are:

  • A company can get relief of 130% (125% before 1 April 2008) on their qualifying costs
  • There is no payable tax credit for losses under this scheme
  • There is no need for the company to own the intellectual property arising from the R&D

What if I Receive an R&D Grant or Subsidy?

A number of Northern Ireland companies will have been awarded R&D grants for projects undertaken within the business, and the implications of receiving such a grant on the company's entitlement to claim R&D tax relief will depend on both the EC notification status of the grant, and the size of the company. The grant provider will be able to confirm whether or not the grant or subsidy is notified.

The SME Scheme

If the grant is a “notified state aid”

As the SME Scheme is itself a notified state aid, none of the R&D costs will qualify under the SME Scheme. However the company may still be able to claim relief for the project under the Large Company Scheme.

If the grant is not a “notified state aid”

The grant should be deducted from the SME qualifying expenditure and relief is due on the net costs under the SME Scheme at 175%. The costs excluded by the grant may also qualify for relief under the Large Company Scheme at 130%.

The Large Company Scheme

Grants are not deducted from the qualifying expenditure and the R&D claim can be made on the gross allowable expenditure.

What is Qualifying R&D for Tax Purposes?

R&D has a specific statutory definition for the purposes of R&D tax relief which is not the same as the commercial meaning.

To qualify for R&D tax relief, the company must be carrying out research and development work in the field of science or technology. The relief is not just for “white coat” scientific research but also for “brown coat” development work in design and engineering that involves overcoming difficult technological problems. This can include creating new processes, products or services, making appreciable improvements to existing ones and even using science and technology to duplicate existing processes, products and services in a new way. Some examples of qualifying activities include software development, engineering design, new construction techniques, bio-energy, cleantech, agri-food and life and health sciences.

Will the Project Qualify?

Judging which projects and activities will qualify for R&D tax relief is usually the area which presents the most difficulty. In determining whether a specific project will qualify for R&D tax relief purposes, it is helpful to consider the following:

  • Did the project seek to achieve an advance in science or technology?
  • Did the advance extend the overall knowledge or capability in the field of science or technology, not just the company's own state of knowledge or capability?
  • Did the project involve an uncertainty that competent professionals could not readily resolve and where solutions are not common knowledge?

It is particularly important that the individuals doing the R&D work are involved when considering whether the project is R&D for tax purposes as they are best placed to understand the scientific or technological problems involved. Particular focus should be given to what advances the project is seeking to achieve and the uncertainties to be faced rather than on the eventual product aspiration, specification or design. Additionally it should be remembered that projects do not need to be successful to qualify.

What Costs Qualify?

There are a broad category of revenue costs which qualify for the purposes of R&D tax relief which include the following:

  • Direct R&D staff costs including salaries, wages, bonuses, class 1 NIC and pension contributions
  • Externally provided R&D staff – these are staff costs paid to an external agency for staff who are directly and actively engaged in the R&D project
  • Consumable items – these include materials and the proportion of water, fuel and power consumed in the R&D process
  • Software directly used in the R&D

Special rules apply for subcontracted R&D costs.

Tax Deduction for Capital Expenditure on R&D

A generous 100% Research & Development Allowance (RDA) is available on capital expenditure such as plant, machinery and buildings used for the R&D activity in the trade.

Recent Developments

Qualifying indirect activities

HMRC has recently changed its practice on activities that are not ‘hands-on’ R&D but support the R&D undertaken by others. These ‘qualifying indirect activities’ (QIA) include maintenance, security, administration and clerical activities. Most importantly, the change applies immediately and amended claims have to be made by the second anniversary of the period end. For example, a company with a 30 June year end must amend its claim for the period to 30 June 2008 by 30 June 2010 or forego the increased relief.

Intellectual property ownership by SMEs

For SMEs to be entitled to their more generous relief, they had to own any intellectual property (IP) resulting from their R&D, but this ownership requirement was abolished in the Pre-Budget Report in December 2009 for accounting periods ending on or after 9 December 2009.

Patent box

Also announced in the December 2009 Pre-Budget Report was the ‘Patent Box’. This proposed a new corporation tax rate of 10% for income from UK patents. However, companies are unlikely to see much benefit in the short term as the rules do not come in until 2013. The consultation is expected to take place this year in time for Finance Bill 2011. It also only applies to patents granted after the legislation is passed.

The Dyson Report

It is also worth commenting on the recent report “Ingenious Britain: Making the UK the leading high tech exporter in Europe”, referred to as the “Dyson Report’ issued in March 2010. This report was commissioned by David Cameron to help the Conservatives reawaken the UK's innate inventiveness and creativity.

The Conservative / Liberal Democrat Coalition published its final coalition agreement on 20 May 2010 setting out the policies negotiated between the two parties in Government. The new 36-page agreement superseded the short initial agreement of 12 May 2010, and in relation to R&D tax relief made the following comment:

“We will consider the implementation of the Dyson Review to make the UK the leading hi-tech exporter in Europe, and refocus the research and development tax credit on hi-tech companies, small firms and start-ups.”

UK Emergency Budget

In view of the above, everything might appear perfect in the world of R&D incentives. However this is not the case. Of most concern is the possibility that the R&D incentive will be withdrawn completely or at least for large companies.

Government borrowing is at an all time high and incentives that are not achieving policy objectives could be withdrawn, particularly if they are seen to be being ‘abused’. There has been much press coverage in recent months, nearly all directed against HMRC, suggesting the R&D incentive is being mishandled. However, the coverage generally does not show how this has come about.

There are expected to be changes announced in the UK Emergency Budget on 22 June 2010, however at the time of writing the quantum and significance of those changes are difficult to predict.

Conclusion

In summary, the UK R&D tax relief regime is an extremely valuable relief of much benefit to companies investing in innovation and R&D, and companies should continue to prepare and submit R&D tax relief claims, including the extra tax reliefs on qualifying indirect activities. Despite though the regimes being in place for just over ten years, there are still a considerable number of companies that are failing to make the claims to which they are entitled to. It is worth revisiting the nature of any R&D activity carried out within the business to ascertain whether it might qualify for the relief.

Finally watch out for possible changes arising from the Emergency Budget on 22 June 2010!

Caroline Keenan is a Tax Associate Partner in the Belfast office of PwC Northern Ireland and leads the Northern Ireland firm's R&D tax relief team.

Email: caroline.keenan@uk.pwc.com

T: 00 44 (0) 28 9041 5248.