This article looks at the main corporation tax reliefs available for small and medium sized companies (SMEs) that undertake research and development (R&D) activities.
Although HMRC statistics show that R&D relief claimed by SMEs is increasing1, many smaller companies are still not claiming the relief that they are entitled to. This is often due to a lack of awareness. In particular, companies may not even be aware that they are undertaking qualifying R&D activities in the first place, as these are defined fairly broadly for tax purposes and encompass more than activities carried out in white coats.
This article only looks at the main R&D reliefs available for SMEs. It does not consider R&D relief for large companies (which operates under a different regime), or more specific reliefs such as Vaccines Research Relief, patent box, or the various Creative Industries reliefs. The article comprises the following sections:
- Overview and conditions
- SME definition
- What is R&D?
- Qualifying expenditure
- Contracting out R&D
- Means of relief: enhanced deduction
- Means of relief: loss making companies
- Restrictions on relief
- Practical points
- Capital expenditure: R&D allowances
- Further information
The main R&D relief legislation can be found in Part 13 CTA 2009, with the SME rules in Chapters 2 and 3. All legislative references in this article are to CTA 2009 as amended unless otherwise stated.
Under the SME regime, companies can claim corporation tax relief for qualifying expenditure on R&D by way of either:
- an enhanced deduction; or
- if they are loss-making, a payable tax credit.
To claim either form of relief a company needs to:
- be an SME (see section 2 below);
- carry on a trade in the period;
- carry out R&D activities (see section 3 below);
- incur qualifying expenditure on those R&D activities (see section 4 below); and
- not fall within one of a number of specific exclusions (see section 9 below).
Each of these conditions, and the different forms of relief, are considered further below.
It should be noted that there is no minimum or maximum level of expenditure for a claim (save for an overall cap of €7.5m on total aid received under the SME scheme – see section 8 below) - provided all of the qualifying conditions are met and the company incurs qualifying expenditure then relief can be claimed.
R&D relief is only available to companies that are subject to UK corporation tax – unincorporated businesses and those not subject to corporation tax cannot claim relief. A company does not however necessarily have to be UK resident - a non-UK resident company may qualify for relief if it has a UK permanent establishment within the charge to corporation tax, and the R&D is relevant to a trade within the charge to corporation tax.
To be an SME for R&D tax relief purposes, a company must have:
- No more than 500 employees; and
- Annual turnover of no more than €100m, or
- An annual balance sheet total of no more than €86m
Where accounts are prepared in sterling, for the purposes of applying these thresholds the turnover and balance sheet totals should be converted to euros using the exchange rate at the balance sheet date.
It should be noted that these thresholds differ from the standard EU definition of an SME, and apply for R&D tax relief purposes only. It is therefore entirely possible for a company to be an SME for R&D relief, but not other purposes.
If the company is part of a group, or has linked or partner enterprises, then employee numbers, turnover and balance sheet totals have to be aggregated when applying these thresholds. More details on this can be found in HMRC’s manuals at CIRD91500 onwards.
The first step when considering whether an SME may qualify for R&D tax relief is to identify the particular activities it undertakes. The definition of R&D for tax purposes is fairly wide – it’s not just lab coats and test tubes. This means that some activities may fall to be classed as R&D which might not have been expected to at first glance.
S1138 CTA 2010 defines R&D for tax purposes as “activities that fall to be treated as research and development in accordance with generally accepted accounting practice”. We therefore need to look to the accounting definition as a starting point.
- research as “original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge or understanding”; and
- development as “the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services before the start of commercial production or use”.
These definitions are fairly widely drawn but they are narrowed and qualified by Guidelines on the Meaning of Research and Development for Tax Purposes issued by the Department for Business, Energy & Industrial Strategy (the BEIS guidelines).
The BEIS guidelines set out that R&D takes place for tax purposes when a project seeks to achieve an advance in science or technology through the resolution of scientific or technological uncertainty.
Looking at the terms used in this definition more closely, an advance in science or technology:
- Means an advance in overall knowledge or capability in a field of science or technology – not just the company’s own knowledge or capability.
- Includes an adaptation of knowledge or capability from another field where this adaptation was not readily deducible.
- May have tangible (e.g. a new product or process) or more intangible outcomes (e.g. new knowledge or cost improvements).
- Does not arise simply because science or technology is used in creating something.
The BEIS guidelines indicate that an advance in science or technology could include projects which:
- Create a process, material, device, product or service which incorporates or represents an increase in overall knowledge or capability in a field of science or technology;
- Make an appreciable improvement to an existing process, material, device, product or service through scientific or technological changes; or
- Use science or technology to duplicate the effect of an existing process, material, device, product or service in a new and appreciably improved way.
Importantly this includes where the advance in science or technology sought by a project is not achieved or fully realised - R&D can still take place for tax purposes even if a project is unsuccessful.
If a particular advance in science or technology has already been made or attempted, but details are not readily available (for example because it is a trade secret), work to achieve such an advance can still qualify as R&D. However, routine copying, analysis or adaptation of an existing product, process, service or material will not be an advance in science or technology.
With regards to scientific or technological uncertainty, the BEIS guidelines set out that this:
- Exists where knowledge of whether something is scientifically possible or technologically feasible, or how to achieve it in practice, is not readily available or deducible.
- Includes system uncertainty – that is uncertainty which results from the complexity of a system rather than uncertainty about how its individual components behave. For example, in electronic devices, the characteristics of individual components may be fixed, but there can still be uncertainty about the best way to combine those components to achieve an overall effect.
- Will often arise from turning something that has already been established as scientifically feasible into a cost-effective, reliable and reproducible process, material, device, product or service.
However, it does not include:
- Uncertainties that can be readily resolved by a competent professional (see below) in that field.
- Improvements, optimisation and fine tuning which do not materially affect the underlying science or technology.
The expression competent professional is not defined in either the legislation or BEIS guidelines. However, some further guidance on the interpretation of this term can be found in HMRC’s manuals at CIRD81300.
With any project it is important to review all activities carefully and distinguish between those that are genuine R&D, and those that are not. For example, elements of a project to produce a new product may qualify as R&D although the whole project does not. Market research to identify demand for that new product will not normally be R&D and, once the product enters into production, the R&D will generally be deemed to have ceased (as this normally means that any scientific or technological uncertainty will have been resolved). However, R&D can take place alongside production where work continues to improve, optimise or otherwise resolve uncertainties.
Once it has been determined that an SME is carrying out R&D activities (which may include through an advance assurance application – see section 9.3. below), the tax rules in CTA 2009 have to be applied to identify the qualifying expenditure connected with those activities on which relief can be claimed.
Broadly, for expenditure to be qualifying expenditure it has to be:
- deductible as a revenue expense of the trade for corporation tax purposes (i.e. not be capital in nature or otherwise disallowable, although R&D allowances may be available for capital expenditure – see section 10 below);
- attributable to the R&D undertaken by the company; and
- fall into one of the following categories:
- Staffing costs
- Software or consumable items
- Externally provided workers
- Payments to subjects for taking part in a clinical trial.
The expenditure must not be incurred in carrying out activities which have been contracted out to the company (i.e. where it is acting as a subcontractor), though some measure of relief may be available in these circumstances (see section 8 below).
Looking at the categories of qualifying expenditure in more detail.
4.1 Staffing costs
Amounts paid to a director or employee because of their employment can qualify for R&D relief, including:
- Salaries, emoluments or other payments (other than benefits in kind).
- Reimbursement of expenses (provided they are an expense to the company of employing staff and paid by the employee in order to fulfil the requirements of their employment – see HMRC manuals at CIRD83200 for more guidance and examples).
- Employer NICs.
- Compulsory contributions in respect of benefits under the social security legislation of another EEA state or Switzerland.
- Pension contributions.
However, the employee or director in question has to be directly and actively engaged in the R&D. If they are only partly engaged directly and actively in R&D activities, the company will need to apportion the costs relating to them on a reasonable basis.
Costs of support staff (secretaries, admin staff etc.) will not generally qualify for relief - they are not directly and actively engaged in R&D even if they provide services exclusively to other staff who are.
However, staff costs arising from qualifying indirect activities may be eligible for relief where they are closely linked to the R&D undertaken. The BEIS guidelines identifies the following as being qualifying indirect activities:
- Scientific and technical information services conducted for the purposes of R&D support (e.g. preparing a report of R&D findings).
- Indirect supporting activities such as maintenance, security, administration and clerical activities, and finance and personnel activities, insofar as undertaken for R&D.
- Ancillary activities essential to the undertaking of the R&D (e.g. taking on and paying staff, leasing laboratories, maintaining R&D equipment).
- Training required to directly support an R&D project.
- Research by students and researchers carried out at universities.
- Research (including related data collection) to devise new scientific or technological testing, survey, or sampling methods, where this research is not R&D in its own right.
- Feasibility studies to inform the strategic direction of a specific R&D activity.
As with the costs of staff engaged directly in R&D, staff costs have to be apportioned if they only carry out qualifying indirect activities part of the time. For example, a maintenance engineer’s time spent repairing equipment used specifically and solely for R&D would qualify for relief, but not the time spent maintaining any other equipment.
It is important to note that relief can only be claimed for the costs of the SME’s own employees and directors – costs associated with self-employed contractors or recharges from other group companies will not qualify unless they can be classed as a payment for externally provided workers – see section 4.3 below.
4.2 Software and consumable items
Expenditure on the following items may qualify for R&D relief:
- Computer software.
- Consumable or transformable materials (referred to together here as consumables).
For these purposes, consumables include normal consumable materials and also utilities such as water, fuel and power.
To qualify for relief, software and consumables have to be employed directly in carrying out the R&D, or in carrying out qualifying indirect activities (as defined in 4.1 above). Items employed in support or secretarial services will not normally qualify unless they are qualifying indirect activities – for example, software used by the HR department for routine work related to R&D staff would be included, but software used to train HR staff would not. Similarly, the cost of power used in a training facility would only qualify to the extent it was providing training to directly support an R&D project, but not training that was required for more general purposes.
As with staff costs, if software or consumables are only partly employed in the R&D, their cost will need to be apportioned. For example, if there is only one electrical supply to a property, and the electricity used in R&D activities cannot be separately metered, it will be necessary to apportion the overall electricity cost. HMRC suggest that a pragmatic approach should be adopted wherever possible, for example apportionment based on floor area or staff numbers may be suitable where there is no particularly high power consumption based on the nature of the R&D.
The rules on consumables changed from 1 April 2015, with two new exclusions being introduced. These state that the cost of consumables will not qualify for R&D relief where:
- they form part of an item produced in the course of R&D activity that is sold or otherwise transferred as part of the company’s ordinary course of business; or
- R&D is being undertaken on a production process, and the consumables form part of an item produced in that process which is sold or transferred as part of the company’s ordinary course of business.
Where not all of a product is sold or transferred, an apportionment may be necessary to identify that portion of consumable costs which can still qualify for relief.
For these purposes, a consumable forms part of an item if it is incorporated into the item produced, or turned into the item produced. This includes situations where the consumable item has been physically and chemically changed in some way during the production process.
The term ordinary course of business is not defined in the legislation, and instead it will be a question of fact based on the nature of the business and transaction in question. The transfer of a waste or scrap item will not be regarded as a transfer in the ordinary course of business, even if consideration is received. HMRC also take the view that the following transactions will not be in the ordinary course of business:
- Where an item is an inevitable by-product of the R&D.
- Where an item is an unintended consequence of the R&D.
- Fortuitous sales of items not usually for sale.
- Where the sale price does not cover the cost of the consumable items incorporated.
More information on these exclusions, including examples, can be found in HMRC’s manuals at CIRD82300.
4.3 Externally provided workers
In certain circumstances, payments to another person (e.g. an agency) for the provision of externally provided workers can qualify for R&D relief.
To be classed as an externally provided worker of a company, a worker has to:
be an individual, and not a director or employee of the SME;
- personally provide, or be under the obligation to personally provide, services to the SME;
- be subject to the supervision, direction or control of the SME;
- have their services supplied through a staff provider; and
- provide their services under a contract with a person other than the SME.
The arrangements must not constitute contracting out of R&D work, for which different rules apply (see section 5 below).
An important point to note is the requirement for a staff provider, such as an agency, to be involved in the arrangements. This means that costs incurred by an SME in engaging self-employed workers directly won’t qualify for R&D relief.
As with the SME’s own staff, externally provided workers have to be directly and actively involved in the R&D – the costs of general support or admin staff are excluded. Where an externally provided worker is only partly engaged in R&D, their costs have to be apportioned.
Expenditure on externally provided workers can include the payment of reimbursed expenses where the expenses are initially incurred by the worker, then refunded by the staff provider and recharged to the SME.As noted in Section 4.1 above, relief may be claimed for recharges of staff costs from other group companies provided these meet all of the conditions above to be classed as a payment for externally provided workers. In particular, it will be necessary for the staff in question to be subject to the control of the SME claiming relief, but providing their services under a contract with another group company, and not be an employee or director of the SME. Alternatively, depending on the contractual arrangements, it may be possible to argue that the R&D activities have been sub-contracted to the other group company (see Section 5 below).
The amount of relief available in respect of externally provided workers depends on whether the staff provider is a connected party. Generally:
- If the staff provider is unconnected, only 65% of the payments made to them will qualify for relief.
- If the staff provider is a connected party (e.g. another group company) that draws up accounts in accordance with UK GAAP (or an overseas equivalent), relief can be claimed on the lower of
- the payment made to the connected party, and
- the relevant staff costs incurred by them.
An unconnected SME and staff provider can make an irrevocable election to be treated as connected parties to improve the SME’s R&D claim, but this does require the staff provider to share what may be commercially sensitive expense details with the contracting SME. More information on this election, and externally provided workers more generally, can be found here.
An SME can still claim some relief if, instead of carrying out R&D in-house, it contracts it out to another party. For expenditure on contracted-out R&D to qualify for relief it must:
- be incurred in making the qualifying element of a sub-contractor payment;
- be attributable to R&D undertaken on behalf of the company;
- not be incurred in carrying out activities contracted out to the SME itself by another person (ie sub-sub-contracting); and
- not be subsidised (see section 8 below).
A sub-contractor payment is a payment made by an SME to another person in respect of contracted-out R&D. The other person does not have to be UK resident, and the R&D does not need to be carried out in the UK.
The amount of expenditure eligible for relief depends on whether the person subcontracted to is a connected party or not:
- If they are unconnected, the SME can claim relief on 65% of the payment made to the subcontractor.
- If they are a connected party, then provided the whole amount of the payment is brought into account in calculating their profits under UK GAAP (or overseas equivalent), relief can be claimed on the lower of:
- the payment made to the subcontractor, and
- the allowable R&D expenses incurred by the subcontractor on the R&D.
As with externally provided workers, non-connected parties can elect to be treated as connected parties for these purposes, but this does require the subcontractor to share what may be commercially sensitive expense details with the contracting SME. More information on this election, and contracting out R&D in general, can be found here.
Relief is given to SMEs for qualifying expenditure on R&D by means of an enhanced deduction. This is currently set at 130% (125% before 1 April 2015) of the qualifying expenditure, and is in addition to the normal deduction available, meaning that for every £100 of qualifying spend an SME can deduct £230 for corporation tax purposes.
If an SME incurs qualifying expenditure before it starts to trade it can, instead of applying the usual pre-commencement expenses rules, elect to be treated as if it made a trading loss in the period equal to 230% of that qualifying expenditure. This provides more flexibility, as the loss arising can be set off in the current period, carried forward or back, surrendered as group relief, or surrendered for a repayable credit (see below) in the same way as any other loss. More information on the treatment of pre-trading expenditure for R&D purposes can be found in HMRC’s guidance at CIRD90200.
If an SME claims an enhanced deduction and makes a trading loss in that period, it can surrender all or part of that loss for a payable tax credit. The loss which can be surrendered is the lower of:
- The unrelieved trading loss, and
- 230% of the qualifying R&D expenditure on which relief has been claimed – i.e. the expenditure plus the 130% enhancement.
For these purposes, the unrelieved trading loss is the amount of the trading loss for the period less:
- Any actual or potential claims to relieve that loss in the same or an earlier period, and
- Any amounts surrendered as group or consortium relief.
The amount of the tax credit payable is 14.5% of the surrendered loss (11% before April 2014).
There are, however, some limitations on when a credit will be paid:
- HMRC can apply the amount of any tax credit claimed in first discharging any other tax debts the SME may have.
- No payment will be made if the SME has outstanding PAYE and NIC liabilities.
- If the CT return for the period is under enquiry, HMRC do not have to pay any amount of tax credit over until the enquiry is completed although the officer in question does have the ability to make provisional payments as they see fit.
Any payable credit received is not treated as taxable income of the SME.
Where a loss is surrendered for a payable credit, it cannot be carried forward for future relief. Companies do however a choice between claiming a repayable credit and keeping the loss in order to carry it forward.
Loss-making SMEs will often prefer the cash flow advantage of claiming the credit. However, it should be noted that, at 14.5%, the rate applied in calculating the credit is lower than the corporation tax rate (currently 19%). Therefore, if there is no immediate cash need and the potential of future profits against which a loss it could be set, it may preferable to carry the loss forward in order to get relief at a higher rate.
It was announced at Budget 2018 that, from April 2020, the amount of payable credit that a loss-making SME can receive in any one year will be capped at three times the company’s total PAYE and NICs liability for that year. This measure was introduced in response to concerns over fraudulent companies (that typically do not have any employees) being set up purely to receive a payable credit. HMRC estimate that close to 95% of companies currently claiming a payable credit will be unaffected by this change. Where companies carrying out genuine R&D activities are subject to this cap, they will still be able to claim a payable credit up to the cap, with any unused losses carried forward to set against future profits. A consultation on how the cap will be applied is expected to be issued at some point in 2019.
There are several circumstances which can deny a company relief under the SME scheme, key ones being where:
- The R&D expenditure is subsidised.
- The R&D project has received over €7.5m of total aid under the SME scheme.
- The R&D has been subcontracted to the company.
Some of these restrictions are required as relief under the SME scheme is classed as State Aid, and therefore cannot be claimed in addition to other State Aid. However, the large company R&D scheme is not State Aid, and if a company is excluded from relief under the SME scheme for any of the reasons above they may still be able to claim some relief under the large company scheme instead.
For these purposes, expenditure is subsidised if:
- Notified State Aid is obtained in respect of it, or any other expenditure attributable to the same R&D project (excluding R&D reliefs);
- Any other grant or subsidy is obtained in respect of it; or
- It is otherwise met directly or indirectly by a person other than the company.
In applying the €7.5m cap, complex steps set out in s1114 CTA 2009 need to be followed which effectively compare the relief received under the SME scheme with that which would have been available under the large company scheme. In reality, the cap should not affect most SMEs.
Further restrictions to note include:
- It is not possible to claim both R&D relief and one of the Creative Sector tax reliefs (e.g. film tax relief, television tax relief, video games tax relief, museums and galleries exhibition tax relief) in respect of the same project.
- If an enhanced deduction, or pre-trading loss, is claimed, losses cannot be surrendered to another company as consortium relief unless that company is also an SME.
To claim either an enhanced deduction or repayable credit, a claim needs to be made in the SME’s corporation tax return. The normal claim deadline of two years from the end of the relevant accounting period applies. Claims can, however, only be made at a time when the SME is a going concern.
9.2 Record keeping
There are no specific record keeping requirements for the purposes of R&D tax relief but however the usual corporation tax requirement to keep sufficient records applies.
SMEs claiming relief should consider how they can demonstrate to HMRC, if challenged, that:
- the project meets the requirements for relief (i.e. that it seeks to achieve an advance in science or technology through the resolution of scientific or technological uncertainty); and
- that all the costs for which relief is claimed are qualifying expenditure.
HMRC appreciate that smaller companies may keep less detailed records than larger ones. However, they will normally expect to see some form of project planning material, which should cover the aim of the project, a link between its outcome and the commercial prospects of the company, a review of the current state of knowledge, any difficulties foreseen, a structure for the project and notes on the particular expertise of specific employees. HMRC accept this may not be formally documented, especially for smaller companies, so officers should be prepared to consider other relevant contemporary evidence.
On enquiry, HMRC are often keen to understand the time-line of R&D projects. In particular, it is important to remember that relief can only be claimed up until the point that the uncertainty being investigated is resolved (or the research abandoned because the issue could not be resolved). HMRC will often expect an SME to be able to demonstrate that they have correctly identified this ‘cut off point’ in calculating their claim.
9.3 Advance assurance
A voluntary advance assurance scheme enables small companies to contact HMRC in advance of submitting a claim for R&D relief and get confirmation that the activities they carry out will qualify.
The main advantage is that, if advance assurance is received, the SME’s claim will be accepted without further enquiry for the first three accounting periods provided it is in line with what was discussed and agreed during the application process. SMEs also get access to HMRC specialists who can help them with questions about relief.
Advance assurance can be applied for before or after the R&D is carried out, but the application has to be made before the first R&D relief claim is made. To be eligible for advance assurance the company must:
- Have made no previous claims for R&D relief;
- Have annual turnover of £2m or less;
- Employ fewer than 50 staff;
- Not be in a group where another group member has made a claim for R&D relief; and
- Not be a serious defaulter or have entered into any scheme which falls under the Disclosure of Tax Avoidance Schemes (DOTAS) regime.
Applications for advance assurance can be made by the company or their agent using a specific form. HMRC will then usually deal with the application via a telephone call, though a site visit may be required for more complicated claims. More information on the advance assurance scheme and the claim form to use can be found here.
9.4 Common errors in SME R&D claims
Common errors in SME R&D tax relief claims include:
- Companies which are not SMEs claiming under the SME scheme.
- Overlooking expenditure on unsuccessful R&D projects – research does not have to be successful to qualify for relief.
- Missing out on relief where expenditure relates to modifications or improvements of an existing product.
- Claiming relief where a product has already entered into production.
- Including non-qualifying indirect activities in a claim (e.g. support or secretarial staff costs).
- Including staff costs for those who are not employees or externally provided workers (e.g. self-employed contractors that the SME has directly engaged).
- Making claims for overheads which do not qualify as consumable items.
- Not restricting unconnected subcontractor expenses to 65%.
- Carrying forward a loss which has been surrendered for a payable credit.
- Not taking subsidies or Notified State Aid into account.
Capital expenditure does not qualify for enhanced deduction under the SME scheme, but may be eligible for a 100% R&D allowance under s437 CAA 2001.
R&D allowances are available where:
- Capital expenditure is incurred on R&D; and
- The person incurring the expenditure is carrying on a trade when the expenditure is incurred, and the R&D relates to that trade; or
- After incurring the expenditure, the person sets up and commences a trade connected with the R&D.
For these purposes, expenditure is incurred on R&D where it is for the purposes of carrying out R&D or providing facilities for carrying out R&D. However, expenditure on the following is specifically excluded:
- Rights in R&D, or rights arising out of R&D.
- Dwellings (unless a building is used as both a dwelling and for R&D purposes, with no more than 20% of the cost referable to the dwelling element).
- Land (except acquisition of a building already constructed on the land and any plant and machinery forming part of it).
The amount of the R&D allowance is equal to 100% of the qualifying expenditure.
More guidance on SME R&D tax relief can be found:
- On GOV.UK
- In HMRC’s Corporate Intangibles Research and Development Manual at CIRD80000 onwards.
- In HMRC’s Making R&D easier for small companies guide