Lee Sharpe looks at recent developments in research and development (R&D) tax reliefs.
Research and development (R&D) tax reliefs for small and medium-sized enterprises (SMEs) are some of the most valuable incentives available in the UK tax regime.
For example, where an SME company identifies £1,000 of qualifying expenditure, this can achieve a £2,300 reduction in taxable profits (in other words, a special further tax-centric profit reduction of £1,300).
In cases where the R&D-eligible expenditure (as enhanced) results in a net loss for corporation tax purposes, the component of loss attributable to R&D can be surrendered in exchange for a payable tax credit from HMRC at a rate of 14.5%.
Of course, if the company is likely to make profits and have a corporation tax liability in the near future, saving corporation tax at the rate of 19% is better than getting an actual tax credit of 14.5%. But an SME undertaking relatively high levels of R&D at an ‘early loss-making stage’ might prefer the payable credit until it can transition to profitable exploitation of its R&D activities.
So runs the logic, at least. But HMRC has become increasingly concerned at the volume of payment claims being made by SMEs and suspects that a good proportion of claims do not actually qualify. It is worth pointing out that while the tax benefit is generous, there are many criteria for a successful tax claim – not all R&D qualifies for tax purposes – and note in particular that only companies can claim the headline R&D reliefs. We shall look at three recent tax cases where R&D claims have been considered.
Innovation does not necessarily mean eligible R&D
The case Grazer Learning v HMRC [2021] UKFTT 0348 (TC) involved a claim for R&D based on creating a novel interactive online platform that matched students with providers of digital learning content, described as a “sat-nav for learning”, that was apparently a significant improvement on anything else on the market.
The taxpayer fundamentally failed on a procedural basis; the taxpayer company did not provide important evidence to the court until very late (several months after the deadline) and not at all to HMRC, as the other party to the case. That late evidence was therefore ignored.
However, the First-tier Tribunal (FTT) did briefly consider the evidence already provided in the context of the claim, and it emphasised something vitally important:
“A novel or innovative approach to the application of existing technology is insufficient to justify a claim for R&D relief. Instead, there needs to be an advance in the technology itself.”
In other words, just because something is innovative, clever, or potentially a resounding commercial success because nobody had ever thought of it before, does not make R&D for tax purposes. Basically, there must be a technological problem that an expert in the relevant field (a ‘competent professional’ in R&D parlance) cannot ‘guarantee’ can be fixed.
For a simple illustration, if I want to bake and sell bread that will last on a shelf for three days without going stale, my company may not know how to do that, but I am guessing there are plenty of experienced commercial bakers and food scientists who would.
However, if I wanted to bake and sell bread that would last on a shelf for three weeks, I imagine there would be experienced commercial bakers and food scientists with plenty of ideas and possible solutions, but no certainties (in fact, there is a great deal of R&D on natural products and particularly food that would be considered a ‘win’ if you could eke out an extra day or two, let alone weeks).
In Grazer, HMRC was ready to accept that the online platform was novel, and included a commercially innovative approach, but argued there was no evidence of technological uncertainty, and that is what matters for an R&D tax claim.
Identifying the competent professional
As part of the R&D claim procedure, it is important to identify who is the expert or competent professional.
In terms of validating the claim, their role is effectively to say, “I am an expert in this field, and I can say that this particular problem cannot readily be resolved by an expert like me”. To use the bread analogy above, I should like to think I might rank as a ‘competent professional’ in the field of taxation, but clearly not in baking bread. Just because it might be hard for my company to bake bread that would last for three days without going stale does not necessarily make it a valid technological uncertainty for actual competent professionals in that field (at the same time, if I am undertaking R&D that another firm is known to have ‘cracked’ but is, for now, their trade secret and not widely known by other professionals in that field, then my project may yet qualify).
In Hadee Engineering Ltd v HMRC [2020] UKFTT 0497 (TC), HMRC argued (amongst other things) that the company’s managing director, while an experienced engineer, was not a competent professional in the particular fields relevant to at least some of the projects being undertaken (NB the projects were quite ‘niche’, such as designing a centrifuge to separate out various animal by-products).
It is quite common for the director of a small OMB company to decide they are the competent professional as part of an R&D claim. While a person with many years’ experience may well qualify as a competent professional, their field of expertise may be quite narrow, and frequently will not cover all aspects of an R&D project. In this case, the company claimed on a diverse range of unusual engineering solutions for its various clients, but HMRC was not convinced that unusual and complicated engineering, on their own, necessarily gave rise to the required technological uncertainty.
The taxpayer’s appeal was allowed in part, but the case demonstrates how many different criteria must be met to make a successful claim.
Subsidised expenditure?
The most favourable R&D tax incentives as outlined above for SMEs are not supposed to be available for subsidised expenditure; in other words, it is the claimant company that is supposed to bear the cost of the project. Where work has been subsidised, its scope to claim is limited to the considerably less generous regime for ‘large’ companies.
In Quinn London Ltd v HMRC [2021] UKFTT 437 (TC), HMRC tried to argue that, since the claimant company was being paid on a commercial basis for the work on which its R&D claim was based, it was being indirectly subsidised by its customer, so was not eligible to claim under the SME regime.
This was quite a ‘nice’ manoeuvre by HMRC: to qualify, R&D should basically complement a company’s existing or intended trade; however, if the court in this case accepted that customer payment effectively subsidised the cost of a project, the vast majority of R&D projects would likely be ineligible for tax relief (NB failed projects can still qualify for R&D tax reliefs, but it would hardly seem right that only failed projects that never got as far as commercial exploitation would be rewarded!).
Fortunately, the FTT found HMRC’s argument to be at odds with a sensible interpretation of the legislation, and the taxpayer’s appeal was allowed.
Conclusion
Despite the government’s stated intent to incentivise R&D in the UK to promote innovation nationally, HMRC is trying very hard to tighten up on tax credit pay-outs to SME companies. I suspect much of HMRC's concern stems from when the original cap for payable tax credits was withdrawn in FA 2012; a similar cap has now effectively been reintroduced, from April 2021, at £20,000 plus 300% of the company’s PAYE and National Insurance contributions bill for the period (although the cap may be avoided in some circumstances).
Note also that the main rate of corporation tax is set to rise to 25% for profits made from 1 April 2023, so many companies will actually be much better off by keeping their enhanced losses and not surrendering them for the 14.5% payable tax credit – so long as they are confident that they will eventually become profitable, of course.
