Recently announced research and development (R&D) tax system changes will go live on 1 April 2024 as part of the ongoing streamlining of UK tax regulations. In a concerted effort to encourage innovation, as seen with the recently proposed adjustments to stock-market listing particulars, it is hoped the changes will make the system more efficient and targeted towards innovation-driven growth.
The current structure of the R&D tax credit system
At the moment, the R&D tax credit system consists of a process for Small and Medium Enterprises (SMEs) and larger companies known as the Research and Development Expenditure Credit (RDEC). The basic eligibility for the SME R&D tax scheme is as follows:-
- Turnover under €100 million
- Balance sheet under €86 million
- No more than 500 employees
While there is no specific set criteria for the RDEC scheme, companies which don’t qualify for the SME R&D tax scheme would most likely be eligible for the larger company scheme. It’s also important to note that an individual company could use the SME scheme for one project and the RDEC scheme for another, dependent upon expenditure.
Current R&D tax relief
While the two schemes are set to be combined on 1 April 2024, we saw changes just last year on 1 April 2023. These are summarised as follows:-
SME R&D tax relief
Before last year’s changes, SMEs could claim back up to 33% of qualifying R&D spending, with a 130% uplift in costs. The split was as follows:-
- 33% for loss-making companies
- 25% to 33% for breakeven/profitable companies
On 1 April 2023, the rate changed to:-
- 18.6 to 27% for (R&D intensive ) loss-making companies
- 8.6% for companies breaking even
- 16.34% to 21.5% for profitable companies
Where qualifying R&D spend was at least 40% of total expenditure, SMEs were deemed “R&D intensive” and eligible for the higher rate.
RDEC R&D tax relief
Before changes last year, those companies using the RDEC scheme had a relief rate of:-
- 10.5% subsidy for loss-making companies
- 13% (10.5% post-tax) for profitable companies
On 1 April 2023, this changed to the following rates:-
- 15% subsidy for loss-making companies
- 20% (14.7% to 16.2% post-tax) for profitable companies
Looking at this from a practical point of view, many people will be relieved that the government is amalgamating these two schemes into one R&D tax relief system starting 1 April 2024.
To recalibrate the rate of tax relief, the government reduced the allowable enhanced rate of R&D expenditure from 130% down to 86%. We also saw the surrender value of tax relief reduced from 14.5% to 10% for non-R&D-intensive SMEs.
This is the rate at which SMEs can convert future tax relief into upfront cash payments today. It will depend upon the company’s financial standing and prospects as to whether accumulating tax relief to offset against future profits or taking discounted cash payment is the best option.
Merging the two schemes into one
Going forward, R&D tax relief will be much simpler with the following changes:-
- Eligibility for R&D intensive status will fall from 40% of qualifying R&D expenditure as a percentage of overall turnover down to 30%
- The staffing and turnover qualifying levels for the old SME scheme have been removed, with all qualifying businesses now able to claim R&D tax relief at 20% (15% to 16.2% post-tax)
- The notional tax rate for loss-making companies will fall from 25% to 19%
- Subsidised expenditure, i.e. covered by grant funding, is not deducted under the new merged scheme, therefore companies can claim the full relief
Under the new arrangement, there will be significant changes regarding outsourced research and development and the claiming of relief. Historically, subcontractors could claim under the two existing schemes, but this opportunity will now be exclusive to the principal company. Many experts believe there will be a period of adjustment within the R&D subcontracting sector, and several contracts may need to be renegotiated.
Qualifying for R&D tax relief
The qualifying terms for those looking to claim tax relief for R&D expenditure remain the same, with the following claims criteria for companies:-
- Work must relate to advancements in their field
- It must involve scientific/technical uncertainty
- Address issues not currently easily resolved by a professional
- Relief must relate to activities in their trade
As we touched on above, the qualifying rate for R&D-intensive companies has fallen from 40% of their expenditure to 30%. While the R&D relief rate adjustment will lead to increases in some areas and a reduction in others, the overall target is to incentivise more companies to invest in R&D.
Financial information required
When applying for R&D tax relief, the applicant must provide detailed financial expenditure broken down across the following nine categories:-
- Staff costs
- Freelance workers
- Subcontracting costs
- Software
- Consumable items
- Payments to trial participants
- Data licence costs
- Contributions to independent R&D costs
- Computing services
The financial information must be accompanied by company details, including:-
- Unique taxpayer reference number
- PAYE reference number
- VAT registration number
- Type of business and SIC code
- Contact details for primary personnel relating to R&D claim
- Contact details for agents working on the R&D project
Failure to provide the above information will lead to an automatic rejection of the claim, which can significantly impact the cash flow of R&D-dependent companies.
Example of an R&D tax relief claim
While there are several scenarios that will create a range of different rates of tax relief, the following calculation demonstrates a practical situation.
Company: XYZ
Pre-tax profit: £400,000
Corporation tax at 25%: £100,000
R&D expenditure: £100,000
Using the enhancement factor of 86% and the new tax relief rate of 20%, the calculation is as follows:-
Enhancement factor on £100,000 R&D expenditure: £86,000
R&D tax relief at 20%: £17,200
As a consequence of the R&D tax relief, the company’s corporation tax payment is reduced:-
Initial corporation tax of £100,000 – R&D tax relief of £17,200 = £82,800 corporation tax payment
In reality, this reduces a company’s corporation tax rate from 25% to 20.7%, which is beneficial to cash flow and resources.
Summary
The merger and simplification of the SME and RDEC R&D tax relief schemes has been broadly welcomed. There is a focus on encouraging companies to increase their R&D expenditure, but the reduction of the 130% enhancement figure down to 86% will have a material impact. However, the qualification for R&D intensive status falls from R&D expenditure of 40% of total turnover down to 30%.
There are many factors to consider when looking at claiming R&D tax relief, and it is vital that you speak with your accountant.