HMRC has been busy setting out a new framework to prevent R&D tax relief being an increasing target for fraud and abuse.
One of its measures involves subjecting SMEs to a cap when they opt for the payable tax credit relief option for their R&D claims.
If you are getting a feeling of déjà vu, it’s because a cap on payable tax credits is not a new concept in the R&D tax relief space. SMEs were previously subjected to a cap when claiming R&D tax credits, but this was lifted in 2012.
However, this measure is back and first impacts companies with accounting periods beginning on or after April 1, 2021.
Who is and is not affected
To be eligible for the payable tax credits, companies need to be a loss-making SME engaged in qualifying R&D activities. If it is a profit-making entity, or has other companies within its group that are profit-making, the benefit of the R&D claim will be a reduction in its Corporation Tax (CT) bill at the nominal CT rate.
Companies claiming less than £20,000 in R&D tax credits are also unaffected. While, at first glance, this may seem an arbitrary limit, HMRC is trying to ensure that the smallest businesses, which truly need the funding, don’t get the short end of the stick.
Calculating the PAYE & NIC cap
Non-exempt companies eligible for a payable R&D tax credit will be limited to £20,000 plus 300% of their company-wide Pay As You Earn (PAYE) and National Insurance Contributions (NICs) for the period.
The PAYE & NIC liabilities are, respectively:
- The amount of income tax for which the company is required to account to Revenue & Customs for the payment period under PAYE regulations, and
- The amount of Class 1 national insurance contributions for which the company is required to account to Revenue & Customs for the payment period.
Companies claiming R&D tax credits are also able to include the PAYE and NICs of connected-parties involved in the R&D project when calculating the cap.
Company A has qualifying R&D expenditure of £400,000.
Their enhanced deduction (230%) is £920,000, with company-wide PAYE & NIC liabilities of £15,000.
Their maximum R&D tax credit eligibility at 14.5% would have been £133,400.
Tax Credit Cap = £20,000 + (3 x £15,000) = £65,000
Company A is capped at £65,000 for the period, should they be entitled to claim R&D tax credits.
Impact of exceeding the PAYE & NIC cap
If the eligible SME tax credit amount is exceeded, the remaining losses are carried forward and offset against future profits.
This can impact loss-making start-ups, as they routinely have minimal salary costs and are mainly using sub-contractors for their R&D projects. Fortunately, the de minimis amount of £20,000 is a safety net in these circumstances.
Pro-rating the PAYE & NIC Cap
While there are no straddle rules to be mindful of, there is a pro-rating of the cap. Should the accounting period be less than 12 months, the de minimis amount (£20,000) would be proportionately reduced.
For example, in this simplified illustration, if the accounting period in question is six months long, the R&D tax credit cap is set at: (£20,000 × 6 ÷ 12) + (3 x (PAYE + NIC liabilities))
The exemption test
A claim for R&D tax credits will remain uncapped if the claimant meets both of the following criteria:
- Its employees are creating, preparing to develop, or managing Intellectual Property (IP), and
- It does not spend more than 15% of its qualifying R&D expenditure on subcontracting R&D to connected parties or providing Externally Provided Workers (EPWs) to connected parties.
Only IP where either the whole or the greater part has been created by the company qualifies for the exemption to the cap.
Avoid double-counting of PAYE & NIC liabilities
When determining a company’s expenditure on workers (ie PAYE & NIC liabilities), the following would need to be deducted from the total amount for the accounting period:
- The portion of staffing costs related to providing externally provided workers for a connected company
- Any staffing costs for the payment period incurred by the company in undertaking contracted out R&D on behalf of a connected company
Building a robust R&D claim
The benefit outcome resulting from a successful R&D claim for SMEs varies drastically from one claimant to another and, while receiving a payable tax credit may sound like a favourable outcome, it is not always the case.
Losses generated through an R&D claim are classed as trading losses, and there are many ways in which these losses may be relieved.
Understanding all the available options available for your clients is just one of the many moving parts in preparing a robust R&D claim.
Khaled Fatheldin is a Senior Tax Analyst at innovation funding specialist Catax. He can be contacted at firstname.lastname@example.org.
This article first appeared on Accountancy Today.