New rules may restrict R&D tax credit refunds for loss making companies/start-ups

Published by on 20 January 2021

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The SME R&D tax credit scheme is a very generous tax incentive which is intended to provide financial support to companies investing in science and technology.

Under the SME scheme qualifying companies may claim a ‘super deduction’ of 230% of qualifying expenditure. This reduces taxable profits and can even generate tax losses for otherwise profitable companies.

Under the SME scheme it is possible to surrender these losses in exchange for a repayable tax credit of 14.5% of the R&D loss surrendered. This means that for £1 of qualifying expenditure they can effectively claim back up to 33p (being 230% x 14.5%).

For profit making companies, £1 of qualifying expenditure can be worth up to 24.7% (being a further deduction of 130% x 19% corporation tax rate).

So far so good, so what is the problem? Well, the issue is that the Government believes that the SME scheme is prone to abuse by sham companies set up deliberately for the purpose of claiming tax credits. The challenge they face is drafting tax legislation which targets this abuse whilst not punishing legitimate enterprises. This brings us to the ‘PAYE cap’.

The PAYE cap is intended to apply to accounting periods starting after 1 April 2021. So if you have a March year end, the rules will apply to the year ending 31 March 2022. The purpose of the rule is to limit the amount of R&D tax credit paid to a company to the total PAYE and National Insurance Contributions (NIC) paid over in the relevant accounting period.

We currently have the first draft of the legislation. Very broadly these will operate as follows for SME R&D tax credit claims:

  • SME tax credit claims below £20,000
    – No restriction to the repayable tax credit.
  • SME tax credit claims in excess of £20,000
    – The cap will be set at £20,000 plus 3 x the total PAYE and National Insurance (NIC) liability for the accounting period concerned.
    – Where accounting periods are less than 12 months the £20,000 cap is proportionately reduced.
    – Total PAYE and NIC liabilities is not limited to only employees involved in R&D. The total can also include some PAYE and NIC of connected persons undertaking subcontract R&D for, or providing workers to, the claimant company.

The above rules create a clear issue for early stage technology and bio science companies. These typically subcontract R&D activities and may have minimal, if any, PAYE costs but are clearly undertaking bona fide R&D activities for a commercial purpose. In an attempt to keep these companies outside of the PAYE cap the legislation states that they will be exempted from any restriction providing that 2 conditions are met:

  • Condition A – requires the company to be creating or preparing to create intellectual property, or managing intellectual property which it holds.
  • Condition B – it does not spend more than 15% of its qualifying R&D expenditure with connected persons on externally provided workers or subcontracting.

Prima facie these rules are intended to keep most genuine companies outside of the PAYE cap. However, the precise wording of the legislation is ambiguous and it remains unclear just how HMRC will operate the rules.

Some key concerns are:

  • Condition A
    • The definition of IP is very tightly worded and implies that there is an intention for this to be legally registered, such as a copy right, patent etc. A lot of software based start-up companies do not do this.
    • What level of evidence will be required by HMRC to prove intention.
    • The legislation requires the company to ‘wholly or mainly’ be managing or creating IP – in tax law this can sometimes be more than 50% and others more than 80% – which is it?
    • If IP is subcontracted, should there be formal legal agreements which recognise where the ownership of IP should vest.
  • Condition B
    • If a company is subcontracting most of its R&D to a subsidiary, is there any risk that the total PAYE and NIC cost (of claimant company and subsidiary) be smaller than the tax credit being claimed.

It should be noted that the above is based on the rules as they are currently drafted and the legislation may well change before it is included in the Finance Bill for the next Budget.

It is recommend that any company who has been claiming R&D tax credits (or intends to do so) under the SME scheme reviews their affairs to ensure that they understand the impact of these rules on their specific circumstances. It is hoped that in most cases there should not be an issue but it is better to confirm this sooner rather than later, whilst there is still time to consider next steps.

If you would like to discuss the topics covered in this article then please get in touch with us. To find out how we can help you with Research and Development Relief visit here or contact a member of our team.

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