RESEARCH AND DEVELOPMENT TAX CREDIT FOR SMEs

From 1 April 2000, spending on R&D by SMEs can qualify for R&D tax credits. The new scheme for R&D tax credits for small and medium-sized companies (SMEs) was introduced in Finance Act 2000. In support of this, the Secretary of State for Trade and Industry issued new Guidelines on the meaning of R&D for tax purposes at the same time, on 28 July 2000.

The SME R&D tax credits allow for enhanced tax relief for certain R&D spending in two ways:

• an increase in the tax relief SMEs can claim for their qualifying non-capital R&D expenditure from the usual deduction of 100% to 150%;
  
  
• or a payable R&D tax credit for companies not in profit - a cash payment of £24 for every £100 spent on qualifying R&D.

This note provides:

• some background to the new R&D tax credit measure for SMEs;
  
  
• information on who can claim;
  
  
• information on how this might benefit your business.

The Inland Revenue are responsible for tax issues including the SME R&D tax credit. Further information can be found at the Inland Revenue website

Introduction

The Chancellor announced proposals for a new R&D tax credit in the 1999 Budget, for implementation in Budget 2000:

"I propose a new R&D tax credit which will give new business and small business - the biggest source of innovative ideas - cash help to research and develop their innovations even before they make their first profits.

At a cost of £150millon a year, this targeted tax cut will underwrite almost one third of research and development costs for small business.

Britain now has one of the best incentives for innovation anywhere in the industrialised world.

Scientific innovation is a prime catalyst of growth. And I want a winner's circle of innovation - inventions that are then developed in Britain and manufactured in Britain, creating growth and jobs in Britain".

The Government aims to create a favourable business climate for businesses to innovate in the UK. Small and medium-sized companies (SMEs) wishing to undertake R&D can face particular difficulties. R&D is often a long-term investment. Smaller companies are the least well able to sustain this necessary investment over long periods of time, and do not necessarily have access to funding. The SME R&D tax credit aims to help overcome these barriers to encourage R&D, since R&D can help create:

• new and more competitive products, services and processes;
  
  
• new markets;
  
  
• high-quality employment opportunities for skilled people.

The R&D tax credit was introduced to help SMEs to undertake R&D, either for the first time, or to encourage them to increase their R&D.

On 28 July 2000 the Secretary of State for Trade and Industry published guidelines on the meaning of R&D for tax purposes, including a new statutory definition of R&D, to coincide with the introduction of R&D tax credits. The definition and guidelines clarify what constitutes R&D for tax purposes and give businesses added certainty in their tax affairs. They apply not only to the R&D tax credit scheme for SMEs, but also for other tax purposes, in particular to R&D allowances (these capital allowances were previously called scientific research allowances), which are 100% tax allowances for capital expenditure. These can be claimed by all businesses regardless of size. You can find more information about R&D allowances, R&D tax credits and the guidelines on what constitutes R&D for tax purposes on the Inland Revenue website.

SMEs therefore can qualify for the usual R&D allowance on their qualifying capital expenditure and the R&D tax credit for SMEs on other non-capital qualifying spending (i.e. not on the same expenditure).

Who can claim?

The R&D tax credit for SMEs is expected to benefit around 4,500 small and medium-sized companies in the UK at a cost to the Exchequer of about £150 million a year. These companies are responsible for about 10% of all UK business expenditure on R&D.

Q: How does the R&D tax credit for small and medium-sized companies work?

Claims for the R&D tax credit (including the payable R&D tax credit) would be made by an eligible company in the company’s tax return.

• The enhanced R&D tax relief is 50% of qualifying R&D expenditure, that is, relief will be given on qualifying expenditure at 150% of cost. Hence, for a company liable at the 20% rate of Corporation Tax, it would provide a further saving to the company equal to 10% of the cost of qualifying R&D, bringing total savings to 30% of eligible R&D expenditure.
  
  
• Companies not in taxable profit can surrender losses to the Exchequer in return for a cash payment, termed the payable R&D tax credit. Broadly, the amount that can be surrendered is the lower of the 150% of qualifying R&D expenditure and the unrelieved trading loss for the accounting period. The company will receive a payment of 16% of the surrendered loss, representing £24 for every £100 of qualifying R&D expenditure. However, the payment is limited to the gross amounts PAYE and Class 1 NIC paid by the companies for the accounting period of the claim.

Q: How will a company know what counts as R&D?

DTI has published Guidelines on the meaning of R&D for tax purposes. They have been given statutory force. The Guidelines support the introduction of the R&D tax credit (and also clarify the meaning of R&D for Research and Development allowances, which provides for 100% relief on capital expenditure relating to R&D).

For those interested in the relevant legislation, the new definition of research and development (R&D) for tax purposes is found in Section 837A Income and Corporation Taxes Act 1988, introduced by Schedule 19 to the Finance Act 2000. It replaces the existing definition of "scientific research" in section 139(1)(a) CAA 1990 for most purposes. In practice, the new definition does not change the range of activities that have qualified as scientific research.

Q: What is an SME?

An SME is defined in accordance with EC State Aid rules.

Broadly speaking, a company will be a SME if it, together with any company it controls by holding 25% or more of the capital or voting rights:

• has fewer than 250 employees, and
  
  
• has an annual turnover not exceeding Euro 40 million (about £25 million), or
  
  
• has an annual balance sheet total not exceeding Euro 27 million (about £17 million).

A company will not be a SME if 25% or more of the capital or voting rights in the company are owned by enterprises that are themselves not SMEs. This rule does not apply to enterprises which are public investment corporations, venture capital companies or institutional investors that do not exercise control over the company either individually or jointly with others.

A company which is an SME will cease to be one only if it fails to meet the qualifying conditions over two consecutive years. Similarly, a company that is not an SME will become one only if it satisfies the criteria for SMEs over two consecutive years.

Q: How will an eligible (SME) company claim the R&D tax credit?

• By completing its self assessment return in the usual way and claiming that amount which qualifies as R&D for the purpose of the tax credit (which will be its direct R&D labour costs, plus the cost of consumables that R&D personnel have used, and eligible costs of subcontracted R&D).

Q: Will a minimum level of R&D expenditure be required in order to qualify?

• Yes. R&D tax relief can only be claimed if a company's qualifying expenditure for an accounting period is not less than the minimum threshold of £25,000 a year. The threshold is increased or decreased proportionally if the accounting period is more or less than 12 months. The relief is given on the costs of staff directly involved in carrying out the R&D, the costs of consumable stores used in the R&D effort, and certain costs where R&D is sub-contracted to another person.

Q: Why only companies?

• Almost all significant R&D activity carried out by small and medium-sized businesses is undertaken by companies. Extending R&D tax credits to unincorporated businesses would make the scheme too complex or unfair in its application.

Q: What about SMEs which are incurring R&D expenditure but which are not in taxable profit?

• A cash payment will be made to SMEs not in taxable profit. They must claim the payment in their tax return. The amount that could be surrendered would be the lower of the 150% of qualifying R&D expenditure and the unrelieved trading loss for the accounting period and be within a cap of NIC and PAYE contributions. The amount payable represents 16% of the surrendered losses, which is equivalent to 24% of the cost of the R&D.

Q: What if the company is not yet trading?

• Companies that are incurring R&D expenditure, but have not yet started to trade, will be able to benefit from the new relief. The R&D spending together with the additional deduction from the R&D tax relief are treated as if they were a trading loss. This means they can be set against other profits, surrendered as group relief, or cashed in to the Exchequer. Again, the claim must be made in the company's tax return.

Q: When did the new R&D tax measures take effect?

• The new definition of R&D applies to the year of assessment 2000/01 onwards for income tax and for accounting periods ending on or after 1 April 2000 for corporation tax.
  
  
• R&D tax credits can be claimed on qualifying R&D expenditure made on or after 1 April 2000.

Q: How will the new definition and Guidelines on R&D and the R&D tax credit affect Scientific Research Associations?

• The new definition does not apply to Scientific Research Associations (section 508 ICTA 1988 continues to apply to them), nor to payments to scientific research associations and universities, colleges, research institutes and similar institutions. These attracted tax relief under sections 136(a) and (b) Capital Allowances Act 1990. The rules have now been moved to a new section 82B in Income and Corporation Taxes Act 1988.
  
  
• Commercial subsidiaries of SRAs could benefit from the R&D tax credit provided they will own the fruits of the R&D they carry on and subject to the nature of the work they are undertaking. They will need to satisfy the same size and ownership considerations applicable to all SMEs.

Q: How will an R&D tax credit impact on Research and Development Allowances?

• On 1 April 2000, Scientific Research Allowances were renamed Research and Development Allowances. The introduction of an R&D tax credit has not resulted in changes to the existing treatment of qualifying capital expenditure.. R&D allowances are given for capital expenditure on R&D assets and are available to all businesses - incorporated or unincorporated both large and small. R&D tax credits are an additional tax benefit given on qualifying revenue spending on R&D by SME companies.

Q: Why do we need an R&D tax credit for SMEs?

• DTI, HMT and Inland Revenue concluded that there is a case for encouraging small firms to undertake or increase R&D. Many of the most innovative ideas are to be found in small firms, but resource constraints can be a major disincentive to them making what is often a long-term investment in the necessary R&D. A tax credit for R&D is a way of providing help to a large number of companies and helps to level the playing field with other major countries who provide similar arrangements (e.g. US).

Q: Why do we think we need a payable tax credit?

• Many small companies, in particular early stage technology-based firms, will be making losses, sometimes over many years - partly due to the need to invest in R&D. The result for such companies will be that they are "tax-exhausted". That is to say, they will not have taxable profits and will therefore not be paying corporation tax. An R&D tax credit based on the premise that increased tax relief for eligible R&D expenditure could be offset against profits and thus reduce corporation tax, would be of no benefit to companies with no taxable profits. Allowing cash payment of the tax credit to such companies should encourage them to invest in R&D, allow them to be treated equitably and help sustain their R&D during their early and sometimes difficult years.

Q: Will an R&D tax credit be available for a company's expenditure against part publicly funded projects?

• Not if the public funding constitutes a notified State Aid. A condition of approval for the UK’s R&D tax credit, under EC State Aid rules, is that individual projects that have been in receipt of a notified state aid cannot be included in a company's R&D expenditure for the purposes of the SME R&D tax credit. This means that R&D projects in certain programmes (such as LINK and some Smart projects) are not eligible for the SME R&D tax credit. For example, a Smart Development Project award recipient cannot apply the 150% deduction in respect of any R&D spending relating to the project for which the award was given (i.e. the grant or its own expenditure). However, the usual 100% deduction can be made for the balance of the company's spending on the project benefiting from the Smart award. Qualifying spending on another separate R&D project can benefit from R&D tax credits as long it has not benefited from a notified State Aid. On the other hand, a recipient of a Smart Feasibility Study award can apply the 150% deduction on the project costs which the company meets from its own resources. Smart recipients and other similarly affected companies therefore need to enquire from the scheme administrators whether the award they receive is a notified or a "de minimis" state aid. They also need to define carefully the boundaries of their projects for accounting purposes so that where appropriate they may still benefit from the SME R&D tax credit.

Q: What happens if the Inland Revenue opens an enquiry into a claim for the R&D tax credits?

The Inland Revenue may enquire into the facts and circumstances of a claim to R&D tax credits to confirm that the claim meets the conditions of the scheme. The inspector handling the enquiry will seek to resolve the enquiry by an agreement. If the company and the inspector cannot reach agreement about the claim, the General or Special Commissioners will consider the facts. The tax Commissioners are an independent body with powers to hear tax appeals.

Q: How do I find out more?

The Inland Revenue leads on tax issues, and there is further information available at their website. If you are unable to find an answer to your query, David Harris is the lead Inland Revenue official and can be contacted by e-mail at david.harris@ir.gsi.gov.uk or by phone on 020 7438 6761. If you have a business-related query, the DTI contact on the R&D SME tax credit is Nicholas Munn, and can be contacted by e-mail at nick.munn@dti.gsi.gov.uk or by phone on 020 7215 6580.

January 2002