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This is part three of our four part guide for accountants that want to develop their knowledge, grow their practice and provide their clients with R&D tax relief services. Companies can also use this to prepare and submit their own R&D tax credit claims.
The other parts cover:
It is important to know what costs can be included in an R&D tax claim. This guide will help you maximise your clients’ R&D tax claims without increasing the risk of an HMRC enquiry by claiming incorrect costs.
R&D tax credits generally allow a company to reclaim costs that are revenue in nature (although capitalised development costs can be claimed in some scenarios – this is common for companies creating software for their own use). Expenses related to capital assets such as buying machinery cannot be reclaimed. The costs associated with creating patents and trademarks are also excluded.
It is common for an expense to be reported in the accounts but not necessarily paid by the claimant. The company must have paid the amount before the R&D tax claim is submitted to HMRC.
The costs that can be included in an R&D tax claim include:
The staff costs of employees (including directors) directly involved with a qualifying R&D tax project can be recouped using R&D tax relief. If the employee is only partially involved with the project, then the relevant proportion is only claimed. Any staff involved with qualifying indirect activities can also have their staff costs claimed.
Staff costs includes salary, wages, bonuses and generally any income received through payroll. The company can also claim secondary class 1 national insurance contributions and company pension contributions.
In some cases the claimant can also recoup reimbursed expenses.
Dividend income is specifically excluded from staff costs and therefore cannot be claimed in the R&D tax claim.
As there are many companies that have shareholders that are also employees, this can result in a claimant not maximising it’s R&D claim. It is therefore important to consider that when a shareholder is also an employee of the company and they spend a significant amount of time involved with research and/or development that instead of taking a dividend, they could take a greater amount of salary.
This goes against the conventional advice given by accountants and can add a significant amount of overall tax saving.
To help maximise your client’s R&D tax claim, it is recommended that towards the end of their accounting period, to liaise with the claimant and take details of any shareholders involved with any qualifying projects. You will need information to determine if the project qualifies and how much time the shareholder spent on the project. This information along with the shareholder’s salary for the year can help you determine whether the shareholder should take a greater salary or a dividend.
Alternatively, you can get in touch with me by email at email@example.com and I can guide you through this or liaise with your client on your behalf. I will do this as a free check.
Outsourcing is broken into two different types of costs – subcontractor and an externally provided worker (EPW).
It is important to distinguish between the two as the rules for each are different.
The easiest method to determine whether the outsourcee is an EPW or a subcontractor, is by deduction – If outsourcee is not an EPW, then it is a subcontractor.
So what is an EPW? An EPW must meet the following conditions:
It is the responsibility of the claimant company to determine whether an EPW relationship exists.
An easy method to use is to ask the outsourcee whether the individual is under PAYE. If they are, then it can be assumed conditions 1,3,4,5 and 6 are met and you will only need to clarify point 2, which will be simple.
A large company can not claim subcontractor costs unless the subcontractor is a qualifying body, individual or partnership. If a large company can not make a claim, then the subcontractor can instead make a claim.
A large company can however claim EPW costs. This is why it is important to establish the type of subcontractor.
This table summarises whether the contractor or subcontractor can make an R&D tax claim in relation to the work it undertakes.
Payment to a connected outsourcee
The payment between an unconnected contractor and outsourcee must be restricted to 65%. This is because HMRC argue that the outsourcee must have a profit motive to undertake the work and therefore not all the work will be for actual R&D activities.
If the two parties are connected, then the claimant may potentially claim 100% of the costs. This is great news for connected parties as it provides a tax planning opportunity to maximise their claim.
How are subcontractors or EPWs connected? To keep it simple, connected party rules exist where:
What is control? Control generally means that the person/company has more than 50% of the shares in the company, but the definition does extend to this.
The individual and the shareholders can also be connected to companies through their family as follows:
When two companies are connected, the maximum amount of costs that can be claimed is the lower of the amount:
So what are relevant costs? Relevant costs include all the qualifying R&D costs, excluding subcontractor costs. It therefore includes staff costs, EPW, consumables, software costs and costs related to clinical trials.
There are tax planning opportunities when the claimant and outsourcee are connected.
For example, lets say Company A is subcontracting to Company B and these two companies are connected as they are controlled by the same person. To maximise the amount Company A can claim, Company B may pay a greater amount of salary to a technical shareholder instead of paying a dividend.
A company and a subcontractor/EPW may jointly elect in writing to HMRC to be treated as being connected although they are not. All payments under the arrangement will be treated as being made amongst connected parties. This election must be made within two years of the end of the claimants accounting period in which the arrangement is made. This would be used when the claimant knows that the subcontractor/EPW has relevant costs more than 65% of the payment, so it can claim more R&D costs.
Consumable costs are expenses relating to items that are consumed or transformed in the research and development process including qualifying indirect activities.
These costs include electrical parts, chemicals and general materials such as plastic, metal, screws, nuts and bolts. As examples, a claimant developing:
Consumables include utilities costs such as heat, light and power, which can be a high cost for manufacturers.
There is a restriction for claiming for consumables when the consumables are included in a product and then this product is sold.
As an example, a customer has requested a machine manufacturer to create a bespoke machine. The creation of this machine meets the requirements of a qualifying R&D project. This machine is created using a trial and error process. If some part of the machine does not work in the testing phase, the engineers remove this part and replace it with another.
Once the machine is built, it is then sold to the customer. In this case, the materials that are still in the machine cannot be claimed as a consumable as the building of the machine is treated as production and not development. The staff costs and outsourcing costs will still qualify. The materials used and replaced can however be claimed as consumables as they were consumed in the R&D and transformed and they were not sold.
The costs of software that is used in research and development can be claimed. An example is claiming costs of CAD to design prototypes. The cost of software that is used or integrated into a new software platform such as a SAAS can also be claimed.
The cost of paying participants of clinical trials is the least common of qualifying costs and restricted to the pharmaceutical industry.
Large businesses are allowed two further categories of qualifying expenditure:
The research must meet the criterion that it is connected to the trade of the claimant funding the research or to a trade that the claimant may conduct in the future based on the research. The independent researcher or subcontractor must not be connected with the claimant and it cannot engage or subcontract to a third party to undertake the research.
The R&D costs may not all fall within qualifying activities and therefore the costs can be apportioned – this will be common for staff costs, consumables (utilities), software. The apportionment does not have to be exact and can be calculated on a reasonable basis. For example, utility costs and be apportioned based on qualifying staff costs divided by total staff costs.
Staff costs can be apportioned using a pragmatic approach. For example, if a developer spends approximately 70% of the accounting period undertaking a qualifying R&D project, then this can be claimed. HMRC will not expect to receive the exact time spent on development nor any timesheets. The technical R&D report must however be able to justify the time claimed.
On a final note, although capital costs cannot be claimed within the R&D tax credit claim (apart from some software developments costs as mentioned above), companies may be able to claim these costs under a special capital allowance (CA) known as research and development capital allowances (RDAs). Under normal circumstances, 18% of expenditure can be claimed under CAs but with RDAs, the company can claim 100% of the cost. More information can be found on HMRC’s website.
In summary, it is important to establish the costs that a claimant can claim in an R&D tax claim to avoid HMRC enquiries and to maximise the claim. It is essential to distinguish between an EPW and subcontractor and be able to identify connected parties.
Once you have identified the qualifying costs, you will need to know the process of claiming. We shall cover this in Part 4 – How to claim R&D tax credits.
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