Client-led R&D - is it subsidised or not? James Geary of Randall and Payne
Research & Development (R&D) Tax Relief has been around for over two decades and is now a firmly established part of the UK Corporate Tax system.
Over its lifetime it has helped to encourage innovation in countless companies ranging from small start-ups to large, established public companies. Total relief given by the government since the schemes began is approaching £40 billion.
As reported in previous articles, the government is currently conducting a wholesale review of the R&D schemes to ensure they are still meeting their policy objectives.
Both our firm and the committees I am involved in via the Chartered Institute of Taxation have taken an active role in collaborating with them, including feeding back real life experience and issues to help shape any changes.
However, as with many reliefs of this kind, we do occasionally see patterns shifting with interpretation of various aspects, and currently we are seeing some unwelcome movement in the HMRC approach to clients who conduct R&D which specifically relates to a client.
Previously understood position
Where a company either carries on R&D that is subcontracted to it (i.e. the contractor company owns the R&D and the knowledge created by it, but has outsourced it) or subsidised (so someone is funding the costs of carrying out the R&D), the claiming company has to use the less generous R&D Expenditure Credit scheme (RDEC) which provides a taxable credit of 13 per cent of the costs incurred.
However, there are grey areas of interpretation here, such as so called "commercial R&D". Take for example a company that has been asked to provide a piece of software for its client that carries out a particular function. That functionality and capability does not exist currently, so the company is required to carry out R&D to make that possible.
The client has asked for a piece of software, they have not asked for some R&D to be conducted. The fact that the company has to carry out R&D to be able to deliver that software does not make the R&D subcontracted.
Furthermore, the R&D, in order to be qualifying for relief, must involve significant technical uncertainties, making it impossible to precisely predict the amount of time that goes into it. Therefore, while the amount the client is paying may well have enough inherent profit to cover any unanticipated time spent, the commercial profit on the contract is eroded as a result. So the company is taking significant risk in undertaking the project.
This has been the long understood position with R&D - if development time was specifically charged for to the client by the hour, then clearly we are dealing with subsidised R&D, but without that, the rules should not apply.
Enter HMRC's new approach
In recent months, we are hearing about a lot of HMRC challenges to the previous understood position above. They are looking to reclassify such arrangements as the above as "subsidised" or "subcontracted" R&D, regardless of any specific contractual arrangements or commercial profit margins. The attitude seems to be that the client is paying for the service, and despite the disconnect between a commercial contract for provision of a service and any company investment in R&D to enhance its knowledge to be able to deliver it (and indeed to reuse that knowledge going forward), to treat this as fully subsidised R&D.
To put it into context, the more generous SME (small and medium sized enterprise) R&D tax credit scheme is worth approximately three times the RDEC.
If this interpretation were correct, then the only R&D that would qualify for the SME scheme would be "blue sky" R&D to develop a new product or service, before any potential customers are identified.
This approach would invalidate a very high proportion of current and historic SME claims.
So which is correct?
Those of us in the profession are strongly backing the long understood provision; not only on technical grounds, but also because it backs up the policy intentions of the scheme to encourage R&D activity within UK industry.
But it is crucial that companies claiming the relief have their eyes open to the risks and have the information to make their own informed decision about what and how they claim. After all, there has always been a bit of a blurred line between funded and non-funded R&D, even if HMRC are currently arguing that this line is in a different place than we have always believed it to be.
We would therefore urge all companies carrying out R&D specific to their clients to speak to their R&D advisers to make sure they are comfortable with their claims position, or at least aware of the magnitude of any potential risks should HMRC select them for enquiry.
With HMRC having taken on more than 100 new compliance staff to their R&D section in the last year, we do expect to see increased numbers of enquiries in the next few months and years, and while we always hoped this activity would be focussed on the more spurious and unjustified claims prepared by unregulated advisers, this issue does raise concerns that client-led R&D could start to come a lot more frequently under the spotlight.
For our clients we strongly recommend signing up to our Tax Investigation Service, as this will ensure that our professional fees in dealing with any enquiries are insurance backed, giving our clients peace of mind that if HMRC enquire there will not be significant professional fees involved.
We offer an hour-long advice clinic free-of-charge to assess your circumstances and let you know the best way forward. www.randall-payne.co.uk.
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