Lifecycle of a tech startup series: R&D tax relief

Episode 9

12 January 2022

Having raised £500,000 and, in episode 8, hired a software developer, KNow Wear Limited is starting to flourish. As Ben Franklin wrote when the USA was in its infancy, nothing is certain except death and taxes. Knowledge of the UK tax system is valuable for any UK business owner, start-ups can dramatically improve their chances of success by ensuring they claim the various tax reliefs and incentives available. Episode 4 looked at the valuable tax reliefs a company can offer its investors, your focus today is on the tax relief (or repayment) available to companies carrying out research and development activities.

At its most basic level, business expenses reduce taxable profits. A business might generate £1m of turnover but that is not the figure a company pays corporation tax on, it can (for example) deduct its staff salary costs (amongst very many other things) before reaching the taxable figure. Expenditure on research and development activities (“R&D”) can provide an enhanced reduction in taxable profits (greater than the cost of those R&D activities), or it can provide for a payment from HMRC in the event you are loss making or not sufficiently profitable to need the full reduction in taxable profits (and therefore corporation tax). Many startups who don’t expect to be profitable for some years make a repayment claim to obtain further capital to support them in their early years.

While you want to focus on your business and products, you know you can’t ignore your expenditure on R&D for too long if you want the advantages offered, as relief must be claimed within two years of the accounting period to which the expenditure relates or the relief / repayment is lost. Legitimately reducing your tax bill or securing a payment from HMRC can be at least as important as bringing in a new investor (especially given you don’t need to give over equity!). 

What do I qualify for?

Your first task is to identify what sort of relief or repayment you could get, which is based on the size of your company. Your company comfortably qualifies for the (greater) relief for small and medium sized enterprises (“SME”s) as opposed to the credit for larger companies. The test to qualify as an SME is:
  1. Do you have fewer than 500 staff; and
  2. Do you have a turnover of 100 million Euros or less; or
  3. Do you have a balance sheet of 86 million Euros or less.
The first condition must be met and at least one of the next two conditions met. In your case, and in the case of the majority of relatively new startups, all three conditions are very comfortably met.

 

What is meant by “research”?

Your next question is, what is “research”? You are wondering if the salary costs of the new software developer (and Sarah, who both develops and will manage the new employee) will qualify for relief. The first project, which will fill all their time (and Chris’s time), will be developing a new, non-invasive, blood glucose measurement system for your wearable. You have also hired a multi-talented general support person responsible for many things including maintenance, IT, building management etc. 

You are able to claim against the full cost (salary, employer NIC and pension contributions) of the new developer, Sarah and Chris (both for Sarah’s development time and time spent managing the new developer) while they are working full time on this new tech, but you cannot claim for the entirety of the salary costs of the support person. What you can claim follows accounting standards, but as an example, the cost of their time spent fixing and maintaining the machinery for Chris would be allowable, while the time spent preparing a dilapidations report for the building’s landlord would not. This person is an example of someone carrying out qualifying “indirect” activities (ie activities that aren’t directly related to the R&D) and it would also include other indirect supporting activities such as clerical, personnel and finance activities, so far as they directly relate to the R&D. The cost of your time spent hiring the new developer also counts (for example).

You can also claim for the cost of materials employed in creating prototypes / running tests etc (provided you don’t go on to sell these prototypes) and you can claim for the utilities used in the research (which may be a proportion of a wider bill, for example a single electricity bill for the business might be apportioned 60% to those carrying out qualifying activities and 40% to others). You can claim for the initial feasibility study into the blood glucose monitoring system. You cannot claim for capital expenditure such as acquiring a property.

The law on what is considered research refers to accounting standards but is also further restricted by the requirements of the Department for Business, Energy and Industrial Strategy (“BEIS”) whose requirements carry the force of law. FRS102 defines research as “Original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding”. 

 

What happens if we discover it doesn’t work?

Research does not need to be successful for expenditure on it to qualify, knowledge can still be furthered by learning what does not work. There needs to be some innovation for a cost to gain relief though, as opposed to repeating an existing process (unless that process is not public knowledge, for example a trade secret). 

 

Does our development have to be entirely unique?

Relief is generally not available if you are copying another’s available research. In your case, while various glucose monitoring technologies already exist, no one has tried to do it your way. As your method of measuring glucose is new, your claim should satisfy the requirements (despite the end result being the same as what others may already have achieved in a different way). Whether something classifies as sufficiently different to existing processes can sometimes be unclear. Following another’s design but painting your product red instead of blue would not count as innovation, measuring glucose via a laser as opposed to through analysing sweat should. The project must seek to achieve an advance in knowledge or capability in the field of science or technology. Activities must directly contribute through resolving uncertainty.

 

Is there any way to get certainty our project qualifies?

HMRC operate a clearance procedure for small companies (fewer than 50 staff and under £2m turnover) should you be in doubt as to qualification. These are submitted through the Government Gateway and the system will guide you as to what enclosures are required etc. If clearance (known as “advance assurance”) is obtained it blesses your first three claims.

 

What is R&D worth to your company?

Now you know that certain costs of your company qualify for enhanced relief, you begin to wonder about the value of this relief. You are aware it doesn’t matter that you haven’t yet started to trade, relief is available because you intend to trade eventually. A quick and rough calculation suggests you will incur around £210,000 of qualifying expense. It does not matter that the new software developer works some of the time from a second home in France, there is no geographical restriction. Instead of offsetting 100% of your costs as is normal, you are able to offset 230% of your qualifying expenditure against your taxable profits, potentially reducing your taxable profits by £210,000 x 2.3 = £483,000. At today’s corporation tax rate of 19% that could save £91,770 in corporation tax. Put another way, almost 44% of your qualifying costs are recovered through a claim. Making the R&D claim has saved you an additional £51,870 in corporation tax compared to if you did not know to make the claim. 

 

What if we have no profits to reduce?

You realise you don’t have any taxable profits to offset however, it could be some time before you have close to half a million of profits to offset and it would be very helpful to get some financial support now. You can claim a payment equal to 14.5% of your qualifying expenditure multiplied by 230%. This equates to £210,000 x 2.3 x 0.145 = £70,035. This is purposefully less than the benefit of offsetting against taxable profits, forcing a decision. A choice is required, would you rather be paid £70,035 when filing your corporation tax return, or wait to become profitable and reduce your tax bill by £91,770? 

You consider your capital requirements and the cost of funding and decide it would be better to receive a smaller payment sooner. Summarising the effect, you can claim a repayment equal to 33.35% of your expenditure, or a tax credit equal to 43.7% of your expenditure. Note the rates fluctuate regularly and this might soon be out of date.

 

Practical points
You notify your accountants of your research and development expenditure. Your accountants might be excellent, but they will need help from you to know what can be claimed (as they will not know what employees are doing). You ask them to ensure a repayment is claimed in your CT600 corporation tax return and work with them to complete an accurate and complete R&D report to accompany the return (as HMRC will open an enquiry in the absence of a report). HMRC aims to make payment within 28 days of receiving a claim, so you should receive your repayment quite quickly.

Want to carry out further research into R&D?
This is a brief summary, HMRC have produced a much fuller guide for startups in plain English, available here.

If you are interested in learning more, or about any of the many other tax efficiencies a start-up (or established) company should consider, please feel free to contact the author, Matt Spencer. Note R&D relief is a company relief. Sole traders or partnerships cannot take advantage of it.

Having secured an additional £70,035 of capital in the near future thanks to your R&D repayment claim, in the next instalment in our series your company looks to expand through overseas hires.

About the author

Matt is a partner within the Corporate and Commercial team, specialising in tax law, advising on and efficiently structuring a wide range of corporate and real estate transactions including M&A, land transfers, developments and leases.He is also expert in employment tax issues and the structuring of employee incentive schemes as well as VAT issues in the public and private sector. 

 

 

Lifecycle of a tech startup series

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