Few people are aware that there are any risks associated with making claims for their research and development (R&D) projects. But the risks are there, and with the Inland Revenue and Customs & Excise now a joint force, many businesses face the very real possibility that severe penalties will be imposed for over-claiming.
More than ever, having the right supporting information is essential to substantiate a claim. Without it, a business risks being penalised for the amount that it cannot justify. So, as well as not getting the R&D tax relief it thought it was due, the business would actually have to pay the Inland Revenue the amount that had been rejected.
This has serious implications for R&D investment levels in the UK, since the knee-jerk reaction of many businesses will be only to submit claims that they know can easily be defended. This will in turn introduce a risk of under-claiming. This double-edged sword would effectively render the UK R&D tax incentive pointless, if it were not for the assistance of specialist claim experts.
Does the financial controller really need outside help?
R&D tax relief claims are relatively straightforward to apply for - a few simple entries on a company self-assessment tax return and it is done.
Or so a financial controller may believe.
While there are some complex tax rules, in general the most confusing question for many people is 'What constitutes R&D for tax purposes?' There are many issues to consider here, not least defining the cut-off point of experimental development. This is an essential task, as any work after this point is almost certainly going to be product development, and thus not an eligible cost for R&D tax relief.
It is this grey area that is hard to work in, and where R&D tax recovery specialists really earn their keep. Only by having a fundamental understanding of the science and technology, together with the numerous precedents that have been set for R&D tax relief claims, can claims be maximised while also minimising the risk of penalties. Many projects may be incorrectly identified as eligible by the inexperienced claim preparer. These projects will often show a distinct lack of technology advance or technology content, and will err more on the side of 'commercial firsts' for a technology area. For example, being the first to come to market with a hosted ISP solution might not be an eligible R&D tax project if it was known with certainty from the outset that combining the various component technologies would achieve a successful result.
Many large organisations give responsibility for collecting the necessary R&D tax claim information to the group financial controller. However, the time of these individuals is constrained, and they will only be able to allocate a low budget to what they believe is a low risk and reward financial task. Often they will just circulate an e-mail to company divisions requesting that the local financial controllers submit their R&D number to head office (enclosing the DTI guidelines on R&D for tax purposes for further help). Mistakenly, they believe that it is everyone else's responsibility to know what R&D is.
Ultimately, this approach will not yield results, since most local financial controllers will have little idea of their businesses' own eligible R&D tax projects. In fact, they will probably not even have time to read the countless pages of guidance. They will simply report back to head office with a number, having run as close as possible to the deadline, leaving the group financial controller with no choice but to consolidate the results and submit the claim.
The group financial controller will have an extremely hard time justifying the figure to the tax authorities if the claim is audited. With no consistent definition on what R&D for tax purposes means within the various businesses of the group, the claim is completely unsupportable.
Successful R&D claims help more accurate budget forecasts
Within a typical consulting project delivered by claim experts, the time spent splits three ways, with 45% for project management, 45% documenting the technology projects with the technology officers, and the final 10% spent with the accounts teams.
UK financial directors have choices to make over the recovery of R&D tax. Should the company continue handling the claims in-house? Should it use its existing auditors or should it turn to R&D tax recovery specialists?
The balance on minimising the risks is heavily tipped towards using a specialist.
For example, my own organisation helped one of our clients, KWI - a leading provider of energy trading and risk management software for the global energy industry - to secure a significant injection of funds through the R&D tax credit. At the same time, we were able to agree an approach with the Inland Revenue for future submissions for R&D tax credits. This will now help KWI to forecast its investment requirement for R&D in the UK more accurately, and to retain much of its development work in the UK, rather than outsourcing it overseas.
Our assistance was required when, upon submission of its claim for R&D tax credits, the Inland Revenue disputed that any of KWI's software developments qualified for tax purposes.
It is important to understand that the R&D tax incentive was designed to reward UK businesses whose scientific and technological advances would bring social and economic benefits to the rest of the UK. Put bluntly, this means that the Government would rather not reward financial institutions for technology advances that will, in the main, remain within those types of organisations. So the mere mention of trading and risk platforms will result in immediate and intense scrutiny for this type of claim. KWI was one such claimant. But banks and trading houses will almost certainly be significant developers of new internal software systems that still contain eligible R&D tax projects. So what can they do to defend their position?
As with all claims, the crux of the argument will be whether there are clearly identifiable technology projects that are eligible for tax purposes.
An eligible R&D tax project must demonstrate three simultaneous components to. For a successful, defensible claim, projects must show:
- a scientific or technological advance
- scientific or technological uncertainties in seeking the advance
- that the research and experimental development is carried out systematically with scientific or technology content.
In KWI's case, future strategic decisions with serious ramifications, hinged on whether its UK software development qualified for R&D tax credits.
Without the credits, it was likely that KWI would no longer retain a development team in the UK, and would outsource the remaining R&D functions to a more cost-effective centre, such as India.
We defended KWI's case with the Inland Revenue, starting with an open forum discussion involving key Inland Revenue tax inspectors, KWI's senior technologists, and RDCL's technologists and tax experts. These discussions enabled the Inland Revenue to fully understand the real concerns about KWI's claim. Specific technology concerns were identified, rather than remaining at a high level of claim rejection solely because of the industry sector to which the software advances had been applied. In other words, the eligible R&D projects could equally have been employed in other areas.
The Inland Revenue then opened up the possibility of a negotiated settlement as a pragmatic way to resolve the debate - an approach not uncommon in a situation where the question of when a technological uncertainty was resolved is open to a degree of interpretation. The alternative would have involved a hearing for KWI at the Special Commissioners, where the outcome would have been uncertain for both the Inland Revenue and KWI.
The open discussion was able to agree a future approach to KWI's R&D tax credit claim write-ups that would allow the tax inspectors to focus future questions in a specific manner.
Thus the open partnership approach to working with the Inland Revenue helped a UK business keep its R&D investment in the UK.
- Michael Cradock is director, RDCL, Tel: 020 7060 2121, IR GUIDELINES
The Inland Revenue says that the aim of the tax credits is to encourage greater R&D spending in order to promote investment in innovation. Between April 2000 and December 2004 around 13,000 claims for R&D tax credits were made, with around £700m of support provided.
The R&D tax credit works by allowing companies to deduct up to 150% of qualifying expenditure on R&D activities when calculating their profit for tax purposes. Companies which are SMEs can, in certain circumstances, surrender this tax relief to claim payable tax credits in cash from the Inland Revenue.
WHAT IS R&D FOR TAX PURPOSES?
Broadly, the guidelines provide that a project which seeks to, for example ...
(a) extend overall knowledge or capability in a field of science or technology; or
(b) create a process, material, device, product or service which incorporates or represents an increase in overall knowledge or capability in a field of science or technology; or
(c) make an appreciable improvement to an existing process, material, device, product or service through scientific or technological changes; or
(d) use science or technology to duplicate the effect of an existing process, material, device, product or service in a new or appreciably improved way (for example, a product which has exactly the same performance characteristics as existing models, but is built in a fundamentally different manner) ... will be R&D for tax purposes if the project seeks to achieve an advance in overall knowledge or capability in a field of science or technology, not a company's own state of knowledge or capability alone.
WHAT COSTS QUALIFY?
Companies can claim R&D tax credits for their revenue expenditure on:
- employing staff directly and actively engaged in carrying out R&D
- paying a staff provider for staff provided to the company who are directly and actively engaged in carrying out R&D
- consumable or transformable materials used directly in carrying out R&D (broadly, physical materials which are consumed in the R&D), and
- power, water, fuel and computer software used directly in carrying out R&D.
There are special rules regarding expenditure on sub-contracted R&D, which differ between the SME and large company schemes. And there are rules which mean that in some cases projects which benefit from a subsidy or grant may have the amount of qualifying expenditure reduced.
HOW MUCH CAN A COMPANY CLAIM?
Claims can only be made in respect of the qualifying expenditure shown above, and there must be qualifying expenditure of at least £10,000 on R&D in the company's accounting period for a claim to be made. There is no upper limit on the claim.
The R&D tax credit works by allowing companies to deduct 150% (under the SME scheme) or 125% (under the large company scheme) of qualifying expenditure on R&D activities when calculating their profit for tax purposes.
Full details of the R&D tax credit legislation are provided in the Inland Revenue's Corporate Intangibles Research and Development (CIRD) manual.
Guidelines which comprise the definition of R&D for tax purposes are published by the DTI.