WHAT ARE R&D TAX CREDITS?

R&D tax credits are designed to reward companies that invest in research and development (R&D) by providing additional tax relief. The regime is currently in a transition period as it is moving to a mainly merged scheme which will eventually mean most companies will access relief in the same way, though there is a very restricted special scheme for some small and medium-sized enterprises (SMEs) regardless of size. The old rules apply to accounting periods beginning before 1 April 2024, namely for: 

• deductions for qualifying expenditure which reduce a profit-making company’s tax bill by up to 24.7% for SMEs 

• the option to receive a cash payment in the form of a tax credit by giving up losses which were created in the period when the R&D expenditure was incurred. HMRC calls this “surrendering losses”. The credit can reduce the company’s PAYE tax and NI bill by an amount equal to 14.5% of losses. From April 2021 this was capped to a maximum of £20,000 plus three times the company’s PAYE and NI liability for the year. 

The second form of tax relief is attractive to newly formed companies and those that are yet to make a profit from their R&D projects. 

SMEs are also able to obtain relief for R&D expenses incurred before trading begins and even receive payments of tax credits, provided conditions are met. 

For accounting periods starting on or after 1 April 2024, it is no longer necessary to distinguish between SMEs and large companies in most cases. The merged scheme is modelled after the Research and Development Expenditure Credit (RDEC), which is what large companies, and smaller companies not eligible for the SME scheme, accessed relief through before that date. 

It is not simply a case of identifying R&D expenditure in the company’s accounts and claiming R&D tax credits on that amount. The definition of what qualifies as R&D is narrower than the normal accounting definition, so additional work will always be needed to enable a claim to be made and accepted by HMRC. 

Once qualifying R&D expenditure has been identified, the first step is to determine whether the accounting period it is relevant to begins before 1 April 2024. If so, the amount and type of relief claimable depends on the nature of the company claiming it. SMEs can claim a higher rate of R&D tax credits than large companies.  

Finally, it’s worth repeating that R&D tax credits are only available to companies. However, there are some R&D incentives for unincorporated businesses; they may be able to claim a special rate of tax relief for capital expenditure on equipment or buildings used for R&D projects. 

HOW IS AN SME DEFINED FOR THESE PURPOSES?

SMEs qualify for higher credits pre-1 April 2024 

To be an SME for R&D tax purposes, a company together with its partner or linked enterprises must have fewer than 500 employees and meet one of the following criteria: 

• annual turnover no greater than €100m (about £87m) 

• balance sheet total (i.e. the total value of its assets) no greater than €86m (about £75m). 

So if either of the limits, turnover or balance sheet total is exceeded, the company will not be regarded as failing the SME test. 

Except in a company’s first year of activity the criteria must be met for two consecutive years for the company to be accepted as an SME. If the company does not meet the SME criteria, it’s regarded as a large enterprise. Once a company’s status as an SME is established, it will not usually change unless it fails to meet the SME criteria for two consecutive years. 

If the company becomes large, it can’t revert to being small or medium-sized until it has met the SME criteria for two years. 

These criteria apply to a company that is engaged in economic enterprise. Therefore, a company that has not yet begun to trade may qualify as an enterprise for the purposes of R&D tax credits. 

There is an exception to that rule which applies where an SME company acquires a partner or linked enterprise and it already counts as a large enterprise. 

 

Linked enterprises 

Two companies will be regarded as linked if one can exercise direct, or indirect, control over the affairs of the other, or if both companies are under common control (of another person or persons, including companies or individuals). In this case the financial ceiling tests are applied to the aggregates of the figures in its own account and those from all other enterprises to which it is linked. 

Where companies are linked, the tests apply to their total staff and turnover or balance sheets as appropriate. 

Example  

HAL plc has 200 staff and a turnover of £40m in the year ended 31 March 2024. At the year end its balance sheet totals £25m. 

HAL owns 51% of the share capital of Dave Ltd and so controls Dave. Dave has 150 staff and a turnover of £25m in the year ended 31 March 2024 for which its balance sheet total is £60m. 

The staff ceiling is not breached and it’s clear that although the balance sheet test is failed, the turnover test is not. Therefore, for the year ending 31 March 2024 HAL and Dave meet the SME test. 

 

Partner enterprises 

 

Companies that are not already linked enterprises are partner enterprises if one of them holds on its own or in combination with other enterprises with which it is linked, 25% or more of the capital or voting rights in the other.  

The ceiling tests are applied to figures based on the accounts of the enterprise plus a proportion of the figures from the accounts of any partner enterprise. 

Example  

Nosy Ltd has 200 staff and a turnover of £40m in the year ended 31 March 2024. At the year end its balance sheet totals £25m. 

Nosy owns 40% of the share capital of Parker Ltd and so does not control Parker. Parker has 150 staff and a turnover of £25m in the year ended 31 March 2024. At the year end its balance sheet total is £60m. 

Therefore, 40% of Parker’s headcount, turnover and balance sheet total must therefore be aggregated with Nosy’s when applying the ceiling tests. 

WHAT CHANGES HAVE BEEN MADE IN RECENT YEARS?

Increased relief 

From 1 April 2015 the additional tax deduction for R&D expenses available to SMEs was increased from 125% to 130%. So, for example, a company which qualifies for R&D relief on expenses of £8,000 will be entitled to a tax deduction of £18,400 (230% of the qualifying R&D expenditure). 

Loss-making companies are able to surrender their losses for payable tax credits. The rate of payable tax credits for losses surrendered by SMEs increased to 14.5% as of April 2014. From April 2021, the repayable credit is capped at three times the company’s PAYE and NI liability for the year plus £20,000. 

From 1 April 2013, HMRC introduced Research & Development Expenditure Credit (RDEC) for large companies. It sat alongside the existing Large Company R&D Scheme until 1 April 2016, when the Large Company R&D Scheme was closed. RDEC is generally more financially rewarding than the Large Company R&D Scheme as more relief is available. From 1 April 2020 the RDEC relief increased to 10.53%. 

For accounting periods commencing on or after 1 April 2023, the SME additional deduction was cut to 86%, the SME repayable credit rate was cut to 10%, and the RDEC credit rate increased to 20%.The net tax reduction increased from 10.53% accordingly, but the exact amount will depend on what the company’s effective rate of tax is following the increase in the main rate of corporation tax from April 2023. 

Expenditure on consumable items on or after 1 April 2015 are not allowable as R&D if: 

• the R&D is for an item being produced or the process of producing an item 

• the consumable items form part of the item produced 

• the item is sold for money or money’s worth; and 

• the consumable items form part of the item produced. 

 

Introduction of cap for credits 

The 2018 Budget and subsequent Finance Bill changed that the way repayable tax credits for SMEs work for accounting periods starting on or after 1 April 2021.  

Originally, the tax credit an SME could claim was unrestricted. From 1 April 2021, the payable R&D tax credit is capped at £20,000 plus three times the loss-making company’s PAYE/NI bill for the accounting period. Any excess losses must be carried forward and offset against future profits which may take considerable time.  

 

Further changes 

For accounting periods beginning on or after 1 April 2024, a merged scheme applies to all companies, other than loss-making “research-intensive” SMEs. The scheme is broadly similar to the RDEC, with some minor differences. 

Significant changes have been made to what expenditure on subcontracted R&D work, or externally provided workers apply from 1 April 2024. In terms of administration, changes have also been made. There is now a requirement for an additional information form (AIF) to be submitted before, or alongside, a claim. Failure to do this will result in the claim being automatically rejected. For further information, see https://tinyurl.com/detailedinfoform. 

For accounting periods beginning on or after 1 April 2023, claimants (or their agent) must notify HMRC of the intention to make a claim where it is the first claim to be made, or there has been a particular time period elapsed since the previous claim. For further information see https://tinyurl.com/intentiontoclaim.

HOW DOES RELIEF WORK PRE-APRIL 2024?

Tax deduction for small and medium-sized enterprises (SMEs) 

The basic R&D tax credit claimable by SMEs is a 130% addition to the amount of qualifying expenditure. Thus, 230% of the qualifying expenses incurred for R&D projects can be deducted for tax purposes. Where this augments or results in a loss, a company can claim a “payable tax credit”. 

Note. For expenditure incurred on or after 1 April 2023, the tax credit is cut to 86%. It is essential that the accounting period being claimed for is identified to ensure the correct amount of relief is applied.  

 

Payable tax credit for loss-making companies 

Where an SME company makes a trading loss for the period for which it submits an R&D claim, it may also claim a payable tax credit. To qualify a company must be a “going concern” at the time it makes the claim (see below) and not in administration or liquidation.  

If the SME has not started to trade, the R&D relief may create a deemed loss for that pre-trading period. This deemed loss can also qualify for a payable tax credit. 

The payable tax credit carries a lower benefit in simple cash terms than carrying the loss forward to use against future profits, but can be advantageous to a company in need of a cash-flow boost. 

 

Surrenderable loss 

We have set out below two examples of how R&D tax credits can be used by companies which have surrenderable losses.  

The surrenderable loss is the lower of the: 

• unrelieved trading loss for the period including the R&D relief (130%); and  

• enhanced R&D qualifying expenditure (230% of R&D costs). 

The unrelieved trading loss is a result of deducting the full qualifying R&D expenditure from the trading loss and then this loss being utilised against any other income or gains in the current or previous accounting period. 

 

Amount of tax credit 

For expenditure incurred after 31 March 2016, the maximum payable tax credit is equal to 14.5% of the qualifying loss, or 33.35% of the qualifying expenditure. However, it is capped to £20,000 plus three times the PAYE and NI liability for the year (since April 2021). 

But the amount claimable for R&D credit might be restricted to the extent that the loss was available to be used by the claimant company. 

Example 1 

Spud Computing Ltd is an SME which had the following results for the year ended 31 March 2023, before it made an R&D claim: 

	£
Trading loss excluding R&D costs	100,000
Qualifying R&D expenses	50,000
Capital gain	10,000

 

Spud Computing makes an R&D claim for the year ending 31 March 2023, which results in the following loss: 

	£
Trading loss	100,000
Additional R&D relief: 130% x qualifying R&D expenses	65,000
Loss after R&D claim	165,000
Loss set against capital gain	(10,000)
Unrelieved loss	155,000

The loss that can be surrendered for a repayable tax credit is the lower of the: 

• unrelieved loss: £155,000 

• R&D relief obtained: £115,000 (£50,000 x 230%). 

Spud Computing Ltd can go on to claim the payable tax credit of 14.5% of the qualifying loss, but this is capped to the total amount of PAYE and NI paid for the payment periods ending in the year to 31 March 2023, so this would need to be checked before claiming. 

 

Example 2 

Where Spud Computing Ltd claimed payable tax credits it would receive a repayment of £16,675 (14.5% x £115,000), which is also 33.35% of the qualifying R&D expenses of £50,000. 

This gives the company a short-term cash flow boost of £16,675.  

However, the overall effect of claiming payable R&D tax credits would be to change the company’s final tax computation for the year as follows: 

	£
Unrelieved loss	155,000
Disallow losses used for R&D payable tax credit	(115,000)
Adjusted loss to carry forward	40,000

 

Although Spud Ltd has obtained an immediate cash-flow benefit of £16,675, it has also given up the potential benefit of using £115,000 of its loss in a future period. If this loss had been retained, it would be available to reduce future profits, saving corporation tax at, say, 19%, being tax of £21,850.  

This loss carried forward only has value to the extent that it can be used against future profits. If a company doesn’t expect to make enough profits to use the losses brought forward in the next few years, the benefit of a near immediate cash refund in return for surrendering a loss looks more attractive. 

Note. For periods beginning on or after 1 April 2023 and before 1 April 2024, the payable tax credit rate was cut to 10%. This would change Spud’s repayable credit calculation as follows: 

Example 

The loss that can be surrendered for a repayable tax credit is the lower of the: 

• unrelieved loss: £155,000 

• R&D relief obtained: £93,000 (£50,000 x 186%). 

Spud Computing Ltd can go on to claim the payable tax credit of 10% of the surrenderable loss, i.e. £9,000 (£90,000 x 10%).

 

Going concern 

An SME can only obtain a tax credit or claim relief for pre-trading expenditure if it is a “going concern” at the time it makes its claim. Going concern is a term used by accountants to describe a company which can continue to operate for the foreseeable future without being required to cease trading or go into liquidation. Broadly, it must be solvent, i.e. able to pay its bills, when it makes an R&D claim with no predictable reason why it will cease to be so. 

A company’s published accounts, as submitted to Companies House, will normally be prepared on a going concern basis. Where the company is audited, the auditor’s report will state whether the company is judged to be a going concern. HMRC will also look at the directors’ report, which must form part of the full accounts. If either the auditor’s report or directors’ report suggests that the company’s going concern status depends on it receiving R&D tax credits, those payable tax credits will not be given.  

 

Conditions applying for SMEs 

To qualify for R&D tax relief for expenditure on an R&D project, the company and project must meet the following conditions: 

1. The R&D undertaken must relate to a trade carried on by the company. 

2. The expenditure must be treated as revenue expenses for accounting purposes, not capital expenditure. 

3. The company must not receive notified state aid or grants in respect of the R&D project. 

4. The SME must not be carrying out the R&D work as a subcontractor of another SME. 

5. The R&D project must not result in total tax relief of more than €7.5m (about £6.5m).  

WHAT ABOUT POST-APRIL 2024?

Single scheme (mostly) 

 

For accounting periods starting on or after 1 April 2024, a new merged scheme has been introduced. Again, it will be crucial to check the start date for the accounting period a claim relates to. 

Under the merged scheme, relief is given as an above-the-line credit (as with RDEC). This is added to income when working out the profit or loss, and then deducted from the corporation tax (CT) liability. To work out the credit, use the following step-by-step approach: 

1. Work out the expenditure which is directly attributable to R&D, which includes both direct R&D and qualifying indirect activities. 

2. Exclude any data and cloud computing costs attributable to qualifying indirect activities. 

3. Exclude any contract or externally provided worker payments attributable to R&D taking place abroad, unless an exemption applies. 

4. Reduce any relevant unconnected subcontractor or external staff provider payments to 65% of the original cost - restrict any payments to connected contractors or staff providers, if the law requires it. 

5. Add all these costs together to get the qualifying expenditure. 

6. Multiply the qualifying expenditure by the credit rate (currently 20%) to get the R&D expenditure credit amount. 

Example - company with profits 

Taters Ltd is preparing its claim for the year ended 31 March 2025, and has summarised the allowable expenditure relating to R&D as £1.5 million. Its profit for the year before including the claim is £3.2 million. The merged scheme credit is £300,000, which increases the taxable profits to £3.3 million. The CT charge is therefore £825,000, but the credit reduces this to £525,000.  

This example is relatively simple as we have assumed there is only one company, and only trading profits with no other tax liabilities outstanding, etc. Nevertheless, there is a strict order for offsetting relief: 

Step 1. The credit is first applied to the CT liability for the same accounting period. This may reduce the amount payable or generate a refund if the liability has already been paid. If this step utilises the credit in full, there is no need to go to the remaining steps. This was the case with Taters.  

Step 2. Compare the unused amount from Step 1 to the “net amount of expenditure credit” that has been claimed. The lower figure is then carried forward to Step 3. The “net amount” is the figure claimed, less notional CT at the applicable rate. The applicable rate is 19% if profits (excluding the R&D credit) don’t exceed £50,000 (including where the company is loss making), and 25% if they do.  

Step 3. Compare the amount from Step 2 to the merged scheme PAYE cap (unless the company is exempt), which is based on the old SME scheme, i.e. 300% of the PAYE and NI costs for the year plus £20,000. The amount up to this cap can be carried down to Step 4, but any excess carries forward as R&D credit for the next year, even if there is no R&D activity in that year. 

Step 4. The amount carried down from Step 3, i.e. up to the PAYE cap, is now applied in discharging any outstanding CT for any other accounting period, i.e. amounts already assessed but not yet paid. 

Step 5. Any amount remaining after settling other CT liabilities at Step 4 can be wholly or partly surrendered to offset the credit against the corporation tax liability of a company in the same group (where applicable). This step is not obligatory. Any amount not surrendered carries down to Step 6. 

Step 6. Any amount remaining at this stage must be used to pay any other company tax liabilities, e.g. VAT, amounts due under PAYE, amounts due under a contract settlement, etc. Any amount remaining carries down to Step 7. 

Step 7. Any amount remaining can be paid to the company, subject to the company being a going concern at the time the claim is made. This won’t be the case if it is in administration, or the accounts suggest that it is relying on receiving the payment of the R&D credit to continue. 

 

Separate scheme for some SMEs 

Where an SME qualifies as “R&D-intensive” and is loss making, it may be able to access Enhanced R&D Intensive Support (ERIS). Under ERIS, the old SME methodology continues, i.e. relief is based on enhancing the amount of expenditure rather than an above the line credit.   

The SME must be loss making before adding the enhancement. 

To qualify as “R&D-intensive”, the company’s relevant R&D expenditure in a period starting on or after 1 April 2024 must be at least 30% of its total relevant expenditure, plus that of any connected companies.  

Where the condition is not met for a period, but was in the preceding period, a period of grace election can be made. Note that a claim under the old SME scheme is sufficient to enable an election. 

The applicable rate for the enhancement is 86%, but the repayable credit rate has been retained at 14.5%, i.e. the rate that applied to SMEs before the reduction from 1 April 2023.