R&D Tax Credits Explained

Various incentive schemes exist to encourage UK companies to invest in innovation, including R&D Tax Credits. HMRC estimates that for every £1 forgone in tax, through Research and Development Tax Credits, £1.53–£2.35 is stimulated in R&D spend by UK companies.

What are R&D Tax Credits?

Research and Development Tax Relief schemes were introduced by the British government in 2000 for Small and Medium Enterprises and in 2002 for Large Companies with the primary goal of rewarding the companies operating within the UK and concentrating on investing in innovation.

Innovation helps businesses grow and subsequently take on more challenging projects. By encouraging companies to undertake innovative work, the UK government ensures growth in employment, stable tax repayments, and contributions to research and development activities.

How do R&D Tax Credits work?

When the company spends money on innovation, whether it is developing something new or improving an existing product, process, or service, it becomes a potential candidate for either a cash rebate or a reduction of the Corporation Tax paid (subject to the company’s financial position).

It’s also worth mentioning that the scope for qualifying projects under the R&D tax relief schemes can only be applied to the last two years.

For small and medium enterprises (SMEs): The R&D incentive comes in the form of a Corporation Tax (CT) tax relief that can reduce a company’s tax bill if liable for CT or result in a payable tax credit.

For large companies: The incentive is called Research and Development Expenditure Credit (RDEC), an above-the-line credit. It can either reduce their tax bill or allow them to claim a payable cash credit.

What counts as R&D?

HMRC has defined three main points that must be satisfied for the project to be deemed eligible:

  1. The activities undertaken during the project must be within a particular sector. It can be anything, starting from manufacturing and process engineering all the way to oil and gas, food processing, and software engineering.
  2. This project’s end goal should be an advance within that sector, such as:
  3. developing something completely new,
  4. appreciably improving the existing product, process, or service,
  5. or duplicating it.
  6. The project needs to have an element of technological or scientific uncertainty. This uncertainty could be due to various challenges like infrastructural constraints, architectural challenges, cost constraints, industry-related trends, etc.

SME R&D Tax Credits

As an SME, you can claim up to 27p for every £1 of qualifying spending. The exact percentage depends on the company’s financial position, i.e., profit or loss-making, and R&D intensity.

Here are the options:

  • If you make a profit per accounting period in question, your benefit will be up to 21.5p per every £1 of qualifying expenditure.
  • If you include the R&D benefit in your initial submission of Tax return, it will reduce the tax payable.
  • If you are amending your already-submitted numbers, then you will receive a cash credit.
  • If you are a loss-making entity, you could claim back up to 18.5p for every £1 of qualifying expenditure.

You can realise the benefit in four ways:

  1. Surrender the loss for cash tax credit at a rate of 10%
  2. Carry back and offset against prior years’ profits (to assist struggling businesses, the Government has now extended the carry back period for tax purposes from 1 year to 3 years for the claims between 1st April 2020 – 31st March 2022)
  3. Carry forward and offset against future profits
  4. Surrender it for group relief

Loss-making entities that have a high R&D intensity (40% or above of their expenditure is spent on R&D) are eligible for a higher payable credit rate of 14.5%. An R&D-intensive entity could therefore claim up to 27p in every £1 of qualifying expenditure.

How do R&D Tax Credits function?

When a company invests in innovation, whether by developing new products or enhancing existing ones, it becomes eligible for either a cash rebate or a reduction in Corporation Tax (subject to the company’s financial status).

It’s important to note that qualifying projects under R&D tax relief schemes are typically restricted to the last two years, in compliance with regulations regarding tax computation submission and amendment deadlines.

What constitutes R&D?

For HMRC to acknowledge an activity as innovative and thus eligible for R&D Tax Relief, it must meet specific criteria:

  • The project’s activities must pertain to a specific sector, ranging from manufacturing and process engineering to software engineering.
  • The project should aim to advance the sector, whether by developing something entirely new, significantly improving existing products or processes, or duplicating them.
  • The project must involve technological or scientific uncertainty, stemming from various challenges such as infrastructural limitations, cost constraints, or industry trends.

Which businesses can claim R&D tax credits?

Despite common misconceptions, all UK companies are eligible for R&D incentive schemes, with the definition of R&D intentionally broad to encompass diverse industries.

Determining a company’s eligibility for R&D Tax Credits involves relatively simple criteria:

  • The company must be a UK limited company subject to Corporation Tax.
  • It must engage in qualifying research and development activities meeting the specified criteria.
  • Expenditure related to these activities should be reflected in the financial statements.

Research & Development Expenditure Credit (RDEC)

The UK government incentivizes innovation through R&D tax credits, accessed by Large Companies via the RDEC scheme. This scheme offers a 20% pre-tax benefit for qualifying expenditure, empowering companies to reinvest in further R&D, talent acquisition, and business growth.

What does RDEC stand for?

Research & Development Expenditure Credit (RDEC) represents the R&D tax scheme tailored for Large Companies (and some SMEs, as detailed below).

The benefits of the RDEC R&D tax credit scheme come in the form of a reduced corporate tax bill or, under certain circumstances, a payable cash credit. Positioned as an above-the-line credit, it appears as income in the company’s Profit and Loss Statement (P&L), potentially influencing R&D investment decisions positively. Subject to a 25% corporate tax, the net benefit typically amounts to around 15%. Unlike its predecessor, the Large Company scheme, the RDEC scheme rewards even loss-making companies with a cash benefit.

The criteria for R&D in tax terms include:

  • Pursuing advancements in a field of science or technology.
    • These advancements could involve developing something entirely new, significantly enhancing an existing process or product, or replicating it with a different method, material, or from a competitor who has kept it as a trade secret.
  • Endeavouring to overcome scientific or technological uncertainties while pursuing these advancements—challenges that knowledgeable employees alone couldn’t resolve without thorough investigation.
  • Failure is inherent to R&D, so a project doesn’t have to succeed to qualify.

What is the RDEC rate?

Introduced in 2013 for Large companies, the RDEC scheme has seen progressive increases in its generosity since its inception. As of April 1, 2023, the RDEC rate stands at 20%, a significant rise from its initial rate. The benefit, reflected in the P&L, boosts EBIT earnings and improves financial standing. However, since the benefit is ‘above the line,’ it is subject to 25% corporation tax, resulting in an effective RDEC rate of 15%.

The benefit can offset against the company’s corporation tax liabilities or serve as a cash benefit, particularly for loss-making companies. Though the rate remains the same for both for-profit and loss-making companies, the method of receiving the benefit differs.

Some SMEs may also qualify under the RDEC scheme if:

  • R&D is subsidized.
  • State Aid has been applied for or received for the R&D project.
  • A large company subcontracted the R&D.

Companies can claim R&D tax relief for their last two completed accounting periods. After two accounting periods, back claiming for R&D undertaken is not possible, underscoring the importance of initiating the R&D tax claim process promptly.

How is RDEC calculated?

Companies qualifying for the RDEC scheme can claim 20% of their qualifying expenditure minus corporation tax, which stands at 25%. For example, if a company’s qualifying expenditure was £600,000, the calculation would be as follows:

£600,000 x 20% = £120,000

£120,000 – 25% = £90,000 (the benefit received)

Is RDEC taxable?

Yes, the credit amount is taxable to corporation tax, resulting in a 25% deduction from the final credit amount received.

R&D Tax Credits are a complicated field. Contact us for an expert consultation.