Original content provided by BDO United Kingdom
Since 1 April 2021, Small and Medium sized Enterprises (SMEs) seeking to make an R&D claim have had to be mindful of the cap for refundable credits. Here is how it works.
In outline, the amount of payable R&D tax credit that an SME can receive is capped at £20,000 plus 300% of its total Pay as you Earn (PAYE) and National Insurance Contributions (NIC) liability for the period covered by the R&D claim.
A company is exempt from the cap if:
- Its employees are creating, preparing to create, or managing Intellectual Property (IP) and
- It does not spend more than 15% of its qualifying R&D expenditure on subcontracting R&D to connected parties; or on the provision of externally provided workers (EPWs) by connected parties.
It is worth noting that the above is apportioned where relevant for periods more or less than 12 months.
Why was the cap on SME R&D tax credits introduced and why does it feel familiar?
To understand the cap, we need to look back to the start of the millennium, when the first R&D incentive was introduced. That initial scheme, while still highly beneficial, came with a restriction – any payable tax credit was capped at the total of a company’s joint PAYE and NIC liability for the period. This mainly affected loss-making and low-profit companies seeking to make use of the new scheme.
It wasn’t until over a decade later in 2012 that this cap was removed. At the same time, the minimum spend threshold of £10,000 was also abolished, meaning a huge boost in the number of innovative companies that could begin to claim under the scheme.
HMRC saw a boom in the number of SMEs claiming and the number of to the amount of payable R&D credits increased by 22% between 2016 and 2018 to reach £2.2 billion. R&D tax reliefs were proving to be effective and the government remained committed to its target of R&D investment reaching 2.4% of GDP by 2027.
Notwithstanding the evident effectiveness of the scheme, HMRC began to identify, and tackle, a growing number of fraudulent claims for payable tax credits on R&D work carried out overseas. This fraud totalled in excess of £300 million and, as a result, a reintroduction of the cap was proposed in the 2018 budget.
Exemptions and protections for genuine SME R&D tax claims
Following consultation on how the cap should work (BDO and others argued for some of the more damaging restrictions to be removed), the government implemented specific rules to protect genuine R&D by SMEs from losing out under the cap. Firstly, there are the Exemption Tests - a claim of any size will be uncapped if it meets both of the following criteria:
- The claimant company can provide proof that it is actively managing the IP arising from, or expected to arise from, the R&D project.
- The proportion of R&D expenditure on connected parties through subcontracted R&D and through the provision of EPWs, must be less than 15% of the company’s total R&D expenditure for the period.
Secondly, the introduction of a £20,000 de minimis. By adding £20,000 to the total PAYE and class 1 NIC liability of claimants within the rules, the legislation ensures that SMEs making a claim for a payable credit of £20,000 or less will not lose out because of the cap.
And finally, with the inclusion of Connected Parties - companies will be allowed to include the PAYE and NIC liabilities for UK employees of connected parties that participate in the company’s R&D activities through either subcontracted R&D arrangements or through the provision of connected Externally Provided Workers (EPWs), when calculating the cap.
Future changes to the cap?
Since the cap was introduced, the government has carried on with reforms to R&D relief with further changes taking effect from April 2023 and scheduled for April 2024. If the two current R&D reliefs, the SME scheme and RDEC, are combined from April 2024, this may mean that the rules for the cap on claims made by SMEs will change or even be abolished as BDO has proposed (as overseas R&D costs, one of the original concerns behind the introduction of the cap, will be removed from the equation in 2024).
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