Bigger Style Research

REBECCA CAVE FCA, ATII, MBA analyses the new rules that larger companies must meet in order to qualify for the new research and development relief.

SMALL AND MEDIUM-SIZED companies have been able to claim an additional 50 per cent tax relief in respect of their revenue expenditure on research and development projects since 1 April 2000, as explained in Allison Plager's article 'New Style Research' in Taxation, 26 April 2001 at page 93. That scheme was introduced by Schedule 20 to the Finance Act 2000 and is referred to as the 'smaller companies scheme' in this article.

A similar 'large company' scheme is now in place in respect of research and development revenue expenditure incurred on or after 1 April 2002, as introduced by section 53 of, and Schedule 12 to, the Finance Act 2002. This large company scheme dovetails into the smaller companies scheme, as large companies for the purposes of this scheme are defined as all those companies that do not fall within the definition used for the smaller companies scheme (see the Table). However, life insurance companies which qualify as smaller companies are treated as large companies for this relief.

The large company scheme is very similar to that for smaller companies in that both schemes are volume based, so the enhanced tax relief is given for all qualifying research and development revenue expenditure once the de minimis limit of £25,000 for the year is exceeded. This threshold is the same for large companies and smaller companies. If the accounting period straddles the start date of 1 April 2002, only the proportion of the period falling after 31 March 2002 is considered for the purposes of this relief and the de minimis limit is reduced accordingly for that and any other short accounting periods.

The major differences between the large company scheme and the smaller companies scheme are:

• the rate of additional tax relief is 25 per cent rather than 50 per cent;
• there is no provision for creating a deemed trading loss by pre-trading expenditure;
• there is no provision for receiving a tax refund if the research and development tax relief creates a loss;
• treatment of subcontracted research and development (see below); and
• the special arrangements for insurance companies (not covered in this article).

Qualifying expenditure

Identify research and development

The first hurdle is to identify projects that qualify as research and development for this scheme. The definition of research and development is the same as used for the smaller companies scheme and for research and development capital allowances given in section 837A, Taxes Act 1988. Allison Plager analysed this definition in her article in Taxation, 26 April 2001 at pages 93 to 95, and there is not much to add to that, other than to qualify for the large company scheme, the research and development work need not result in the intellectual property remaining in control of the company that carries on the research and development.

Relevant research and development

The second hurdle is that the company can only claim the additional tax relief in respect of qualifying expenditure incurred on research and development projects that are relevant to the company. The definition of the research and development work that can be regarded as relevant is included in paragraph 4 of Schedule 20 to the Finance Act 2000. Essentially, the project must be related to the company's trade, an extension of that trade, or to a trade that it is intending to carry on. In addition, medical research can be relevant if it is related to the welfare of the company's workers.

This relevance condition can be broken where the project is subcontracted out to another company. Within a large group, the research and development expenditure may be separated from the trade that is eventually to benefit from the research when a few specialised subsidiaries carry on research and development work for the group. This circle is squared by paragraph 14 of Schedule 12 to the Finance Act 2002 which deems the research and development to be 'relevant' for the company carrying on the subcontracted research and development work, if the commissioning company is another member of the same group when the payment for the research and development work is made.

This condition for the research and development work to be relevant in all circumstances will prevent companies from claiming the enhanced tax relief for sponsoring 'blue sky research' undertaken externally or internally.

Direct costs

The third major hurdle that must be met for the research and development costs to qualify is for the expenditure to fall within the restricted definitions of staff costs and consumable stores, which are common to both the smaller company and large company schemes, as set out in paragraphs 5 and 6 of Schedule 20 to the Finance Act 2000. The main difficulty is that any element of indirect costs is denied. This means that the cost data delivered by many internal costing systems must be deconstructed to eliminate all overheads, indirect staff costs such as administrative workers, and certain payroll costs such as the value of benefits in kind, Class 1A and Class 1B National Insurance contributions.

This difficulty was addressed by an Opposition amendment to the 2002 Finance Bill put forward at committee stage, but Dawn Primarolo said that the Government had received only one representation indicating that this could be a problem for large companies, so the relieving amendment would not be accepted. From my research into the operation of the smaller companies scheme, it is clear that the collection of costs data within a company's accounting system can be a major bar to making a claim for research and development tax credits, and this difficulty can only be magnified for large companies.

Anti-avoidance provisions

Accountants who advise companies seeking to make a claim under either the large company scheme or the smaller company scheme should be aware of the anti-avoidance provisions contained in paragraph 21 of Schedule 20 to the Finance Act 2000, and paragraph 16 of Schedule 12 to the Finance Act 2002. Any arrangement which allows the company either to claim research and development tax relief to which it is not entitled, or to claim a greater amount than would be due will mean those transactions are disregarded for the accounting period. An 'arrangement' would include collusion between organisations to increase the fee paid for subcontracted research and development work, or professional advice to claim for items of expenditure which do not qualify under the scheme.

Subcontracted work

Both the smaller company and large company schemes allow for the tax relief to be given where the company pays another organisation to undertake research and development work on its behalf. However, the level of tax relief available, 25 per cent or 50 per cent, which the organisation is eligible to claim depends on the classification of the original commissioning organisation, as a large company, smaller company or other institution. The position for large companies and smaller companies can be summarised as follows:

Large companies

A large company can claim the additional 25 per cent tax relief for qualifying revenue expenditure on a research and development project if:

• it carries out the project on its own behalf; or
• the research and development work is contracted to it by another large company or institution; or
• it pays a qualifying body, individual, or partnership of individuals to carry out the research and development work on its behalf.

Qualifying bodies encompass research institutions such as universities, charities, health service trusts and any other body the Government may prescribe.

A large company cannot get the 25 per cent tax relief under the large company scheme for research and development expenditure that is either:

• related to projects contracted out to a smaller company; or
• related to projects contracted to it by a smaller company.

The rules are drafted in favour of the smaller company, which will generally be eligible to claim the tax relief itself.

Refunded contributions

Any payment received by a large company which is intended to refund the costs of qualifying research and development work that has been undertaken by or contracted out to another institution is treated as cancelling out the additional 25 per cent tax relief which has been given under the large company scheme (paragraph 15 of Schedule 12 to the Finance Act 2002).

Smaller companies

A smaller company can claim the additional 50 per cent tax relief for qualifying revenue expenditure in a research and development project if:

• it carries on the research and development project on its own behalf; or
• it pays another company, which is not a large company, to undertake the research and development on its behalf.

A smaller company can claim the additional 25 per cent tax relief under the large company scheme for qualifying research and development expenditure incurred on or after 1 April 2002 if:

• the research and development project is contracted out to it by a large company; or
• it pays a qualifying body, an individual, or partnership made up of individuals to carry out the research and development work on its behalf.

To summarise, when research and development work is subcontracted under the smaller companies scheme, the company that is funding the research and development work receives the tax relief. Whereas when research and development work is subcontracted under the large company scheme, it is generally the company that undertakes the research and development work that receives that tax relief.

Vaccines research

Large companies will also be able to claim an additional 50 per cent tax relief for research and development revenue expenditure related projects qualifying under the scheme for vaccines research, as introduced by section 54 of, and Schedule 13 to, the Finance Act 2002. The start date has not been specified, as the Government is waiting for confirmation from the European Commission that the scheme does not violate the European Union rules on state aid.

The vaccines research scheme applies to qualifying research and development expenditure incurred on projects relating to vaccines or medicines for use with humans to treat or prevent HIV/AIDS, malaria, tuberculosis, or other diseases specified by regulation. The same constituents of qualifying research and development expenditure are the same as for the large company or smaller company scheme, i.e. revenue expenditure on staffing costs or consumable stores.

The 50 per cent tax relief for vaccines research is given in addition to the 25 per cent tax relief given to large companies for the same qualifying research and development expenditure. Thus a large company undertaking vaccines research can effectively get up to 75 per cent additional tax relief to support its vaccines research. If the research and development expenditure does not qualify under the large company scheme, but does qualify as under the vaccines scheme, the company can deduct 150 per cent of the qualifying costs from its taxable profits, giving it an additional 50 per cent tax relief.

Conclusion

The two new research and development tax relief schemes provide some very positive incentives for research and development. However, in order to substantiate a claim for either tax relief, the company's cost accounting system must permit the isolation and extraction of the costs that constitute qualifying research and development expenditure.

Rebecca Cave FCA, ATII, MBA is a freelance tax writer; website: www.taxwriter.co.uk.

Issue: 3868 / Categories: