Research In Practice

Research In Practice

VIJAY THAKRAR and PAUL HARRIS of Ernst & Young look at how the new research and development relief for large companies operates in practice.

THE DETAIL OF the research and development relief legislation has been covered by other authors in various articles in Taxation. We intend to focus on practical issues, although the following summary of the reliefs will help set the scene.

From 1 April 2000, small and medium-sized companies have been able to claim an additional revenue deduction for qualifying research and development expenditure with a 50 per cent uplift. If the company is loss making, then the losses attributable to the research and development costs can be surrendered for a cash refund equal to 24 pence for every pound of qualifying research and development expenditure (or 16 per cent of the enhanced deduction).

The claim for a cash repayment can only be made in a computation or in an amended computation and must be made within one year of the filing date, normally two years after the end of the accounting period.

From 1 April 2002, the research and development relief has been extended to all companies. For ease, we divide these into small and medium-sized enterprises and large companies. A large company is one which is not a small or medium-sized enterprise throughout the whole of its accounting period. The uplift is 25 per cent and no cash repayment can be claimed. The effective relief is 7.5 pence for each pound of qualifying research and development expenditure. Example 2 shows the effect of obtaining relief or not, if a large company incurs qualifying research and development expenditure of £500,000.

The relief for small and medium-sized enterprises is given to the company for whose benefit the research and development is undertaken, hence the requirement for the intellectual property in the research and development to be held by the small and medium-sized enterprises making the research and development claim. By contrast, the relief for large companies is focussed on the company undertaking the research and development work; hence there is no need (unlike the situation with small and medium-sized enterprises) for the company to hold the intellectual property. The location of intellectual property is often the subject of planning to minimise tax; hence the new rules came as some relief to those involved in offshore tax planning strategies.

For large companies, the main relief is for research and development expenditure directly undertaken by the company, but the expenditure is restricted to staffing costs and consumable stores. It is also possible to claim relief for work subcontracted to qualifying bodies or for funding of independent research and development, known as funded research and development.

The new 25 per cent relief is also available to small and medium-sized enterprises which undertake research and development work for large companies or foreign small and medium-sized enterprises; otherwise no relief would be available for either company. The claim is under the new rules, that is, a 25 per cent uplift with no cash refund. This is not well known, however, and small and medium-sized enterprises may be missing out on this additional relief available from 1 April 2002.

Practical issues

Revenue approach

The tax relief is driven by the Treasury which has a budget of £500 million a year for the relief (for both small and medium-sized enterprises and large companies). This relief is designed to encourage innovation in the United Kingdom. The relief is the second most favourable for the G7 countries. Only Canada's relief is better because (we understand) its record on research and development is apparently worse than that of the United Kingdom.

The Department of Trade and Industry has published guidelines which have the force of law in defining qualifying research and development, and these are causing problems for the Revenue, professional advisers and tax directors in industry. In response to this, the Revenue has appointed one Inspector as a research and development specialist for each area. These Inspectors are generally making great efforts in applying the rules, although it will take some time for them to learn the intricacies of the rules, and apply the definition on a consistent basis throughout the United Kingdom.

Currently, computations submitted to Dundee or Cardiff may be dealt with by an Inspector who has real experience. This is because those districts deal with small and medium-sized enterprise companies making claims restricted to smaller entities. It is with those districts that we, as a firm, have had most queries. In other districts, the Revenue's experience is understandably patchy, and it is hoped that the Revenue will work to ensure a level playing field for all in the future.

Consumable stores

The Revenue points to the accounting standards for a definition, but consumable stores only appears in Statement of Standard Accounting Practice 9 (stocks) and is not defined there.

The Revenue appears to be taking a narrow view and requires that the equipment or materials are stored as well as consumed during the research and development project. Some Inspectors have indicated that in their view energy costs do not qualify, as these are not stored, unless presumably the company has its own gas holder or battery bank. More seriously, where software companies use existing software as part of the research and development project, sometimes known as development licences, some Inspectors have challenged claims for costs of such licences on the grounds that the software still exists after the project and hence is not consumed. However, we are trying to enter into a debate with the Revenue's specialists in this area, as such an approach is hardly likely to encourage research and development spending in the United Kingdom. To deny relief for what most businesses regard as consumables, e.g. lighting, heating, software licences, seems contrary to the purpose of the legislation, let alone debatable in terms of actual definition.

This restrictive view of consumable stores is a policy decision by the Revenue. If a restrictive view does ultimately prevail then, without planning, many costs of research and development projects will not qualify for the relief.

Staffing costs

The cash refund for small and medium-sized enterprises is limited to the pay-as-you-earn and National Insurance payable by the company for all its employees, including those who are not involved with research and development. Hence, small and medium-sized enterprises which have more than one company may wish to have all employees in the research and development company to maximise the cash refund.

For large companies with one company with the employment contracts which recharges costs to a group company undertaking the research and development, strictly those costs will not be qualifying staffing costs, although the Revenue is exercising flexibility and common sense on this issue.

A practical problem we have come across is where a company used agency workers in its start-up phase. Such individuals are deemed to be employees of the company for pay-as-you-earn purposes, but the liability to pay the pay-as-you-earn and National Insurance is with the agency. The Revenue's view is that no research and development tax relief is available for agency workers as they are not employees of the company.

When does research end?

We have had success in agreeing activities which qualify for research and development, but one key aspect for both the Revenue and advisers is when the research and development ends and commercial pre-production begins. This is another grey area. Another related issue is whether incremental spend on projects qualifies for the relief.

While the Department of Trade and Industry guidelines are ambiguous in places, the dividing line seems to be that the initial production, testing and incorporating the results of that testing in the product qualifies. However, if the product is then accepted for commercial production, the research and development phase ends. This can be subjective and difficult to assess in retrospect, particularly on software projects. It is therefore critical to document the project, in order to provide evidence of the testing phase at the time it is undertaken. This will then provide persuasive evidence to the Inspector of Taxes.

Capital allowances

The research and development relief is available only for revenue expenditure but, where capital assets are concerned, full 100 per cent capital allowances are available on plant and machinery and certain buildings used for research and development.

Documentation

The Revenue is increasingly looking at companies' websites, press releases, and other correspondence, such as tax clearance letters and directors' statements, in the statutory accounts. This is a double-edged sword, as such documents can also be used to provide details of the innovative research being undertaken. The initial objectives and aim of the research and development project should also be documented at the beginning of the project.

Timing

While the small and medium-sized enterprise rules require a claim for the whole expenditure including the uplift, interestingly, the new rules only refer to the claim for the 25 per cent uplift. The actual expenditure is deductible under normal principles (see section 82A, Taxes Act 1988).

An enhanced tax claim is available for the research and development expenditure only in so far as the expenditure itself is deductible against profits for that period. This means that if any revenue expenditure is capitalised, then the enhanced claim can only be made as the expenditure is charged to the profit and loss account. There is an interesting debate about which gives the best result, 100 per cent capital allowances for capitalised costs or 125 per cent relief over a number of years for expenditure released to profit and loss.

Advance planning

Critical to all United Kingdom groups is forward planning in this area. The research and development work within the group should be reviewed, and changes considered to maximise that relief, for instance by transferring employees, subcontracting work to agency workers, documenting key stages (in layman language), switching benefits in kind into cash payments. Advance planning is necessary to ensure that the maximum relief available can be claimed for research and development costs.

Summary

This is a valuable relief for which the Treasury will need to show value for the £500 million per annum cost by demonstrating that it encourages United Kingdom companies to undertake research and development work. The Inland Revenue appreciates this and is working to process research and development claims, particularly cash refunds claimed by small and medium sized enterprises, promptly.

Companies should review their research and development expenditure and plan ahead to maximise the claim, from capturing the qualifying expenditure in their accounting system for the tax computation to ensuring that all documentation that the Inspector may request is available to give a picture of the research and development work and to avoid unnecessary queries.

We are finding that companies are not claiming the relief because they do not consider that they undertake research and development. In practice, virtually all companies undertake research and development of some form and after some investigation, some qualifying research can usually be found.

This is a genuine and valuable relief introduced by the Government to encourage innovation by United Kingdom companies. However, the definition of qualifying research and development often leads to more questions than answers, and some Inspectors are taking a very restrictive view on what expenditure qualifies, particularly on consumable stores. The Revenue issued a special Tax Bulletin on research and development just before Christmas. This notes that generally expenditure on consumable stores (for example disposable laboratory equipment) will be revenue expenditure and could qualify for research and development tax relief, but costs of heat, light, power, rent, rates, etc. are not consumable stores in the view of the Revenue.

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