Research and Development (R&D) tax relief is a government-backed incentive scheme designed to encourage UK businesses to invest in innovative projects in science and technology. The tax relief allows companies to reduce their corporation tax bill or claim cash back on qualifying R&D activities. There are pitfalls in claiming R&D tax relief for commercially developed software which can have serious implications for a business, but the benefits of the relief on the funding provided for the innovative work make it worth spending the time to claim. It has been estimated by HMRC that just under 5% of R&D tax relief claims are fraudulent, and because of this, some significant changes are planned or in consultation for the period beyond April 2023.
Importance of R&D Tax relief for UK businesses
R&D tax reliefs can significantly reduce a company's tax bill or provide cash back to fund further research and development activities. This incentive encourages businesses to invest in innovation, improve their competitiveness, and drive economic growth. From April 2023 the tax relief will be reduced for SME R&D relief but increases for larger organisations under the RDEC scheme.
Understanding R&D Tax relief for Commercially Developed Software
R&D tax relief for commercially developed software is available to companies that develop innovative software solutions for sale. The scheme aims to encourage the development of new software products or substantial improvements to existing software.
Our experience is as an SME where from April 2023 tax relief is 18.6p per £1 for loss-making businesses and 21.5p per £1 for profitable companies. There is a cap on payable credits which is £20,000 plus 3x relevant PAYE and NIC liabilities in the period. There are some complex exemptions to the cap around management activity in creation of intellectual property and where no more than 15% of qualifying R&D is spend on subcontracted externally provided workers (EPWs).
Definition of R&D Tax relief for Commercially Developed Software
To claim R&D tax relief for commercially developed software, the software must meet certain eligibility criteria. Specifically it must seek an advance in knowledge or capability or an increase in overall knowledge, but in either case, a competent professional working in that field would recognise it as a significant improvement. The improvements may include creating a process, material, device, product or service that increases the knowledge or capability, a visible improvement to an existing process, material, device, product or service like cost savings or less waste or using science or technology to copy the effect of a current process, material, device, product or service in a new or improved way.
The development process must also involve a degree of technical uncertainty, and the company must be able to demonstrate that it invested in research and development activities to develop the software. It is not sufficient to simply implement a common software pattern like a web enabled database application hosted by a service provider. Such an application would be unlikely to be able to pass the competent professional recognises it as a significant improvement test.
The bar as to what passes this test increases each year as what was new technology becomes more mainstream.
To be eligible for R&D tax relief, a company must be liable for corporation tax and must have spent money on qualifying R&D activities. From April 2023 expenditure on data sets and cloud computing can be eligible. The company must also be registered in the UK or have a UK permanent establishment. Qualifying direct R&D activities are those that try to resolve the scientific or technological uncertainties. There are also some qualifying indirect activities. Direct activities may include things like creating or adapting software, materials or equipment needed to resolve the uncertainty, planning activities such as a detailed plan of how you will carry out the project and designing, testing and analysis to resolve the scientific or technological uncertainty. Qualifying indirect activities form part of the project, but do not directly lead to resolving the uncertainty. They include things like creating information services for R&D support such as preparing a report of R&D findings
ancillary activities needed to begin R&D, for example, taking on and paying staff, leasing laboratories and maintaining research and development equipment including computers used for R&D purposes), training required to support the R&D project, research by students and researchers carried out at UK universities, research including data collection to make new scientific or technological testing, survey, or sampling methods, where this research is not R&D in its own right feasibility studies to inform the strategic direction of a specific R&D activity.
Difference between R&D Tax relief between Software and Other Sectors
The eligibility criteria for R&D tax relief differ between software development and other sectors. Companies that develop software for sale can claim R&D tax relief if the software is innovative and involves a degree of technical uncertainty. Businesses in other sectors may be eligible for R&D tax relief if they have developed new physical products or manufacturing processes that meet the eligibility criteria.
Importance of Documentation
Documentation is crucial when claiming R&D tax relief. Companies must maintain accurate records of their R&D activities, including project plans, progress reports, and technical documentation. This documentation is necessary to demonstrate to HM Revenue and Customs (HMRC) that the company meets the eligibility criteria. You will need to provide the Registered company name, Company Unique Taxpayer Reference, Start and End dates for the claim, Employee costs, Costs for EPWs, Software costs for software licences bought for R&D and consumables costs.
Pitfall #1: Misunderstanding Eligibility Criteria
One of the most common pitfalls when claiming R&D tax relief is misunderstanding the eligibility criteria. Companies may think that any software development activity qualifies for R&D tax relief, but this is not the case. If a company claims tax relief for ineligible activities, they risk facing penalties, interest charges, and continued inspection.
From April 2023, subcontracted EPWs will generally need to be on a UK payroll, limiting the applicability of R&D tax relief to overseas EPW's. It looks like activities subcontracted to third parties by SME's will need to be carried out in the UK for their costs to qualify for enhanced R&D tax relief, and for larger organisations this also affects eligibility for overseas independent research eligibility.
Pitfall #2: Not Understanding What Qualifies as R&D
To claim R&D tax relief, a company must identify which of their software development activities qualify as R&D. The definition of R&D can be confusing, and many companies may not be aware of what qualifies as R&D. This can result in missed opportunities to claim tax relief or overstatement of R&D activities. Generally speaking, support activities and customisation of existing shipping software which is being paid for by customers is not R&D. Using standard tooling to build well understood applications for internal or external use is not R&D. A competent technical professional should be able to help you understand what is and what is not R&D. You'll need to explain the baseline, that is to say, the capability of existing solutions to the issue at hand. Then you need to be able to explain the advance in technology sought and the technical uncertainties which you face. You need to document the work done in support of the activity, and the anticipated technology advance you are seeking. If this sounds difficult you need a competent technology professional to help you!
Pitfall #3: Failing to Keep Accurate Records
As previously mentioned, record keeping compliance is essential when claiming R&D tax relief. Companies must keep detailed records of their R&D activities, including project plans, progress reports, and technical specifications. Claims must be made digitally, and the categories and brief details of the activities provided. These claims must be endorsed by a named senior officer of the company. Companies must inform HMRC in advance of intention to claim within six months of the end of the accounting period and must provide details of any agent who has advised the company. Failure to maintain these records can result in penalties and interest charges. Failure to meet the compliance requirements will invalidate a claim.
Pitfall #4: Overstating R&D Activities
Overstating R&D activities can be tempting, but it can also lead to serious consequences. When businesses exaggerate their R&D activities, they risk being audited and losing their eligibility for the R&D tax relief. Overstating R&D activities can also damage a business's reputation and make it difficult to receive funding in the future.
Common reasons for overstatement include a lack of understanding of what qualifies as R&D, pressure to maximise the relief, including activities that are performed by EPWs which are not R&D, or simply a mistake. To avoid these pitfalls, businesses should ensure that they have a clear understanding of what qualifies as R&D and keep accurate records of their activities. One way to do this is through accurate work assignment categories to clearly differentiate between paid consultancy work for example and research work in support a specific R&D project. Companies should seek professional advice to ensure that they are not overstating their R&D activities.
Pitfall #5: Understating R&D Activities
On the other hand, businesses that underestimate their R&D activities may miss out on valuable tax reliefs. Understating R&D activities can occur when a business does not fully appreciate the breadth of activities that qualify for the relief, or if they fail to keep accurate records of their R&D activities.
Consequences of understating R&D activities include missed opportunities for tax reliefs, as well as the risk of being audited and losing eligibility for future reliefs. To avoid this pitfall, businesses should ensure that they have a clear understanding of what qualifies as R&D and maintain accurate records of their activities and again, seek professional advice to ensure that they do now understate their R&D activities.
Pitfall #6: Lack of Awareness of Relevant Regulations and Legislation
Finally, a lack of awareness of relevant regulations and legislation can be a serious pitfall for businesses seeking to claim R&D tax reliefs. The UK government has set out specific guidelines and regulations for claiming R&D tax reliefs, and failure to comply with these can result in the loss of eligibility for the relief. The regulations changed in April 2023 and further change should be expected. Keep an eye on the HMRC guidance to ensure you are abreast of impending changes.
Common mistakes made due to a lack of awareness include not keeping accurate records, failing to identify all qualifying activities, and not understanding the specific regulations and guidelines for claiming the relief. To avoid this pitfall, businesses should seek professional advice to ensure that they are aware of all relevant regulations and legislation. Failure to provide the required information will invalidate a claim.
In conclusion, the UK R&D Tax relief scheme is an important source of funding for businesses engaged in R&D activities, particularly in the software development sector. However, there are several pitfalls that businesses must avoid in order to successfully claim the relief. These include misunderstanding eligibility criteria especially regarding overseas EPWs, not understanding what qualifies as R&D, failing to keep accurate records, overstating R&D activities, understating R&D activities, and a lack of awareness of relevant regulations and legislation.
Businesses can avoid these pitfalls by seeking professional advice, maintaining accurate records for compliance with the digital submission process, and developing a clear understanding of what qualifies as R&D. By doing so, they can ensure that they maximise their chances of successfully claiming the R&D tax relief and receiving the relief on the funding they provided for the innovative work.