R&D Tax Relief: Conditions to be Satisfied

Author: Hammad Baig
In: Article Published: Tuesday 06 August 2019

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Introduction

1. R&D Tax Credits are a tax incentive from the UK Government designed to encourage companies to invest in research and development (R&D).  The scheme has been around since 2000 and last year over 39,000 UK companies claimed almost £3.5bn in tax relief. Only limited companies qualify for R&D tax relief and eligible companies have the options of either reducing their tax bill or claiming payable cash credits as a proportion of their R&D expenditure.

2. Companies may be entitled to corporation tax relief in respect of qualifying expenditure that they incur on R&D. The conditions that must be met, and the value and form of the R&D tax relief available, depends on whether a company is a small or medium-sized enterprise (an SME), or a large company, for these purposes.

3. R&D tax relief is available in the following forms:

(a) relief for SMEs by way of:

(i) an enhanced deduction (currently 230% of qualifying expenditure) in computing profits subject to corporation tax; or

(ii) a payable tax credit (currently 14.5% of the enhanced deduction).

(b) relief for SMEs through the R&D expenditure credit (RDEC), where SME R&D relief is not available, and:

(i) the SME's qualifying R&D expenditure is subsidised;

(ii) the cap on total R&D relief for the project is exceeded; or

(iii) the R&D is sub-contracted to the SME.

(c) relief for large companies by way of:

(i) the RDEC; and

(ii) in respect of expenditure incurred before 1 April 2017, vaccine research relief for large companies by way of an enhanced deduction (140% of qualifying expenditure) in computing profits subject to corporation tax.

837A of the Income and Corporation Taxes Act 1988

4. This note is drafted further to section 837A of the Income and Corporation Taxes Act 1988 (ICTA88).  

The definition of R&D 

5. Research and Development is defined for tax purposes in section 837A of ICTA88. This says the definition of R&D for tax purposes follows UK GAAP. For the purposes of R&D allowances this definition is extended to include oil and gas exploration and appraisal, as defined in section 837B of ICTA88. This note applies to this extended definition as well.

6. The definition of R&D can be found in the accounting standards UK GAAP and IAS 38, however R&D that meets the accounting standards definition does not automatically qualify for relief. These accounting definitions are looked at through a narrow prism by the Department of Business, Innovation & Skills (BIS) R&D guidelines, see in particular:

(a) section 104Y and 1041 of the Corporation Tax Act 2009;

(b) section 1138 of the Corporation Tax Act 2010; and

(c) section 1006 of the Income Tax Act 2007:

(i) the Research and Development (Prescribed Activities) Regulations 2004, SI 2004/712 incorporate the BIS R&D guidelines into the definition of R&D for tax purposes;

(ii) R&D for tax purposes takes place when a project seeks to achieve an advance in science or technology;

(iii) the activities that directly contribute to achieving this advance in science or technology through the resolution of scientific or technological uncertainty are R&D;

(iv) certain qualifying indirect activities related to the project are also R&D activities, other than qualifying indirect activities which do not directly contribute to the resolution of the project’s scientific or technological uncertainty are not R&D.

Advance in Science or Technology

7. An advance in science or technology means an advance in overall knowledge or capability in a field of science or technology. This does not mean a company’s own state of knowledge or capability alone, see BE Studios v Smith & Williamson [2006] STC 358, paragraph 46. This includes the adaptation of knowledge or capability from another field of science or technology in order to make such an advance where this adaptation was not readily deducible.

8. An advance in science or technology may have tangible consequences (such as a new or more efficient cleaning product, or a process which generates less waste) or more intangible outcomes (new knowledge or cost improvements, for example).

9. A process, material, device, product, service or source of knowledge does not become an advance in science or technology simply because science or technology is used in its creation. Work which uses science or technology but which does not advance scientific or technological capability as a whole is not an advance in science or technology.

10. A project which seeks to, for example:

(a) extend overall knowledge or capability in a field of science or technology; or

(b) create a process, material, device, product or service which incorporates or represents an increase in overall knowledge or capability in a field of science or technology; or

(c) make an appreciable improvement to an existing process, material, device, product or service through scientific or technological changes; or

(d) use science or technology to duplicate the effect of an existing process, material, device, product or service in a new or appreciably improved way (e.g. a product that has exactly the same performance characteristics as existing models, but is built in a fundamentally different manner),

will therefore be R&D:

(i) even if the advance in science or technology sought by a project is not achieved or not fully realised, R&D still takes place;

(ii) if a particular advance in science or technology has already been made or attempted but details are not readily available (for example, if it is a trade secret), work to achieve such an advance can still be an advance in science or technology; 

(iii) however, the routine analysis, copying or adaptation of an existing product, process, service or material, will not be an advance in science or technology.

Scientific or technological uncertainty

11. Scientific or technological uncertainty exists when knowledge of whether something is scientifically possible or technologically feasible, or how to achieve it in practice, is not readily available or deducible by a competent professional working in the field. This includes system uncertainty. Scientific or technological uncertainty will often arise from turning something that has already been established as scientifically feasible into a cost-effective, reliable and reproducible process, material, device, product or service.

12. Uncertainties that can readily be resolved by a competent professional working in the field are not scientific or technological uncertainties. Similarly, improvements, optimisations and fine-tuning which do not materially affect the underlying science or technology do not constitute work to resolve scientific or technological uncertainty.

Other definitions

Science  

13. Science is the systematic study of the nature and behaviour of the physical and material universe. Work in the arts, humanities and social sciences, including economics, is not science for the purpose of these BIS guidelines. Mathematical techniques are frequently used in science, but mathematical advances in and of themselves are not science unless they are advances in representing the nature and behaviour of the physical and material universe.

Technology  

14. Technology is the practical application of scientific principles and knowledge, where ‘scientific’ is based on the definition of science above.

Project   

15. A project consists of a number of activities conducted to a method or plans in order to achieve an advance in science or technology. It is important to get the boundaries of the project correct. It should encompass all the activities that collectively serve to resolve the scientific or technological uncertainty associated with achieving the advance, so it could include a number of different sub-projects. A project may itself be part of a larger commercial project, but that does not make the parts of the commercial project that do not address scientific or technological uncertainty into R&D.

Overall knowledge or capability   

16. Overall knowledge or capability in a field of science or technology means the knowledge or capability in the field that is publicly available or is readily deducible from the publicly available knowledge or capability by a competent professional working in the field. Work that seeks an advance relative to this overall knowledge or capability is R&D.

17. Overall knowledge or capability in a field of science or technology can still be advanced (and hence R&D can still be done) in situations where:

(a) several companies are working at the cutting edge in the same field, and are doing similar work independently; or

(b) work has already been done but this is not known in general because it is a trade secret, and another company repeats the work; or

(c) it is known that a particular advance in science or technology has been achieved, but the details of how are not readily available.

18. However, the routine analysis, copying or adaptation of an existing process, material, device, product or service will not advance overall knowledge or capability, even though it may be completely new to the company or the company’s trade.

Appreciable improvement  

19. Appreciable improvement means to change or adapt the scientific or technological characteristics of something to the point where it is ‘better’ than the original. The improvement should be more than a minor or routine upgrading, and should represent something that would generally be acknowledged by a competent professional working in the field as a genuine and non-trivial improvement. Improvements arising from the adaptation of knowledge or capability from another field of science or technology are appreciable improvements if they would generally be acknowledged by a competent professional working in the field as a genuine and non-trivial improvement.

20. Improvements that arise from taking existing science or technology and deploying it in a new context (e.g. a different trade) with only minor or routine changes are not appreciable improvements. A process, material, device, product or service will not be appreciably improved if it simply brings a company into line with overall knowledge or capability in science or technology, even though it may be completely new to the company or the company’s trade.

21. The question of what scale of advance would constitute an appreciable improvement will differ between fields of science and technology and will depend on what a competent professional working in the field would regard as a genuine and non-trivial improvement.

Directly contribute  

22. To directly contribute to achieving an advance in science or technology, an activity (or several activities in combination) must attempt to resolve an element of the scientific or technological uncertainty associated with achieving the advance.

23. Activities which directly contribute to R&D include:

(a) activities to create or adapt software, materials or equipment needed to resolve the scientific or technological uncertainty, provided that the software, material or equipment is created or adapted solely for use in R&D;

(b) scientific or technological planning activities; and

(c) scientific or technological design, testing and analysis undertaken to resolve the scientific or technological uncertainty;

24. Activities which do not directly contribute to the resolution of scientific or technological uncertainty include:

(i) the range of commercial and financial steps necessary for innovation and for the successful development and marketing of a new or appreciably improved process, material, device, product or service;

(ii) work to develop non-scientific or non-technological aspects of a new or appreciably improved process, material, device, product or service;

(iii) the production and distribution of goods and services;

(iv) administration and other supporting services;

(v) general support services (such as transportation, storage, cleaning, repair, maintenance and security); and

(vi) qualifying indirect activities.

System uncertainty  

25. System uncertainty is scientific or technological uncertainty that results from the complexity of a system rather than uncertainty about how its individual components behave. For example, in electronic devices, the characteristics of individual components or chips are fixed, but there can still be uncertainty about the best way to combine those components to achieve an overall effect. However, assembling a number of components (or software sub-programs) to an established pattern, or following routine methods for doing so, involves little or no scientific or technological uncertainty.

26. Similarly, work on combining standard technologies, devices, and/or processes can involve scientific or technological uncertainty even if the principles for their integration are well known. There will be scientific or technological uncertainty if a competent professional working in the field cannot readily deduce how the separate components or sub-systems should be combined to have the intended function.

Qualifying indirect activity   

27. These are activities which form part of a project but do not directly contribute to the resolution of the scientific or technological uncertainty. They are:

(a) scientific and technical information services, insofar as they are conducted for the purpose of R&D support (such as the preparation of the original report of R&D findings);

(b) indirect supporting activities such as maintenance, security, administration and clerical activities, and finance and personnel activities, insofar as undertaken for R&D;

(c) ancillary activities essential to the undertaking of R&D (e.g. taking on and paying staff, leasing laboratories and maintaining research and development equipment including computers used for R&D purposes);

(d) training required to directly support an R&D project;

(e) research by students and researchers carried out at universities;

(f) research (including related data collection) to devise new scientific or technological testing, survey, or sampling methods, where this research is not R&D in its own right; and

(g) feasibility studies to inform the strategic direction of a specific R&D activity.

28. Activities not described in paragraph 27 are not qualifying indirect activities.

Commentary on particular questions which arise

Start and end of R&D 

29. R&D begins when work to resolve the scientific or technological uncertainty starts, and ends when that uncertainty is resolved or work to resolve it ceases. This means that work to identify the requirements for the process, material, device, product or service, where no scientific or technological questions are at issue, is not R&D.

30. R&D ends when knowledge is codified in a form usable by a competent professional working in the field, or when a prototype or pilot plant with all the functional characteristics of the final process, material, device, product or service is produced.

31. Although R&D for a process, material, device, product or service may have ended, new problems which involve scientific or technological uncertainty may emerge after it has been turned over to production or put into use. The resolution of these problems may require new R&D to be carried out. But there is a distinction to be drawn between such problems and routine fault fixing.

Planning as part of R&D   

32. Scientific or technological planning activities associated with a project directly contribute to resolving the scientific or technological uncertainty associated with the project, and are therefore R&D. These include defining scientific or technological objectives, assessing scientific or technological feasibility, identifying particular scientific or technological uncertainties, estimating development time, schedule, and resources of the R&D, and high-level outlining of the scientific or technical work, as well as the detailed planning and management of the work.

33. Elements of a company’s planning activity relating to a project but not directly contributing to the resolution of scientific or technological uncertainty, such as identifying or researching market niches in which R&D might benefit a company, or examination of a project’s financial, marketing, and legal aspects, fall outside the category of scientific or technological planning, and are therefore not R&D.

Abortive projects 

34. Not all projects succeed in their aims. What counts is whether there is an intention to achieve an advance in science or technology, not whether ultimately the associated scientific or technological uncertainty is completely resolved, or resolved to the degree intended. Scientific or technological planning activities associated with projects which are not taken forward (e.g. because of insurmountable technical or commercial challenges) are still R&D.

Prototypes, pilot plants  

35. A prototype is an original model on which something new or appreciably improved is patterned, and of which all things of the same type are representations or copies. It is a basic experimental model possessing the essential characteristics of the intended process, material, device, product or service. The design, construction and testing of prototypes generally fall within the scope of R&D for tax purposes. But once any modifications necessary to reflect the test findings have been made to the prototypes, and further testing has been satisfactorily completed, the scientific or technological uncertainty has been resolved and further work will not be R&D.

36. Section 28 of Finance Act 2015 introduced a restriction in the costs that can be claimed in respect of prototypes which are subsequently sold. Expenditure on consumable items which form part of such a prototype no longer qualify for R&D relief where the expenditure is incurred on or after 1 April 2015; see also sections 1126A and 1126B of Corporate Tax Act 2009.

37. Similarly the construction and operation of pilot plants, while assessing their operations, is R&D, until the scientific or technological uncertainty associated with the intended advance in science or technology has been resolved.

Design  

38. When achieving design objectives requires the resolution of scientific or technological uncertainty within a project, work to do this will be R&D. Design activities which do not directly contribute to the resolution of scientific or technological uncertainty within a project are not R&D.

Cosmetic and aesthetic effects 

39. Cosmetic and aesthetic qualities are not of themselves science or technology, and so work to improve the cosmetic or aesthetic appeal of a process, material, device, product or service will not in itself be R&D. However, work to create a desired cosmetic or aesthetic effect through the application of science or technology can require a scientific or technological advance, and resolving the scientific or technological uncertainty associated with such a project would therefore be R&D

Content delivered through science or technology 

40. Information or other content that is delivered through a scientific or technological medium is not of itself science or technology. However, improvements in scientific or technological means to create, manipulate and transfer information or other content can be scientific or technological advances, and resolving the scientific or technological uncertainty associated with such projects will therefore be R&D.

Conclusion

41. If your company carries out research and development, then you may be eligible for R&D Tax Credits, which can reduce your tax bill or increase taxable losses.

HAMMAD BAIG © 2019

BARRISTER

33 BEDFORD ROW

The author of this article, Hammad Baig, can assist with all aspects of the law relating to R&D relief. Should you require assistance in this area, then please do not hesitate to contact Hammad Baig’s clerk Mark Byrne.

NOTICE: This article is provided free of charge for information purposes only; it does not constitute legal advice and should not be relied on as such. No responsibility for the accuracy and/or correctness of the information and commentary set out in the article, or for any consequences of relying on it, is assumed or accepted by any member of Chambers or by Chambers as a whole.