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Tax Adviser by Shiv Mahalingham BSc(Econ) ACA CTA(Fellow)

Shiv Mahalingham BSc(Econ) ACA CTA(Fellow), considers some of the practicalities, processes and qualifying conditions for companies to claim Research and Development (R&D) tax credits.

Introduction

The Guidelines issued by the Department of Trade and Industry on 5 March 2004 (http://www.dti.gov.uk/rd-guide/rd-guidelines-2004.htm) have introduced some much needed clarity to the definition of R&D for the purposes of the corporation tax credits available in the UK; the guidelines were discussed by David Bertram in the August edition of Tax Adviser.

However, for many Companies, the definition itself is only the start of what can be an extremely long and complicated process and this follow up article will demonstrate that there is potentially much more to do once a company is satisfied that its operations would actually qualify as R&D.

References in this article will be made to the following legislation:

• Finance Act 2000, Schedule 20 tax credits - Small/Medium sized Companies (as defined for EU State Aid purposes in Commission Recommendation 96/280/EC of 3 April 1996) (SME):

• Finance Act 2002, Schedule 12 tax credits – Large Companies

Outsourced R&D

Companies involved in R&D frequently outsource aspects of the process to specialist companies who possess the relevant expertise; the payments made by the Principal Company in relation to such arrangements can be quite significant and the Sub-contractor Companies themselves may incur considerable expenses throughout the R&D process.

So, is it possible for both the Principal Company (who has contracted out the R&D) and the Sub-contractor Company to claim R&D tax credits for expenses that they have each incurred? The answer to this question is the focus of this article; it is an answer that depends largely upon the following:

1. Whether the Principal Company and the Sub-contractor Company are SMEs or Large Companies.

2. The nature of the expenses incurred.

Work contracted out by a Large Principal Company

FA 2002, Schedule 12, Paragraph 5 provides that expenses incurred in relation to work contracted out by Large Companies would qualify for the 25% Large Companies tax credit provided that the work has been contracted to an individual, partnership of individuals or a ‘qualifying body’; such bodies would typically include Universities, Charities, Scientific research organisations or NHS bodies. The Sub-contractor must undertake such work directly on behalf of the Principal Company and the expenditure must be attributable to relevant (ie, in relation to trade that the Company carries on, or from which it is intended that a trade to be carried on by the Company will be derived) R&D in relation to the Principal Company.

HM Treasury and the Inland Revenue maintain a list of qualifying bodies and the December 2003 Summary of Responses to the ‘Defining Innovation’ document issued by the Inland Revenue (hereinafter ‘the December summary’) specifies (at Section 2.21 http://www.inlandrevenue.gov.uk/pbr2003/rd-taxcredits.pdf) that a generic definition of qualifying bodies is to be formulated so that companies will be assisted in assessing whether bodies they are sub-contracting work to fall within the definition.

It should be noted that the qualifying bodies specified are not within the charge to UK corporation tax and that expenses incurred by the Principal Company in relation to work subcontracted to companies will not generally qualify for the credit.

There is one exception to the above rule; payments incurred by a Principal Company in subcontracting work to a company in the same group will qualify for the credit if the activities of the Subcontractor Company would have been R&D activities if carried out by the Principal Company.

Inland Revenue bulletin REV BN16 states in this regard:

'this will prevent spending by the subcontractor being disallowed if the subcontractor is merely carrying on a routine activity as part of some wider project of the group'.

Work contracted out by a Principal Company that is an SME

FA 2000, Schedule 20, Paragraphs 9-12 permit SME Companies to make a 50% R&D claim for qualifying payments made to a Sub-contractor Company for relevant R&D contracted out; the level of the claim would depend upon whether or not the Principal Company and the Sub-contractor Company are connected (Section 839 ICTA88):

Principal Company and Sub-contractor Company are connected - where the Sub-contractor Company includes:

(1) the payment made to it, and

(2) its expenses of carrying out the sub-contracted work in its accounts in accordance with GAAP for a period ending not more than 12 months after the end of the Principal Company’s accounting period in which it makes the payment,

the Principal Company may claim R&D tax credits on the lower of:

• the payment that it makes to the Sub-contractor Company, and

• the amount that the Sub-contractor Company spends on qualifying staffing costs, consumable stores or externally provided workers when it carries out the work for the Principal Company in its accounting periods ending not more than 12 months after the end of the Principal Company’s accounting period in which the payment was made.

The above is essentially an attempt to ensure that any profit made on the contract R&D is not subject to the tax credit.

Principal Company and Sub-contractor Company are not connected - The Principal Company may claim R&D tax credits on 65% of the payment it makes to the Sub-contractor Company. The percentage 65% may seem arbitrary but when grossed up with the 50% tax credit one approaches 100%.

The companies may make a joint election to be treated as if they are connected. The election must be made in relation to all sub-contractor payments paid under the same contract or other arrangement and must be made by notice in writing given to the Inland Revenue before the end of the period of two years beginning with the end of the company’s accounting period in which the contract or other arrangement is entered into. The election will be irrevocable.

Work contracted in to a Sub-contractor Company that is a Large Company

The ownership of the Intellectual Property (IP) rights relating to the particular R&D in question is largely irrelevant for the purposes of the FA 2002 Large Company tax credit and a Large Company may make a claim for qualifying R&D expenses even if the IP rights are vested in another company.

Unfortunately, the size of the Principal Company that has contracted the work out is also an important consideration; FA 2002, Schedule 12, Paragraph 5 provides authority that expenses incurred on work contracted in from another company will not qualify for the credit if such work has been contracted in from an SME.

Work contracted in to a Sub-contractor Company that is an SME

FA 2000, Schedule 20, Paragraph 3 imposes the condition that any IP created by the R&D would need to be vested in the Claimant Company in order to qualify for the tax credit. The IP does not have to be vested for any specified period and may be held in conjunction with other parties.

It is quite likely that the IP would vest with the Principal Company who has contracted the work out and in such circumstances the tax credit would not be available to the (SME) Subcontractor Company.

Subject to the above, Finance Act 2002, Schedule 12, Paragraphs 7-10 provide authority that the expenditure incurred by an SME Subcontractor Company on relevant R&D work contracted to it by a Large Company or a person not in the course of a trade, profession or vocation assessable under Case I or II of Schedule D (such as a charity or person resident outside of the UK), qualifies for R&D tax credits provided that the expenditure is on qualifying staffing costs, consumable stores, or externally provided workers.

If the Principal Company is an SME, the tax credit will not be available for the Subcontractor Company; arguably the Principal Company will have already claimed the R&D tax credit.

If the Principal Company is a Large Company, or a person outside Case I or Case II of Schedule D, then the R&D tax credit is available to the SME Sub-contractor Company but at the Large Company rate of 25% rather than the SME rate of 50%.

It is interesting to note that under SSAP 13, the Sub-contractor Company in this case may not actually be required to treat the expenditure as R&D for accounting purposes, but such expense will still be eligible for the R&D tax credits.

Qualifying expenses

If one assumes that a company’s operations qualify as R&D for the purposes of the tax credit and that any work contracted in or out that qualifies can be supported by the appropriate documentation, the company will now need to ascertain which expenses actually now qualify for the credit and which ones do not.

Staff costs

Staff costs are likely to be significant for R&D companies but which costs will actually qualify for the credit in the first instance? The Inland Revenue Corporate Intangibles Research and Development Manual (CIRD) section 84000 is a useful starting point and it highlights that salaries, class 1 primary National Insurance contributions and pension fund payments are examples of costs that will qualify but credits will not be permitted for recruitment costs, benefits in kind and class 1A/1B National Insurance contributions.

Salary costs of another company in the same group recharged to the Claimant Company do not qualify.

The December summary (at section 3.5) specifies that benefits in kind are to remain non-qualifying despite the amended definition of ‘staff costs’ to include benefits in kind in the second tax law rewrite Act, Income Tax Earnings and Pensions Act 2003 (ITEPA). Note that benefits in kind will qualify for the period to 1/4/04 (i.e. until ITEPA's amendment by FA 2004).

Note that in this regard, companies that are contemplating (or have already implemented) a flexible benefits system to mitigate National Insurance costs (both employee’s and employer’s) should ensure that the impact of such systems on the potential R&D credit is fully considered.

The degree of time spent actively involved in R&D

Many employees spend a proportion of their time actively involved in the R&D process but a proportion of their time on non-qualifying activities. It is necessary in such circumstances for companies to find a reliable method of attributing a percentage to employees based upon the proportion of time spent:

1. Directly contributing to the R&D function; as discussed in David Bertram’s article

2. In qualifying indirect activities; as discussed in David Bertram’s article

3. In non-qualifying activities; essentially any activities not captured by 1 and 2 above.

This can be an extremely difficult task for a company with a substantial workforce and is now necessary on a full apportionment basis with the abolition of the 80-20 rule which previously permitted the inclusion (or exclusion) of 100% of the qualifying salary costs of an individual who spent greater than 80% (or less than 20%) of their time actively involved in the R&D process.

It would of course save administrative costs if such analysis could be performed on a department or cost-centre basis without having to attribute percentages to each and every employee. CIRD 84000 states, 'companies should feel free to approach their inspector to see if pragmatic guidelines can be adopted which will produce a sufficiently accurate result'.

The August 2003 Chartered Institute of Taxation consultation response (http://www.tax.org.uk/attach.pl/1983/834/DEFININGINNOVATIONDfinal091003owl.doc) in fact argues the following with regards to cost centres that include an element of qualifying and non-qualifying expenditure:

'We think that all expenditure that is properly charged to an R&D cost centre in respect of qualifying R&D should qualify for R&D relief. This would include patenting costs, overhead costs, the cost of producing user manuals, etc. All of these costs are necessarily incurred in bringing a new invention to the marketplace.'

Arguably such costs will not have been incurred in the first instance if the actual R&D work to which they relate had not taken place.

Consumable stores

A new statutory definition of consumable stores has been introduced which has removed the requirement for an item to be physically stored and has also included materials consumed or transformed, water, fuel (including electricity and gas), software used directly and actively in the R & D and specially commissioned parts for prototypes.

This will represent a significant extension of the amount of expenses that will qualify for many companies.

Externally provided workers

For expenditure incurred on or after 9 April 2003, the additional expenditure category of externally provided workers (EPW) qualifies for R&D tax credits. The EPW must be an individual and not a director or employee of the company and must personally provide or be under an obligation to provide services to the company. The company should supervise or have the right to supervise the way in which the EPW carries out duties and the services of the EPW should be provided under a contract via a staff provider.

Recruitment costs and fees payable to employment agencies do not qualify but if the staff provider is not connected to the company, 65% of the expenditure paid to the staff provider for the supply of EPWs for R&D is allowable as a deduction.

The EPWs must be directly and actively engaged in the R&D, rather than being support staff such as those providing secretarial or administrative services. If the workers are partly engaged on R&D, and partly on non-R&D activities, only the proportion of qualifying expenditure relating to the R&D is allowable. The expenditure must be for the provision of staff and not for other services.

If the staff provider is connected, the amount of qualifying expenditure is restricted with reference to the same methodology as for work contracted out by an SME Principal Company to a connected company.

Conclusion

Establishing whether a company’s operations will qualify under the definition of R&D for the purposes of the UK tax credit will only be part of the battle, as there are many other questions to be answered:

1. What expenses will qualify?

2. How is it possible to make an apportionment for costs such as relate to qualifying and non-qualifying activities?

3. Can a Principal Company make a claim if the company incurs expenses in contracting work out?

4. Can a Sub-contractor Company make a claim if the company incurs expenses on work contracted in?

This article has discussed the above and it should be reiterated that it is not just the Principal Company who has initiated the R&D process that stands to benefit from the credit, but also the many Subcontractor Companies in the market place to which R&D work may be outsourced and who contribute to the process. It is essential, therefore, for companies who are involved in contract R&D to review their position with a view to maximising the R&D tax claim. A company involved in contracting R&D work out should similarly ensure that they are capturing all qualifying payments made in relation to work contracted out.

In addition to the above, there have been some dramatic changes to the R&D rules and subsequently the methodology surrounding claims made by companies in prior years may no longer be applicable; companies may not be maximising their R&D tax credits due to the extension of the rules relating to consumable stores and externally provided workers.

It should be noted that there is one final step in the process. Once a company has established that its operations qualify as R&D and that all possible qualifying expenses have been included, it will need to ensure that detailed documentation is in place to substantiate the claim. One would hope that the net tax benefits substantially outweighed any administrative costs or opportunity costs associated with the information gathering and documentation process. The Inland Revenue is planning on releasing documentation requirements in relation to R&D Claims to assist companies with this task.

Shiv Mahalingham BSc(Econ) ACA CTA(Fellow)
Ernst and Young LLP, Energy Tax Group
smahalingham@uk.ey.com

The statements made and views expressed in this work are solely those of the author and do not necessarily represent the views of Ernst & Young LLP.

This article was first published in ‘Tax Adviser’ November 2004, and is reproduced with the kind permission of the author.