Changing accounting practices are having a big impact on research and development (R&D) tax credit claims.
Anyone who does not have a clear understanding of how this behavioural change impacts R&D tax credit claims runs the risk of failing to unlock the incentive’s full benefit.
More and more businesses are now preparing accounts under accounting standard FRS101 (a reduced version of international accounting standards) or FRS102, which has replaced UK Generally Accepted Accounting Practice (UK GAAP).
In practice, this switch means that more R&D expenditure is being capitalised.
What are the implications of capitalising R&D expenditure?
Many companies don’t understand the implications when R&D costs are capitalised for accounting purposes. In this article, we will look at intangible assets which are revenue expenditure for the purposes of your Corporation Tax return.
Important distinction: capital expenditure vs capitalised expenditure
If you’re looking for advice on capital allowances, that’s different – referring to allowances for ‘tangible’ things you could (at least try to) ‘pick up and throw’. That advice lives in the article: R&D capital allowances and R&D capital expenditure – are you missing out on valuable deductions?
Capitalising R&D expenditure
Why do businesses capitalise expenditure? Capitalised expenditure sits on the balance sheet (now the statement of financial position) for accounting purposes and the costs are depreciated (or amortised), to reflect the fact that they benefit a business over a number of years.
So your profit & loss account (or income statement) shows a depreciation expense in each year the asset is in use, rather than one huge expense in the year of purchase. This means that your business’s profits for the year are an accurate representation of how the business is doing.
Assets such as buildings or fixtures and fittings, are classified as tangible fixed assets (they have physical form). But what happens if instead of a building, your business is investing in a software platform, like an ERP system?
Here, a similar principle applies: the asset will benefit the business over a number of years, so it also follows that this expenditure should sit on the balance sheet and be charged to the income statement over the life of the asset. Except a software platform doesn’t have physical form, so it is an intangible asset.
Changing accounting practices
Accounting standards set out criteria for when this type of expenditure could and should be capitalised. Under UK GAAP, there was more flexibility compared to international standards (IFRS) or FRS102.
Where UK GAAP says certain expenditure could be capitalised, IFRS and FRS102 say it should be.
This means that many companies have found themselves having to consider capitalising costs that they would previously be expensing because they are transitioning from UK GAAP to FRS102.
Tax treatment of intangible assets
Before considering how R&D tax credits and intangible assets interact, it is necessary to understand the tax treatment of intangible assets in general, as it differs from tangible assets.
For intangible assets, the equivalent of depreciation is amortisation. Unlike the depreciation charge, amortisation generally is tax deductible. So, tax relief on intangible asset expenditure is given over however many years the asset benefits the business.
It is important to note that the tax treatment of intangibles differs for different types of asset (e.g. goodwill, licenses, trademarks, patents etc) and this article does not seek to analyse the different treatment of these types of asset.
The most common examples of R&D expenditure capitalised as intangible assets would be a software platform, or a development project that is work in progress over a number of accounting periods.
How does capitalising expenditure affect R&D tax credits?
To include capitalised expenditure in your R&D tax credit claim, there are a number of legislative conditions which must be met. It is not enough that your expenditure relates to your R&D project. One of the conditions that must be met is that the expenditure is deductible in calculating, for Corporation Tax purposes, the profits of your trade.
For intangible assets, the tax deductible amortisation charge meets this condition. This means that only this amount would be eligible for your R&D tax credit claim each year, effectively spreading your claim over a number of accounting periods and delaying access to valuable growth fuel for your business.
Section 1308 explained
Fortunately, in 2005, the government stepped in to help fix this issue. They introduced a specific tax provision that allows you to access the full benefit in year one, provided you meet certain criteria, for example, that the expenditure is on R&D and is not capital in nature.
The specific tax provision that allows intangible asset expenditure to be included in an R&D tax credit claim is Section 1308 Corporation Tax Act 2009.
Let’s put some numbers to this to make it clearer:
£100k of qualifying R&D expenditure is spent by a business on developing a software platform. Amortised over 5 years, £20k would be charged to the income statement each year. This is allowable for tax purposes and would allow £20k of R&D costs to be claimed each year, meaning the benefit would be received over five years. However, utilising section 1308 CTA 2009 instead would allow for the whole £100k costs to be included in the R&D claim all at once meaning the whole benefit would be received in the first year.
So, in this example, each year £20k of the total development costs has been deducted in calculating taxable profits. This means that, even if the whole £100k otherwise qualifies as R&D expenditure, only £20k each year qualifies for your R&D tax credit claim, as this is the amount which is tax deductible each year.
This is only a timing difference, but it is the difference between including £100k of R&D costs in year one, or £20k each year for five years.
Capitalising expenditure – intangible fixed assets vs tangible fixed assets
It is worth noting that the above section on section 1308 is only available where R&D expenditure is capitalised as intangible fixed assets (IFAs).
If R&D expenditure is capitalised as tangible fixed assets (TFAs), a section 108 deduction is not available on the expenditure. It is normally not possible to include expenditure that is capitalised as a TFA in an R&D claim.
While we cannot advise on whether expenditure should be capitalised as an IFA or a TFA, additional consideration should be given to the matter where the capitalised expenditure relates to R&D.
Need help with claiming R&D tax credits for intangible assets? Use an expert
It takes expert analysis to ensure that you get the right result for your business. Therefore, you should seek specialist advice to help.
ForrestBrown is the UK’s largest specialist R&D tax consultancy. Our rigorous approach produces robust R&D tax credit claims. We quality assure each claim for accuracy with a distinct team including ex-HMRC R&D Unit tax inspectors.
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