A guide to R&D tax credits for software development

If your business is tackling technological uncertainties as part of software development, there’s a chance you could benefit from research and development (R&D) tax relief.

R&D tax relief is a reward for investing in innovation that frees you up to take more risks and grow your company in exciting ways.

What qualifies as R&D in software development?

If your software company is taking a risk by attempting to solve a scientific or technological challenge then you may be carrying out R&D. You might be developing a new product, process or service, or improving an existing one.

Here are some of the more common areas for qualifying software R&D:

• Artificial Intelligence (AI) and Machine Learning
• Cloud computing
• Data processing and storage technologies
• IoT
• Augmented reality
• Robotics

Yet software R&D can be difficult to identify given its technical nature so we’ll take a deeper dive. Click on any of the below links to find out more:

• Who qualifies for software development R&D tax relief
• How and what sorts of software qualifies
• Which specific software development qualifies for R&D tax credits
• What type of expenditure is included and which staff roles qualify

Who qualifies?

The types of company which could qualify for R&D tax relief for software development include:

• Companies that develop a software product
• Companies that provide software development services.
• Businesses that develop software in-house: Any business that performs a bespoke software development project.

General principles: how software development qualifies for R&D tax relief

HMRC considers software development activities to either sit within the information and communication sector, or be activity underpinned by the field of computer science. HMRC are looking to see an advance in overall knowledge or capability against presently available knowledge, not just your company’s own advancement. 

What types of software development might qualify for R&D tax credits?

Overcoming scientific or technological uncertainty

Resolving software difficulties and challenges that have not yet been overcome by a competent professional in the field. The knowledge gained must not have been simply adapted from freely available knowledge.

HMRC also needs to be able to see how the improvements to the software were made, which problems were faced, and how they were overcome.

The introduction of new software products or systems

This could include, for example, the development of novel software capabilities to improve the speed of a system. It might be the optimisation or re-architecting, or integration of different technologies that did not already interoperate.

Improving an existing product or system

This consists of improving the capability of an existing product or system. It can’t just be configuring a software product for your business but it could include adapting bespoke systems for integration (with web programs, new hardware, new devices or making legacy technologies interoperate).

Specific software development that qualifies for R&D tax relief

Branches of software development such as AI; data processing and storage, cloud computing, augmented reality, software-defined networking, robotics, and video games. All are projects that have lots of potential to contain the activities that will allow you to make a successful R&D tax credit claim.

AI and machine learning

Software is continually evolving. Something perhaps best demonstrated by the rapid advances in AI and large language models (LLM) in recent times. ChatGPT is now ubiquitous, and more and more companies are developing products and services with elements of AI.

It doesn’t stop there. The widespread availability of increasingly sophisticated AI tools and the low barrier to entry means we’re effectively in an AI arms race: advances from one group constitute a threat that needs to be defended against by another group. This constant risk and mitigation battle has the potential to contain significant amounts of innovation and risk-taking, prime candidates for R&D tax relief. 

Much of the current focus of AI is around security and risk, but at some point, this will need to shift focus to address the high costs of electricity and computer resource alongside the corresponding environmental impact of the technology. AI will need to evolve in more cost-effective and greener ways, heralding new and exciting innovation. 

With the increased adoption of multiple AI tools by businesses another interesting area of software development emerges around the operational management of these tools. We’re going to see more software developed to facilitate the parallel processing and management of big GPU clusters.

Branches of AI and their application include:

AI and security

The security threat posed by the widespread availability and power of AI tools means that businesses need to be constantly investing to make things secure in an evolving space. New threats must be detected and then mitigated. 

AI legal services

AI is being adopted by law firms and is slowly transforming the legal sector. Machine learning is being employed to save time by carrying out mundane tasks such as scanning vast archives of legal documents for particular types of clauses to more sophisticated eDiscovery and even case outcome prediction.

AI recruitment

AI recruiter bots can save recruiters significant amounts of time by automating sourcing, screening and scheduling. These bots handle everything from CV analysis to assessing a candidate for company ‘fit’. The aim is to free up time for businesses and recruiters, and better match candidates with suitable employers. However, there are concerns around hiring bots with biases that are discriminating against particular applicants.

AI healthcare treatments

From an AI tool used to spot tiny cancers missed by doctors to machine learning aiding the early stage diagnosis of dementia, AI has the potential to revolutionise healthcare. Everything from the Analysis and processing of microscopic detail medical images e.g. macular imagery for early detection and prevention of eye diseases.

AI in data processing

Financial data

Speculation continues to suggest that investment fund management could be revolutionised by AI.

Network data

Securing network data against increasing threats Automated inspection of every packet of data that passes through a network for enhanced security. Cambridge-based software company, Darktrace, offers a self-learning AI to deliver bespoke security tailored to an organisation’s entire digital ecosystem, preventing and defending against cybersecurity threats.

FInd out more about R&D tax relief for AI.

What type of R&D expenditure can be claimed as part of software projects?

There are many areas of expenditure which you can claim for as part of an R&D project, spanning from direct and externally provided staff, to licence costs and consumables.
The core areas of costs include:

• Direct R&D staff costs

• Externally provided R&D staff

• Consumable items such as fuel and power used in R&D process

• Prototypes, where created to test the R&D being undertaken

• Subcontracted R&D with the SME and RDEC schemes.

• Data and cloud computing costs (for accounting periods beginning on or after 1 April 2023).

• Pure maths (for accounting periods beginning on or after 1 April 2023) – mathematical advances in themselves are treated as science for the purposes of R&D tax relief.

Find out more about how changes to the R&D incentives in 2023 relate to cloud and data costs.

Which staff roles count towards R&D tax relief?

Your R&D team will most likely span across several different departments in your business and this means that a variety of different job roles could be eligible for tax relief.

This could include: 

• Project Managers
• QA and testing specialists
• Senior management
• Developer
• Software Engineers

What software guidance is available from HMRC?

HMRC provided updated guidance on software R&D as part of its Guidance for Compliance 3 (GfC3). Used in conjunction with the BIS guidelines, GfC3 provides contextualised guidance, specific examples and clarifies what information HMRC requires for software R&D claims.

Read more about HMRC compliance, GfC and what it means for your software R&D claim. 

It supersedes all previous software R&D guidance including the October 2018 updated guidance issued by HMRC and informed by a special subcommittee made up of agents from HMRC’s R&D Consultative Committee – including our own software expert, Tom Heslin.

Software development moves fast. That’s why HMRC needs to provide regularly updated guidance. When you make a software R&D tax relief claim, it’s vitally important to include a competent technical professional (usually a senior developer) in the information-gathering stage of the process. This will help populate the additional information form and technical narrative.  

Since the publication of this specific software guidance, there are two further significant developments to be aware of when considering whether you are eligible to claim R&D tax relief.

Firstly, from April 2023, pure mathematics has been included in the definition of R&D for tax purposes. This change (the first change to the definition in several years) recognises that mathematical techniques are frequently used in science, and are in themselves treated as a science for the purposes of the guidelines. This disambiguation should give tech firms more confidence when claiming.

This definition change was accompanied by the inclusion of data and cloud computing costs in qualifying R&D expenditure. It is particularly beneficial to businesses operating in AI and machine learning. It’s important to note that when it comes to data there are stipulations around not simply being a broker of the data – you need to be actively using the data, essentially the end point of the data’s journey. 

Read more about the impact of changes to data, cloud and maths.  

Additional Information Form

HMRC introduced the Additional Information Form (AIF) as a requirement for all R&D claims submitted from 1 August 2023. Although the form mandates how supporting information for your R&D claim needs to be provided, it doesn’t help with the specifics, including what to write and how to position it. ForrestBrown can help software companies present the relevant information in the right way in support of your R&D claim. 

It is clear that HMRC wants more specifics from the people doing the R&D. Due to the pace of change within the software industry and high turnover of IT contractors, this can prove a problem. It’s therefore increasingly important to capture details of your software R&D projects – you’ll need to provide more detail across significantly more case studies than ever before. ForrestBrown’s sector specialists are available to help you navigate the increased complexity around software R&D claims.   

Misconceptions around software claims

There are several misconceptions software developers may have when encountering R&D tax credits. Because of this, some companies do not make a claim when they are eligible to do so. Below we explore the most common myths we’ve heard in the context of software development.

1.    Only new software qualifies

This is not true. Even if the software currently exists, improving existing software and overcoming new challenges, still counts as genuine R&D. A rival software developer may already have the capability you seek. But, if your experts don’t have that technical information available to them — experimenting to discover a solution — then that’s still qualifying R&D activity.

2.   Part of the project wasn’t R&D

Even if the project has standard elements within it, if a new aspect was implemented, it still constitutes R&D. For instance, if there is a new component that fits into a larger existing system. This could still be valid R&D providing there were underlying technological uncertainties that needed to be resolved within the additional component and its incorporation into a wider system.

Some businesses limit the scope of their R&D by failing to include project management, development of tooling for the product and indirect activities that qualify, like certain finance activities.

3.   We weren’t taking a financial risk

One of the key criteria of a qualifying R&D tax credit claim is that there is uncertainty in the outcome. i.e. you don’t know for sure if what you’re doing is going to be successful. If this uncertainty is present in your project, you will be taking a financial risk in undertaking the project, and therefore it may well qualify for R&D tax credits.

4.   We used subcontractors and they don’t qualify

For many years, the use of subcontractors has counted as qualifying expenditure for an R&D software project providing the work they perform on the project is R&D. And this was still the case even if the subcontractors were based outside of the UK. However, it is no longer as straightforward as this. Software companies need to be aware of changes to the rules around subcontracting as part of the introduction of a merged scheme. This reform came into force for accounting periods on or after 1 April 2024, and includes changes to qualifying overseas expenditure.

5.   Capitalising software expenditure doesn’t have an impact on my claim

Another area of confusion is to do with the accounting and tax treatment of software development. Capitalising the costs of software development is a common practice for accounting purposes. Indeed, some businesses that work by outsourcing software development are often recommended to capitalise software R&D costs.

Imagine this scenario: You’ve spent a lot of money on a big project which is intended to benefit your company for years to come. Your business (or your accountant) spreads out the costs on the balance sheet over multiple accounting periods. This is where you make your company appear more profitable in the current year to give more clarity to shareholders and investors. This is entirely normal.

It does not stop you from claiming R&D tax relief. But what’s important to bear in mind is that capitalising expenditure in this way could have an impact on the size of your R&D tax credit claim. Fortunately, there is a tax mechanism to allow you to do both, but it takes expert analysis to decide which is most beneficial to your business.

Therefore, you should carefully weigh up the pros and cons of doing this with a chartered tax adviser that specialises in R&D tax relief (like ForrestBrown).

What can’t you claim for?

So, we’ve looked at what qualifies as R&D within software development but of course, there are some things that you can’t claim for. These include completely routine projects that do not require any advance in capability or the resolution of technical challenges.

Also, it’s important to note that not all of a commercial project is eligible even where there is R&D taking place. Beta testing, user acceptance testing and initial market research are all areas of a project that must be discounted.

You can’t always expect your accountant to have the specialist technical knowledge required to draw the boundaries between your R&D and non-R&D activity. Companies that submit an R&D tax relief claim themselves, or use a non-specialist R&D adviser, often do not identify all their qualifying expenditure. Thereby, missing out on valuable funding for their business.

How much are software R&D claims worth?

The short answer: it depends on how much you’ve invested. It also depends on the specific rates of relief that will apply to your business during a period of unprecedented change. 

Click through for the latest SME rates and RDEC rates, and view our merged scheme guide for details on how this will impact your software claim.   

For many, the positive impact of R&D tax incentives can be transformative. They help businesses to embed a culture of innovation; a virtuous circle where a business spends money on innovation and sees the positive impact accumulates year on year.

Money that is recuperated via an R&D claim often allows for the recruitment of more technical expertise and further investment in R&D. Plus that business gets more resource, becomes more agile, can try new approaches and take more (calculated) commercial risks. Fail fast. Test and learn.

More innovation, larger claims, better hiring, more staff learning, business growth, industry development and the continued growth of the wider UK economy. It really pays to be among the businesses utilising this valuable government incentive and nowhere is this more true than in software development.

How ForrestBrown can help

ForrestBrown’s combination of specialist software sector experience, tax knowledge and understanding of HMRC’s evolving requirements means we’re ideally placed to support your software R&D claim at a time of increased complexity and scrutiny.

As innovation incentive specialists, we help businesses make the most of their investment in innovation. This spans grant funding, patent box and R&D tax relief. We were named best independent consultancy firm at the Taxation Awards 2023 in recognition of our technical excellence and service innovation.

Meet the ForrestBrown software experts

At ForrestBrown, we’ll assemble the best possible team to support your claim. This will include sector specialists with decades of experience in the software industry who are able to discuss your innovation on a peer-to-peer basis, speaking directly to engineers. Ultimately this saves you time and helps create a more robust claim at a time of increased HMRC compliance.