R&D tax incentives and software
If your business is involved in software development, there’s a good chance you could benefit significantly from research and development (R&D) tax credits. Taking advantage of the government’s R&D tax relief for your software development can free you up to take more risks and grow your company in exciting ways.
What qualifies as R&D in software development?
The definition of R&D (for tax credits) is purposefully broad. 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:
- AI and Machine Learning
- Cloud computing
- Data processing and storage technologies
- Augmented reality
Yet software R&D is one that is more nuanced than most so we’ll take a deeper dive. Find out:
- 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 for software development R&D tax relief?
Software is continually evolving e.g. a number of well-established branches continue to do so (AI, Cloud, mobile) and new applications for software are developed (e.g. robots, augmented reality, IoT and others yet to come).
Any company that is developing software could qualify for R&D tax relief:
- Software development companies: Typically, a business that has teams of software developers to support other businesses in their software projects.
- Software houses: May create and iterate software, provide Software as a Service (SaaS), business tools or enterprise resource planning (ERP) systems.
- 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?
- Software that overcomes scientific or technological uncertainty
- Introduction of new software products or systems (jump to second point and so on)
- Improving an existing product or system
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 capability 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, including:
AI and machine learning
More and more companies are developing products and services with elements of AI.
AI is the science of making computers able to make decisions in complex situations. Most of today’s AI uses statistical techniques to calculate a probability, which will allow the software to ‘make decisions.’ It does this by calculating what is most likely the correct outcome based on the data it has available for a very specialised task.
AI or machine learning tools like convolutional neural networks are used to make the decisions once they are trained to perform the task. Training a machine learning classifier (a tool that can classify something into two or more categories) involves developing and deciding a treatment of data used to train the neural network to correctly perform the task.
As everyday processes have become increasingly digitalised, AI and machine learning are becoming a driving force within the software industry. Machine learning is being built into a fascinating variety of processes and functions. Branches of AI and their applications include:
AI natural language processing
AI call centre automated agents/speech software
Automated agents/speech software that includes natural language processing and even sentiment analysis). Filament specialises in building bespoke AI and machine learning chatbots for their clients’ customer services. The bots that Filament produce can distinguish a client’s brand, enhance relationships with existing customers and open the door to new customers.
AI legal services
Reviewing vast archives of legal documents to search for particular types of clauses.
Sourcing the ideal candidate and vetting. AI recruiter bots such as Mya can save recruiters 75% of their time through the means of automating sourcing, screening and scheduling. This provides recruiters with the time to focus on identifying candidates and matching them with suitable employers.
AI political analysis and planning
Using sentiment analysis to deploy automatic messaging tailored to specific individuals – for better or worse.
AI image analysis
AI satellite imagery analysis
Trawling through masses of astral data for signs of habitable planets, for example.
AI healthcare treatments
Analysis and processing of microscopic detail medical images e.g. macular imagery for early detection and prevention of eye diseases.
AI in data processing
Speculation continues to suggest that investment fund management could be revolutionised by AI.
Automated inspection of every packet of data that passes through a network for enhanced security. Cambridge-based software company, Darktrace, uses AI techniques to identify and learn what is ordinary within a company’s network or database. Using machine learning, Darktrace can spot patterns and prevent cybercrimes before they take place and pose a real threat to a company. Darktrace has currently identified 48,000 previously unknown threats in over 3,000 networks, therefore proving itself to be a highly valuable security tool
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.
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
- Software Engineers
What innovations are there in software development currently?
Software is everywhere. Connecting people, data and things in new and extraordinary ways. Robot vacuum cleaners, wearable fitness trackers, clever thermostats and other remote home control devices. This is the Internet of Things (IoT) and it’s just getting started.The Internet of Everything (IoE); the Industrial Internet of Things (IIOT), and financial technology (FinTech) are among the innovations spreading from consumer goods to B2B products and services too. In 2019 connected devices using the IoT totalled around 27 billion. By 2025 it’s thought to be 75 billion.
Infinite software applications
All these connected devices point to the continued importance of software interfaces and software development. Many new products have software interfaces ready to use right out of the box.
Some encourage, or even require, developers to join sandbox environments in which interoperability is programmed via open APIs. Others need to be updated and redesigned to interface with more advanced technologies like software-defined networking, automation, robotics, AI and augmented reality.
Data retrieval and storage technologies
A significant area of R&D taking place in the software sector involves how data is structured and accessed. This includes creating new search processes and using new methods to search for information — such as custom-made internal search tools. These can be useful in many ways. For instance, a recommendations engine on an eCommerce site enhanced by the way metadata is structured between products. Salesforce has devised a system called Seq2SQL (which can translate natural language questions and turn them into database queries). This will mean that users can ask their database a question about their customers and Seq2SQL will return an answer from that database. This completely abstracts the complexity of forming the query. It also required significant software innovation to understand how to interpret the questions and parse them into database queries automatically.
Cloud applications rely on remote servers — often operated by third-party providers — for processing data that is accessed via the web. Thorough testing of cloud applications prior to deployment is essential to ensure they are secure and operating efficiently.
Cloud services can be very useful as they offer software and hardware combined as a service. This might be a hosting environment, where your code can run in the cloud provider’s environment. This can be designed in a way that allows them to scale (add more computing resource) rapidly and efficiently.
Microservices is an architecture style wherein applications are built as a collection of smaller, individual services connected by APIs, rather than one whole app that is interconnected. Using a microservice architecture means that the services can scale more efficiently. The cloud also provides software services where computationally expensive activities are undertaken specifically in the AI / machine learning space.
You may well be carrying out R&D if you are: building cloud software from the ground up; improving your existing cloud software product; developing innovative cloud tooling, or developing technology that allows different packages to interoperate in new ways.
Find out more about how changes to the R&D incentives in 2023 relate to cloud and data costs.
Video games development and visual effects
The UK has a thriving video games industry —and HMRC incentivises it further with not one but two tax incentives: Video Game Tax Relief (VGTR) and software R&D tax credits. Typically, the R&D tax credit is worth more, especially if there are significant technical developments to the software tooling. But how do you differentiate the qualifying activity for R&D tax credits from that of VGTR?
Here’s an example: If a developer created or improved a games engine to assist with the production of video games, then that games engine could be included in your R&D tax credit expenditure. The development of the game itself — voice acting, story development, art style — would be eligible for VGTR. However, one potential element of software R&D in the video game’s production is lighting within the game environment. If lighting needs to dynamically alter as the game is played, for example, this would go into the R&D tax credit claim.
What was the 2018 update to the HMRC software guidance?
To clarify how the definition of R&D for tax purposes (the BIS Guidelines) applies to software, HMRC published significant new guidance in October 2018.
This guidance was issued by HMRC’s R&D tax specialists, with support from the digital information officer of HMRC’s own Chief Technology Office. It was informed by a special subcommittee made up of agents from HMRC’s R&D Consultative Committee – including ForrestBrown’s very own software expert, Tom Heslin.
The new guidance removed outdated and generic examples — as these were quick to become obsolete — and replaced these with more up-to-date case studies. Importantly, the guidance did not change what counts as software R&D, it simply made clearer what does.
Why did HMRC update their software guidance and what does it mean for businesses?
Software development moves fast and HMRC’s previous guidance was outdated, short and limited. This had led to a lack of clear understanding of what constitutes software R&D for the purposes of R&D tax credit claims.
Factor in that software accounts for over 65% of all R&D tax credit claims submitted, and the need for new guidance is obvious. Especially when you consider that HMRC say that they have not, in general, been receiving the information they need in support of claims.
The new HMRC software guidance is fuller and explained in more detail. Used in conjunction with the BIS guidelines, it provides contextualised guidance and clarifies what information HMRC requires for software R&D tax credit claims.
If you’re pointed to the HMRC software guidance don’t be put off if you see lots of specific examples of software activity that doesn’t qualify. Fundamentally, your claim needs to focus on the underlying technology instead of just a software product or process.
When you make a software R&D tax credit claim, it’s vitally important to include a competent technical professional (usually a senior developer) in the information-gathering stage of the process.
ForrestBrown’s award-winning process is already aligned to this guidance. In fact, our lead software specialist, Tom Heslin, worked with HMRC to help formulate it. This means we are uniquely positioned to create a software R&D tax credit claim that will withstand scrutiny from HMRC in the context of this new guidance.
Misconceptions around software R&D tax credit 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
Providing that the work they perform on the project is R&D, the use of subcontractors does indeed count as qualifying expenditure on an R&D software project. And this is still the case even if the subcontractors are based outside of the UK.
5. Capitalising software expenditure doesn’t have an impact on my R&D tax credit 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 credits. 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 credits (like ForrestBrown).
What can’t you claim for in software R&D?
So, we’ve looked at what qualifies as R&D within software development. 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, 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 credit 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 tax credits worth?
The short answer: It depends on how much you’ve invested.
For most, the positive impact of R&D tax incentives is usually profound and regularly transformative. Besides the immediate cash, they help businesses to achieve a culture of innovation. This is a virtuous circle. When a business spends money on innovation, the positive impact accumulates year on year.
ICT businesses claim 28% of all R&D tax credit claims made by SMEs. However, it’s not just pure ICT businesses who qualify. There are many other types of business who could potentially claim software R&D tax credits, if they have ‘developed software to overcome a challenge.’
Money that is recuperated via an R&D tax credit claim often allows 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 discovering this valuable government incentive.
How ForrestBrown can help with your software R&D tax credit claim
ForrestBrown’s combination of specialist technical expertise, tax knowledge and understanding of HMRC’s R&D tax credit claims process, means that we can help improve your software claim.
We are the largest specialist R&D tax credit consultancy in the UK. Our commitment to excellence means we’re the best. Don’t just take our word for it. 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 expert
It’s not just chartered tax advisers who make up our award-winning ForrestBrown team. We’ve also enlisted specialist technical talent from industry and Tom Heslin MSc is one of our expert software sector specialists.