Does your business claim R&D tax relief for developing products and services with a customer in mind? If this is the case, and for many businesses it is, then you need to know about HMRC’s recent change in approach.
HMRC are challenging a number of SME research and development (R&D) tax relief claims for customer-led R&D on the basis that this R&D is subsidised by customers. As a result, some businesses are now facing challenges due to their contractual arrangements.
If you entered a contract that relates to your R&D either before or during your project, you now need to be proactive in reviewing your R&D tax claim – or you could be exposing your business to risk.
Read the latest on the state of play for subsidised expenditureRead more
Changes afoot for customer-led R&D
Most businesses have little or no interaction with HMRC when filing R&D tax relief claims. As such, many won’t realise that things have changed. In general, the only businesses that will be aware of a change in approach are the few who have so far received an HMRC enquiry.
At ForrestBrown, we have seen this trend in a small number of our own claims, and in those prepared elsewhere that we have supported through the enquiry process.
We are aware that HMRC is in the process of updating its published guidance on subsidised R&D expenditure. Once this new guidance is live, all companies making SME R&D tax credit claims will need to reconsider their filing position and the disclosures to HMRC required to protect their business.
As part of our recent work on the R&D tax relief consultation, we engaged widely with key stakeholders within our industry. Through these discussions, and from our work with other accountancy practices and professional advisers, we have become aware of a fundamental disagreement with HMRC in the technical interpretation of the R&D tax legislation.
An example of HMRC’s tightening approach in practice
The types of businesses and projects that this topic could affect are broad since the majority of commercial R&D will be customer-led. This includes any R&D undertaken to develop products or services with a specific customer in mind. If we consider a simple product development scenario in the manufacturing sector:
EXAMPLE 1: Developing a product
Say a company decides to start an R&D project to develop a new product.
This SME company has taken on risk and carried out self-generated R&D. On completion of the project, it hopes to sell its new product to customers and retailers.
Those customers have neither contracted this R&D to the company nor are they subsidising the company’s R&D expenditure by purchasing the product from it. SME relief should therefore be available.
EXAMPLE 2: Commission of a product
Unlike the above example, the company secures a contract up front with a retailer to supply the product if it is successfully developed.
Because this R&D took place to fulfil a contract, HMRC now considers that the company’s R&D expenditure in developing the product has been subsidised by the retailer.
In HMRC’s opinion, therefore, SME relief is not available.
Note: Although these examples deal with product development, contracts for services are affected similarly.
How we interpret the subsidised R&D legislation
We have commented extensively on the challenges facing R&D tax relief and the specialist R&D tax advice market in particular. We share HMRC’s concerns about errors and fraud in R&D tax relief claims and agree that action needs to be taken to reduce errors and address attempted fraud.
However, we disagree with HMRC’s technical interpretation of the law regarding subsidised R&D expenditure and contracting out of R&D activities. We believe that it is an incorrect interpretation of the legislation. If it is applied broadly, it will render SME R&D tax relief extremely narrow in scope and create unintended and unwanted policy outcomes.
A tightening in scope of R&D tax relief
SME R&D tax relief was not intended to apply only to truly ‘blue sky’ R&D. The relief is only available to companies and therefore is targeted at commercial R&D. Commercialisation is a given. Some companies will develop new products in the hope of being able to sell these profitably in the future. Most will seek to manage their commercial risk by identifying customers and a route to market earlier than that.
In both scenarios, the company carries the risk of its R&D failing. HMRC’s interpretation seeks to penalise these efforts and we don’t believe that’s right, either technically or economically.
R&D tax incentives are designed to encourage businesses to invest in more innovation, by reducing the cost (and therefore the risk) of carrying out that R&D. To achieve its policy intent, relief must be awarded to entities where it encourages more R&D to be undertaken.
If the relief is directed at the wrong entity, it becomes passive and has little to no impact. It is wasted money from the government’s perspective. Any interpretation which results in this outcome is either wrong or has exposed a major flaw in the tax legislation which the government should act to remedy urgently.
Why is HMRC taking this approach to subsidised R&D expenditure?
We think HMRC is adopting this new approach to subsidised expenditure in an effort to reduce error and fraud worth an estimated £311m, following public criticism from the National Audit Office. For a long time now, we have seen government and HMRC take a piecemeal approach to address this issue – with the new PAYE and NIC cap, new software guidance, CT600 amendment rules and its online service.
Changes which address the root causes of errors are welcome. However, while this narrowing of scope may reduce the overall cost of the incentive, it also serves to deny genuine innovative companies access to relief.
Disagreements between HMRC and tax advisers do happen, even within the relatively established scope of R&D tax reliefs. For example, until 2009, HMRC held the view that qualifying indirect activities could not attract relief. Many years of discussion with the R&D tax community eventually led to a U-turn from HMRC. Interpretations of the law can differ and change over time and we expect this subject to evolve as this discussion progresses.
It may seem counter-intuitive for an R&D tax adviser to disagree with the body administering the relief. At ForrestBrown, we understand that our role as tax advisers sometimes leads us to disagree on points of law with HMRC. As with qualifying indirect activities, among other points over the years, a technical debate is a normal and healthy part of the relationship between HMRC and tax advisers. Such discussions often lead to positive changes which benefit all parties.
We would prefer to see HMRC work together with HM Treasury and the Department for Business, Energy and Industrial Strategy (BEIS) to reform the incentive by improving targeting, defining a simpler rule base and increasing regulation of the tax advice market – something we explain in further detail in our R&D tax relief consultation response.
How ForrestBrown can help
To understand whether your R&D claim might be affected by this change, you need to be:
- Making use of the SME R&D tax relief scheme; and,
- Undertaking any customer-led R&D projects.
If you have any questions or concerns, please don’t hesitate to contact us. Now more than ever it is a critical time to ensure your business is enquiry ready. Don’t wait for HMRC to send you an R&D eligibility letter, to open an enquiry or indeed seek a discovery assessment.
Our team of chartered tax advisers, sector specialists and former HMRC inspectors have first-hand experience of helping businesses navigate this issue. By reviewing your relationships and your contracts, our advice will help you to be proactive in managing your business risk and provide practical recommendations for next steps.
If you or your client is already facing an enquiry on this issue – or any other – we can help you navigate this process to achieve the best possible outcome for you or your client’s business. Please don’t hesitate to contact me directly by email at firstname.lastname@example.org.