Insight

R&D Tax Relief - Linking R&D Qualifying Expenditure

Maximising the value of your R&D work comes down to accurately attributing what you have spent within the framework of R&D tax legislation. Find out how...
R&D Tax Relief - Linking R&D Qualifying Expenditure

You’ve identified qualifying project work within your business, defined the advances and established the areas of work to overcome challenges contributing directly or indirectly to achieving those advances.

But how do you identify and capture the financial outlays associated with this work in order to claim research and development tax relief/R&D tax credits? 

Many businesses don’t realise there is a rule base to follow in this regard and put together costs through applying their internal cost-plus methods, such as hourly charge out rates, materials plus profit uplift, absorption of wider business overheads etc. Others attribute a percentage of turnover or entire expenditure cost categories such as cost of sales. None of these approaches are correct or acceptable. 

Maximising the value of your work comes down to accurately attributing what you have spent within the framework of R&D tax legislation. This requires an up-to-date knowledge of the details around the types of cost that can be included in your claim, combined with thought around how to establish a just and reasonable link between these costs and your qualifying activities.

There are 5 categories of costs that can be included in an R&D claim:

  1. Staffing costs 
  2. Software and consumable items
  3. Externally provided workers
  4. Payments to qualifying bodies
  5. Contracted out R&D

All costs need to be allocated within the boundaries of R&D. This means they must be linked to qualifying activities per the BEIS guidelines. Qualifying costs that relate directly to your R&D work will differ from the total costs incurred throughout the journey of getting to your final developed material, product, process, or service.

I’ve looked at the 4 cost categories in overview here.

Staffing costs that qualify for R&D

This category is concerned with capturing an element of the remuneration paid to your company’s in-house employees. 

There are two aspects to consider; what types of “earnings” paid to your employees can be included in the cost base; and when/how are those costs attributable to the R&D work carried out.

1. Earnings for R&D tax relief

Here you may include “earnings consisting of money” that are “paid because of the director’s or employee’s employment”. In other words, cash emoluments. 

This means that gross wages, employer’s National Insurance Contributions, employer’s pension contributions, cash allowances and reimbursed expenses* can all form the cost base. I say “base” as not all these costs can be included in full in your R&D claim. See 2. below.

Benefits in kind such as health insurance, company cars etc. are excluded, as are dividend payments.

*Costs must be borne by the employee and claimed back from your company. Therefore, invoices settled directly by the company or purchases made on a company credit card cannot be included. Care is also needed to only include expenses that are closely linked to the R&D work and are allowable as staffing costs/deductible against profits chargeable to corporation tax. For example, expenditure on reimbursement for client entertaining should not be included in an R&D claim.

2. Attributing staffing costs to the R&D work

The time spent by employees on activities that collectively contribute to seeking the advance directly or indirectly (this may be wider than just the problem-solving work) will need to be considered for each employee’s involvement in each qualifying project. Here you must consider those activities that fall within the boundaries of R&D per the BEIS guidelines.

There is no set methodology required to apportion staff costs. HMRC requires that the apportionment is “just and reasonable”. It is about finding a prudent means to link the underlying time of your employees to the qualifying work they have been involved in.

Example of staffing costs and qualifying research and development expenditure
An example of staffing costs apportionment for R&D related activities

In the claims I prepare for my clients, I expand this table and annotate with footnotes to include other helpful information for HMRC so they can better understand how an individual member of staff contributed to the qualifying R&D work.

Claiming an unsupportable apportionment of staff costs or getting the boundaries of R&D wrong is one of the most common mistakes made in R&D claims.

Software and consumable items that qualify for R&D

Software

Your R&D project may incur running costs associated with annual software licensing fees.

Firstly, you will need to identify softwares with licensing fees that are revenue in nature. This means you are looking at software licences that are paid for with regularity (at least annually) and are not a one-off capital purchase for use of a platform for example. 

You will then need to consider whether these softwares are employed directly in order to carry out your qualifying R&D work – this can be wholly or partly. For example, developer licences to provide development tool kits in software development, CAD software to perform design work, software to perform colour matching, software to analyse material compositions etc. 

From 1 April 2023, costs incurred in relation to cloud computing (not hosting) and the purchase of data sets to the extent it is used in R&D work may be considered for inclusion. 

A just and reasonable method to apportion software costs to projects (or across all qualifying project work if more practical) needs to be ascertained. Even where software is solely used for qualifying R&D, be careful to ensure any element of cost relating to help and support is excluded. If the contract does not specify this, then applying a reasonable basis to exclude such elements is advisable.

Consumable items

Consumables are materials used or transformed in your R&D projects, such as raw materials, laboratory or workshop disposables, water, gas, electricity (Water, Fuel and Power).

Electricity cables under a sunset sky
Water, Fuel and Power costs can be apportioned as part of your R&D claim if paid for separately (e.g. are not wrapped up as an all inclusive rent payment for your premises)

Components used to create a prototype or test rig for testing purposes could also feature in this category.

Again, you must consider how to establish a link between the research and development expenditure on consumables and the qualifying activities for your project. Avoid taking a broad-brush approach to allocating percentages by expenditure categories without breaking these down as far as possible. Look to analyse ledger codes to isolate those costs that are allowable, exclude items that are clearly disallowable and apportion from there.

It’s also important to exclude any costs for items that are sold for scrap or residual value, or feature in an end saleable product/production process.

There is no set methodology! This will depend on your business, the R&D versus non-R&D usage and the data available on which to apportion to drive out the fairest links.

Externally provided workers (EPWs)

EPWs are individuals provided to your company through a staff provider, for example, agency staff, contractors and freelancers.

They work like regular employees but are paid via third-party staff providers rather than being on your organisation's payroll.

EPWs must work under the supervision/direction/control of staff within your company. And, just like an employed member of staff, you must apportion expenditure if an EPW carries out both R&D and non-R&D activities.

You cannot include agency fees and prima facie, you cannot include the full amount of the invoice for work undertaken by EPWs; only 65% of the qualifying costs (i.e. costs apportioned to qualifying activities) can be included in the R&D claim. This 65% restriction applies when the staff provider is not a connected party. 

However, if you use workers from a connected party e.g. a group company (or make a claim to be treated as connected) you’ll need to prepare your claim based on the underlying staffing costs of the individuals provided by the staff provider as you would for your own in-house employees (see staffing costs above). There are a few more tests to be applied (as you would expect from tax legislation) to check whether any restrictions apply to the calculated costs, which are not considered further here.

Contracted out R&D

The costs that you can include for subcontractors differs depending on whether you are claiming under the ‘large companies’ RDEC scheme or the SME scheme.

If you are claiming under RDEC, money spent on subcontractors does not normally qualify for tax relief, but there are some exceptions. Companies claiming under the RDEC scheme can only claim if the activities are subcontracted to: 

  • An individual, or partnership of individuals, or
  • A qualifying body (meaning a university, charity or research institution).

If you are making a claim under the SME scheme, you can include 65% of the qualifying costs (you will need to apportion your invoiced costs to exclude any non-qualifying work) made to an unconnected subcontractor. 

As with the EPW cost category, where a subcontractor is connected to your company, or you elect to be treated as connected you must look through the payment to consider the underlying qualifying R&D expenditure (across all qualifying cost categories mentioned in this article) incurred by the subcontractor. Again, there are further tests to be applied to check whether any further restrictions apply to the calculated costs.

The diagram below is helpful to visually summarise the position:

Diagram that shows the differences between unconnected and connected subcontractors
The SME scheme sees differences between handling unconnected and connected subcontractors

Getting your claim right

Knowing exactly which underlying costs to include in your claim and moreover, working out an acceptable method to attribute these to your qualifying work is not always easy. 

Many of the businesses that I work with worry about getting things wrong or how to demonstrate to HMRC that the tax rules have been understood and correctly applied. 

The specifics of a business’ operations and development endeavours can muddy the waters sometimes, so it's always best to speak to a specialist about your organisation's R&D activities and get the right support with putting things across in the best possible way.

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