The financial benefits offered through R&D tax credits are a great way to encourage business growth, but it can be difficult to correctly determine which scheme your organisation is eligible to claim for a qualifying project under: SME or RDEC or both?
Both schemes offer tax relief on eligible expenditure but not at the same rates and there are some differences between these schemes around allowable expenditure types, which can have significant impacts on the overall financial benefits available to your organisation.
What are the two schemes for R&D tax credits?
Since 1 April 2002, there have been two schemes running side by side giving tax relief under the R&D tax credits regime but there have been a few changes made over the years so it's important to ensure the most up to date set of tax rules are applied.
A quick glance back at the evolution of tax credits:
- 1 April 2000 - R&D tax relief was launched with just the SME scheme.
- 1 April 2002 - The scheme for Large Companies launched for claimants not meeting the definition of an SME or not eligible to claim under the SME scheme for another reason.
- 1 April 2013 - The Large Companies scheme was replaced by RDEC (Research & Development Expenditure Credit).
What is the difference between the financial benefits of the two schemes?
The SME scheme is currently much more generous than the RDEC scheme in terms of the tax/cash benefits delivered via an R&D tax credits claim.
SME financial reward
Rates of relief can result in financial benefits worth between 25% and 33.35% for every £1 of qualifying expenditure identified, depending on whether the claimant company was profit-making or loss-making in the relevant tax year.
RDEC financial reward
Under RDEC, by comparison, the tax/cash benefit is currently 10.53% for every £1 of qualifying expenditure.
RDEC, despite offering lower rates of relief, can still bring significant tax benefits to large companies, whose R&D investment is often much greater in comparison to SMEs, running into hundreds of thousands of pounds worth of tax relief.
Unlike the current SME scheme, RDEC also showcases a company’s R&D investment, boosting company results by being accounted for “above the line” to show as income and reflected in profit before tax.
How to know which R&D tax scheme applies
There are a number of aspects that need to be considered collectively to work out which scheme your company is eligible to claim under. SMEs are defined by their size based on:
- Employee headcount (fewer than 500 employees) and
- Falling below either the annual turnover threshold of €100m or the gross assets threshold of €86m.
These tests to determine eligibility are collectively referred to as ceiling tests for R&D tax credits purposes.
Understanding ceilings tests
The ceiling tests thresholds can become complex to determine but are essential to get right. As noted above, not only are the rates of relief very different, but eligible expenditure categories also differ slightly between the two schemes.
Who ceilings tests apply to
It's also important to note that ceiling test requirements are not always applied for the claimant company in isolation! They can transcend the claimant organisation in some instances, meaning that this data is aggregated with that of other companies that are deemed to be “partnered” or “linked” with the claimant company to correctly assess if these ceiling tests have been met.
This is often an aspect overlooked by companies, meaning they wrongfully claim under the SME scheme as they don't realise they should factor in other group companies or other groups linked by commonality of beneficial ownership, for example.
When to consider ceilings tests
Ceiling tests must be considered annually with the relevant data for 3 consecutive claim periods looked at to determine a claimant company’s status as an SME. This is because failing the ceiling tests for a single claim period does not always automatically change a company’s claim status from SME to RDEC.
In other scenarios, company takeovers or demergers alter the status quo when applying the ceiling tests and in these cases there are more legislative rules to be worked through and applied to conclude on the status of a company.
Even in cases where your company meets the ceiling threshold tests for SME status, there are other matters to be considered by reference to other areas of R&D tax legislation to determine whether a project is to be categorised under the SME scheme or RDEC scheme.
On a project by project basis, due thought must be given as to whether any other factors mean a project must be claimed under RDEC, or even whether your company is entitled to claim for a particular project at all.
Additional criteria for determining whether a project may be claimed under the SME or RDEC scheme
To (try to) simplify things, let’s look at further aspects to consider under 3 broad areas...
1. Whether your project is self-led
Is your R&D project self-led? This means your organisation identified its own project, and is undertaking development work to meet your own goals/objectives/outputs either to solve an internal problem to benefit your business where there is not a direct saleable output e.g. developing an IT system; or you are developing something without a specific customer in mind e.g. you are looking to develop a new or improved product to solve a problem in your industry. In this case, provided you meet the ceiling threshold tests, you'd likely be able to claim under the SME scheme, unless funding causes complications! We'll dig into that below.
If your project isn't self-led, it may be customer-led. There are a number of ways this could manifest, and it is not possible to provide definitive scenarios and answers. So for simplicity, let's look at a couple of scenarios:
A customer focus group tells you they may potentially be interested in buying X if it was available – this helps you to set the commercial specifications for a new product/device/material/processing capability and, in turn, you go on to define a qualifying development project by reference to the scientific and/or technological specifications under pinning this. In this scenario, there is a good chance that your work project may be claimable under the SME scheme (again assuming ceiling test thresholds are met), and also subject to considering how your work is funded.
A customer contracts with you for the supply of goods or services. They will be paying you for the solution/output. The factors to consider here are more involved - whether or not your project can be claimed under the SME scheme will depend on a) whether the R&D has been subcontracted to you and if it hasn’t then b) whether the customer has funded the qualifying expenditure. More on this below...
2. Are you undertaking qualifying activities as a subcontractor?
Each contract must be considered on its own merits to reach a conclusion. Some key considerations regarding the complexities of subcontracting are:
- Who is bearing the financial risk of failure?
- How are you paid – fixed price/time and materials?
- How do you quote for the work that you know involves R&D and uncertainty of success, but the customer doesn’t i.e. because the customer is simply asking for a deliverable of some kind?
- What happens if you fail or there are overruns or unexpected price increases or delays?
- What does the contract say, is the customer asking for a deliverable or detailing a development road map?
- Who sets the scientific/technological specifications – this is different to the commercial objectives and tangible/intangible outcomes sought?
- Who sets the project road map?
- Does the principal have a vested interest in the R&D? Or are they only concerned with the features and functionalities of the deliverable requested?
- Does your work form a specific part of a larger development project of the principal?
Intellectual property (IP)
- Which party to the contract does the IP vest with?
It is important to outline the tax technical filing position taken within the legislative framework so HMRC can see the complexities have been considered, understood and applied to your situation. If you conclude the R&D project has not been subcontracted to you then HMRC may not agree with the view taken and investigate this further to satisfy any concerns they may have. In this case, it will be up to you to convince HMRC why your conclusions are correct.
Note that in 2021, HMRC changed its guidelines in this area and is now seeking to define the concept of subcontracted activities very widely - to capture many arrangements and without regard to conclusions derived from the above fact patterns. The legislation has not changed, only HMRC's interpretation of the legislation, but as things currently stand, this means that under scenario B above, there is a higher risk of HMRC challenge and it may be difficult to convince them otherwise.
Where a qualifying R&D project is subcontracted, you must then determine whose R&D it is - in other words, which party to the contract is eligible to claim. The table below provides a useful summary for determining whether your organisation can claim at all and if you can, under which scheme you can claim. You will see that this is driven by your company's status as an SME or non-SME (a Large company), this status being determined by the ceiling threshold tests.
Note that a large company (a company that must claim under the RDEC scheme) cannot ever claim for R&D that it subcontracts out to another company. However, an SME who is the contracting company will always be the one who can claim and under the SME scheme, regardless of the status of the subcontractor. The table also demonstrates that in some circumstances, an SME undertaking R&D work as a subcontractor may still be able to make a claim for qualifying expenditure associated with the project under RDEC, which will depend on the status of the principal contracting party.
3. Subsidised qualifying expenditure
Your activities may be funded in-house, which keeps things 'simple' (in the world of R&D tax credits!)
But if your qualifying expenditure is funded by external means, some or all of the qualifying expenditure attributable to your qualifying project will need to be claimed under the RDEC scheme. Sources of outside funding might include:
- Payments by a customer for goods or services you are delivering - whether or not the project has been classified as “Subcontracted R&D”.
- Payments/contributions from group companies.
- Grant funding.
Establishing whether or not qualifying expenditure has been subsidised is not always clear cut, especially around the supply of goods or services to a customer on fixed price contracts for example.
Grant funding needs further consideration as different types of grants have different implications! It is possible where grants are involved that you could be in a hybrid situation where part of your project costs are claimable under the SME scheme and part are claimable under the RDEC scheme.
So, which scheme should you claim under?
Try as we might, there's no clear-cut answer from the outset that determines whether a project is eligible to be claimed under the SME scheme or the RDEC scheme.
Instead, careful consideration is a must, on a case by case basis, analysing every aspect of your organisation's R&D project from ceilings tests to funding.
As a rough guide, when undertaking a qualifying project, if your organisation is:
- Below the ceiling threshold tests
- Running projects that are self-led opposed to working as a subcontractor on that project (subcontracting out R&D is fine)
- Incurring the financial burden
You're likely to be eligible to claim under the SME scheme.
All other outcomes must be considered based on the facts in case. Sometimes it is still possible to claim under RDEC and in some instances, you may need to consider if you can claim at all...
As you'll have learned, qualifying criteria for each scheme can quickly become overwhelming, so it's always best to speak to a specialist about your organisation's R&D activities. That way, you can get expert advice on what your next steps should be as well as manage your expectations. Take a look at how working with an R&D tax specialist will benefit your claim.
If you think you're eligible for R&D tax credits but aren't sure which scheme applies to your organisation, let's talk!