UK R&D tax credits

R&D tax reliefs provide a valuable source of financing for R&D businesses, particularly start-ups that may have limited access to alternative sources of funding. Both the R&D activity and the costs must satisfy certain conditions to qualify for tax relief.

A new R&D tax relief scheme was introduced for accounting years beginning on or after 1 April 2024. Prior to this date, there were two tax relief schemes - one for small and medium sized businesses (SMEs), known as the SME scheme and another predominantly for larger companies, known as the Research and Development Expenditure Credit (RDEC) scheme.

The new R&D relief scheme - post 1 April 2024

The new R&D tax relief scheme is effectively a merger of the two previous schemes and enables eligible companies to claim a 20% tax credit for qualifying R&D costs. The mechanics of the tax credit are based on the previous RDEC, whereby an “above the line” credit is brought into account as a trade receipt. The merged scheme includes a new restriction on claiming tax relief for overseas R&D.

An alternative tax relief is available for certain loss-making research-intensive SMEs, which can claim an additional tax deduction of 186% on qualifying R&D expenditure.  The research-intensive scheme was introduced following widespread lobbying across R&D industries, most notably the life sciences sector amidst concern that reduced tax reliefs for SMEs may prove to be an insurmountable stumbling block to start-ups, which are often reliant on R&D tax reliefs as a source of financing. A research-intensive SME cannot claim both this relief and the new RDEC.

The introduction of the merged scheme follows a wide-ranging government review into the UK’s R&D tax relief system, that was launched in Spring 2021, with the objective of modernising the system to ensure that R&D tax reliefs effectively incentivise UK innovation, whilst combatting opportunities for abuse. 

What is R&D?

To qualify for relief, the R&D activities must satisfy the definition of R&D under generally accepted accounting practice. The activity must also fall within guidance issued by the UK government – currently maintained by the Department for Science, Innovation and Technology (DSIT).

Broadly, for tax purposes, activities will qualify as R&D when they take place within a project seeking to achieve an advance in science or technology. R&D activities should directly contribute to seeking to achieve this advance in science or technology, through the resolution of scientific or technological uncertainty. Certain indirect activities related to the project will also qualify as R&D for tax relief purposes. Activities other than qualifying indirect activities that do not directly contribute to the resolution of the project’s scientific or technological uncertainty are not R&D. From April 2023, advances in pure mathematics constitute R&D.

What is qualifying R&D expenditure?

Tax relief will only be available for certain costs on R&D activities. Broadly, the expenditure must be revenue and not capital in nature and must be attributable to R&D activities undertaken by the company itself or contracted out by it. R&D tax relief is limited to specific R&D-related costs, including: staffing costs, the costs of externally provided workers (EPWs), software, data licences, cloud computing services, payments to subjects in clinical trials, consumable or transferable materials, or certain payments for contracted-out R&D.

When claiming R&D tax relief for staffing costs and the costs of EPWs – the relevant individuals must be directly and actively engaged in the R&D activity. Under the new scheme, tax relief is only available for the cost of EPWs that are paid through the UK’s Pay As You Earn (PAYE) system, with tax deducted at source and subject to national insurance contributions (NICs).

Ineligible companies

Certain companies are not eligible to claim R&D tax reliefs, these include: UK universities and other higher education institutions, charities, scientific research organisations, NHS bodies, and certain prescribed overseas bodies.

Key characteristics of the new scheme

The newly merged scheme has the following features:

• 20% credit - Above-the-line tax credit, meaning relief is shown in pre-tax profits/losses. Credit will either increase taxable profits, or reduce losses.
• Credit is taxable - meaning the effective relief rate is 15% for most companies (paying corporation tax at 25%). The effective relief rate is 16.2% for companies paying tax at the small companies rate (19%).
• Relief is capped – cap is calculated by reference to the company’s PAYE/NIC liabilities. Broadly, the cap is £20,000 plus 3x the company’s PAYE and NICs costs on workers for the relevant period.
• Doesn’t prevent other claims for support – Tax credit can be claimed in addition to other UK grants and subsidies.
• Enhanced relief for R&D intensive SMEs - Alternative tax relief, whereby additional tax deduction of 186% is available on qualifying R&D expenditure. The deduction operates to reduce an SME’s taxable profits. A repayable cash credit at a rate of 14.5% of surrenderable losses may also be available. Broadly, an SME will be research intensive, where 30% of its total expenditure is on qualifying R&D.  The enhanced tax relief for research intensive SMEs has been available since April 2023, although the research intensity threshold was reduced from 40% from 1 April 2024.
• Restriction on relief for overseas expenditure – subject to exceptions, relief is only available where R&D is undertaken in the UK.
• Contracted-out R&D – subject to certain conditions, tax relief may still be available where R&D is contracted-out to another party.

Overseas Restriction

Prior to April 2024, to qualify for tax relief, there was no requirement for R&D to be undertaken in the UK. However, to refocus R&D tax reliefs to specifically target UK innovation, the new scheme now includes a territorial restriction, whereby tax relief is restricted for overseas R&D.

Generally, where R&D is subcontracted, tax relief will only be available where the subcontracted R&D activity is undertaken in the UK. When considering where the R&D activity is undertaken, the location from where consumables, data or software are sourced will not be relevant.

There is a limited exemption, whereby R&D subcontracted overseas will remain eligible for tax relief. For the exemption to apply there must be conditions necessary for the purposes of the R&D in the overseas location, that are not present in the UK, and it would be wholly unreasonable to try and replicate in the UK.

Such conditions could include geographical, environmental or social conditions. Overseas R&D expenditure should also remain eligible for tax relief where there are regulatory or other legal requirements that activities must take place outside the UK. However, the cost of the R&D and the availability of workers to undertake the R&D activity will not be considered necessary conditions for the exemption to apply.

The exemption also applies to EPWs, whereby tax relief may still be available for the costs of EPWs undertaking R&D overseas, and not subject to PAYE. However, given that the costs and availability of workers will not be considered necessary conditions, this exemption is expected to have limited applicability.

HMRC’s guidance states that if either costs or staff availability on their own, or a combination of them, is the main reason for R&D to be undertaken overseas, then UK R&D tax relief will not be available. However, where other factors are significant, the mere fact that costs and staff availability are relevant will not in itself prevent relief for the overseas expenditure.

Contracted-out R&D

Under the new scheme, businesses can now claim tax relief for the cost of R&D contracted-out to another party. It is common for businesses involved in complex R&D projects to contract part of the R&D activity to another party that has the expertise and equipment to undertake the R&D more efficiently. Under the previous regime, tax relief for contracted-out R&D costs was very limited and usually only available to SMEs.

Amongst other conditions, under the new rules, tax relief will only be available for contracted-out R&D where the definition of “contracted-out” is met. There are three conditions for R&D to be “contracted-out”: there must be a contract between the business claiming relief and another party for activities to be undertaken; the activities must include R&D; and when entering into the contract, it is reasonable to assume having regard to the terms of the contract and any surrounding circumstances, that the business intended or contemplated that R&D would be undertaken. Therefore, when determining whether tax relief is available for contracted-out R&D, the terms of the agreement in which the R&D is contracted-out will be important.