How to Calculate R&D Tax Credits

The R&D tax credit is part of the UK government’s financial incentives designed to encourage companies to invest and engage in innovation (research and development) by giving them access to cash as rewards for their activities. But, unfortunately, it is still unclear to many how to calculate R&D tax credit.

Companies can file R&D tax claims annually for their qualifying R&D activity costs carried out in the accounting period (their company’s financial year). Thus, the value of a company’s R&D tax credit depends on its qualifying expenditure, referring to how much the claimant business spent on qualifying R&D activities for tax purposes.

If the claiming business is profitable, it can use its R&D costs to reduce its company’s tax bill more than the usual deductions. On the other hand, if the company is loss-making, it does not owe the HM Revenue and Customs (or simply HMRC) any tax for the financial year. Thus, it can opt to turn its R&D tax incentive as additional losses and carry them forward to future years or surrender them for an immediate cash benefit.

How to Calculate R&D Tax Credit: Eligibility and Qualifying Expenditure

Before getting into the nitty-gritty of calculating R&D tax credit, let’s first look at eligibility and qualifying expenditure.

Who Is Eligible?

The R&D tax credit scheme is available to SMEs and large companies attempting to resolve technological or scientific uncertainties. The work in question must meet the requirements of qualifying R&D activity.

A company must be subject to the UK corporation tax to make an R&D tax claim. This definition covers:

• A company registered in the UK as LTD or PLC
• A branch of an overseas company with a UK presence
• A partnership of limited companies

The eligible R&D work does not have to take place within the UK to benefit from the scheme. However, the UK-registered company needs to fund (at least in part) the work in question – for example, UK companies subcontracting some of their operations to overseas entities.

Factors Affecting the Value of R&D Tax Credit

The UK’s R&D tax relief offers a maximum return value of up to 33% for every £1 spent on R&D activities. However, the exact return rate depends on the following three factors:

• The size of the company
• The amount of corporation tax it pays
• Whether the company is profitable or loss-making

What’s more, the size of a company determines which R&D tax credit scheme it belongs to, with each differing in the amount of cash benefit it offers:

• The SME scheme is available to companies employing 500 people or less with an annual turnover of under €100 million (£86 million), or whose annual balance sheet total falls under €86 million (£74 million).
• Large companies qualify for the less lucrative scheme called Research and Development Expenditure Credit (RDEC).

Factors such as state aid, subsidies, and grants can change an SME’s status to that of a large company, at least by R&D tax definition, making the former eligible for the RDEC scheme.

Additionally, HMRC will classify companies with a headcount of less than 500 but exceed the gross assets and turnover thresholds as large companies under the RDEC scheme.

Identify Your Qualifying R&D Expenditure

Before calculating R&D Tax credit, companies need to know their qualifying expenditures. Below are the five categories of costs companies can claim for R&D relief:

• Staffing costs
• Capital expenditure
• Software and consumable items
• Payment to subcontractors
• Externally provided workers

Due to the complexity of identifying qualifying expenditure, it is best to hire (or consult) an R&D tax credit professional.

How to Calculate R&D Tax Credit for SMEs

Most companies in the UK that claim R&D tax relief fit into the SME category. The rate at which businesses calculate their R&D tax credit depends on whether they are making a profit or a loss:

• For a profit-making business, an R&D tax credit reduces its corporation tax bill at a relief rate of 25%. Therefore, if the business’s R&D spend the previous year was £100,000, it could claim a £25,000 reduction in its next tax bill.
• A loss-making business will receive its R&D tax credit in cash since it does not offset tax liability. It is entitled to a relief rate of up to 33%. Thus, if its R&D spend the previous year was £100,000, it could get a cash credit of £33,000.

1. Profit-Making SME

From the example above, you can see that profitable SMEs can benefit from up to 25% average savings. Thus, if Company X were to spend £100,000 on R&D projects, they could reduce their total corporation tax by up to £25,000. In addition, they could ultimately deduct 130% of their qualifying costs from their annual profit on top of the standard 100% allowed – for total savings of 230%.

How to calculate:

1. Identify and calculate the qualifying expenditure. It’s the amount the company declares as having spent on qualifying R&D.
2. Enhance the qualifying expenditure by multiplying it by 130% - increasing the annual R&D expense and reducing the taxable profit.
3. Subtract the original corporation tax amount from the new rate to reveal the tax saving.

Example:

Company X made profits of £400,000 for the year, calculate the R&D tax credit saving.

The qualifying expenditure is £100,000, that’s already in accounts as expenditure

Corporation Tax (CT) before R&D tax credit claim is £76,000

• Enhanced R&D qualifying spend or uplift: £100,000 × 130% = £130,000
• The revised profit: £400,000 - £130,000 = £270,000
• Corporation tax: £270,000 × 19% = £51,300

The corporation tax saving: £76,000 - £51,300 = £24,700 (approximately 25%)

2. Loss-Making SME

Loss-making SMEs have two options:

• Secure a cash benefit after making a successful claim
• Avoid surrendering the R&D loss and instead, carry the loss forward or backward against profits

How to calculate:

1. Identify and calculate the qualifying expenditure using the list above. It’s the amount the company declares as having spent on qualifying R&D.
2. Enhance your qualifying expenditure by multiplying it by 130%. Since the company has made a loss, this will increase the final figure.
3. At this point, the company can choose one of two routes to follow:
   1. Cash in or surrender the losses. You calculate this by taking the lower figure between the annual loss and 230% of the qualifying expenditure. Then, submit the final figure to HMRC to receive a 14.5% cash tax credit.
   2. Carry forward the loss as an alternative to cashing in the losses. It means that you can carry it forward and offset it against future taxable profit at a later date.

Example:

Company Y made a £300,000 loss in the previous year, calculate the R&D tax credit saving.

The qualifying expenditure is £100,000, that’s already in accounts as expenditure

Corporation Tax (CT) before R&D tax credit claim is £0 since the company did not realise a profit

• Enhanced R&D qualifying spend or uplift: £100,000 × 130% = £130,000
• The revised loss after deducting profit: £300,000 - £130,000 = (£430,000)
• The maximum losses Company Y should surrender to HMRC: £100,000 × 230% = £230,000

Company Y can now:

• Carry the additional loss forward and offset it against future taxable profits, or
• Surrender the lower of the revised loss or 230% of the qualifying expenditure in exchange for a 14.5% cash tax credit as follows:

Savings from R&D tax credit: £230,000 × 14.5% = £33,350 (approximately 33%)

Company Y will then carry forward £200,000 to the next year.

How to Calculate R&D Tax Credit for a Large Company

Companies can claim RDEC if they fail to qualify for the SME R&D relief scheme and they fall under one of the following criteria:

• Are a large company employing over 500 people or with a €100 million annual turnover
• Are a large company or SME subcontracted or grant-funded to conduct R&D
• Are a large company claiming expenditure subcontracted to them by another large company

The RDEC scheme enables large companies to claim a 13% R&D tax credit of their qualifying R&D costs. The difference is that companies can claim RDEC as cash payments rather than deductions from taxable profits.

How to calculate:

1. Identify and calculate the qualifying expenditure. It’s the amount the company declares as having spent on qualifying R&D.
2. Enhance the qualifying expenditure by multiplying it by 13% RDEC.
3. Subtract the original corporation tax amount from the new rate to reveal the tax saving.

Example:

Company Z made a £10,000,000 profit for the year. Calculate the R&D tax credit saving.

The qualifying expenditure is £3,000,000 that’s already in accounts as expenditure

Corporation Tax (CT) before R&D tax credit claim is £1,900,000 (£10,000,000 × 19%)

• Enhanced R&D qualifying spend or uplift (RDEC): £3,000,000 × 19% = £390,000
• Taxable profit: £10,000,000 + £390,000 = £10,390,000
• Corporation tax: £10,390,000 × 19% = £1,974,100
• Corporation tax payable: £1,974,100 - £390,000 = £1,584,100

The corporation tax saving: £1,900,000 - £1,584,100 = £315,900 (approximately 19%)

Large companies that either made a loss or failed to make a profit are still eligible for an R&D tax credit pay out. However, they are subject to certain restrictions.

How Subcontractors Calculate R&D Tax Credit

Different rules apply for RDEC and SME scheme subcontractors subcontracted to do R&D work for another company subject to the UK corporation tax.

For example, say, a company subcontracts its R&D project to:

• An SME subcontractor: It cannot claim more than 65% of the qualified R&D expenditure
• An RDEC subcontractor: Must be a qualifying entity (whether individual or partnership status) to be eligible

Making an R&D tax relief claim is a compliance matter while preparing one requires a thorough and accurate understanding of the different qualified expenditures, underlying technology, and industry challenges.

The ambiguity of HMRC’s R&D definition and the underlying technicalities companies need to apply to their business make it challenging to identify qualifying activities. Hence, the need to hire an R&D tax credit expert.

FAQ

What counts as R&D activity?

The HM Revenue and Customs (HMRC) defines R&D activity for tax purposes as any project seeking to achieve advances in either science or technology.

It includes qualifying activities that either directly or indirectly contribute to the achievement of advancements (in science or technology) that resolve uncertainty – for example, development activities to create new processes, products, or software.

Can someone help me with an R&D tax credit calculation?

Yes. You can get a professional R&D tax credit expert to help calculate your cash benefit. They can also help you determine your R&D qualifying activities, prepare your claim, and present your innovations to HMRC.

What industries can claim R&D tax credits?

Eligible R&D work can occur in any industry and sector, provided it meets the criteria – the achievement of advancements (in science or technology) that resolve uncertainty.