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New cap on SME R&D tax credit scheme

On the 12 November 2020, the government published draft legislation to implement a Research & Development (R&D) tax credit PAYE cap for small and medium enterprises (SMEs). Companies receiving repayable R&D tax credits under the SME scheme will be affected by these new rules. The legislation will take effect from 1 April 2021 and accounting periods straddling 1 April must be treated as two separate periods with the cap applying to the second period (i.e. from 1 April 2021 onwards).
Why was this set up

The new rules have been designed to target perceived fraudulent claims using structures set up in the UK to claim a repayable credit even though no R&D work was actually carried out in the UK and could reduce the relief available to thousands of legitimate startups and scaleups.

SME R&D tax credits to be capped

The cap will limit the payable R&D tax credit to three times the total PAYE and NIC liability of the company for the year plus £20,000. A company will be able to include a portion of a connected party’s PAYE and NIC liabilities attributable to the R&D project when calculating the cap. HMRC still has to confirm whether this will include any compulsory contributions paid by a connected overseas related party in the relevant country.

A company making a claim for a payable R&D tax credit of less than £20,000 will not be impacted by the cap. Unfortunately, any amount over the cap limit (i.e. 3 x combined PAYE & NIC liability + £20,000 grace amount) will be forfeited.

The cap applies to unprofitable businesses, as well as firms that are taken into an artificial loss by the enhancement mechanism and then surrender this loss for a cash lump sum.

Subcontractor fees from unconnected businesses, or salaries for most overseas workers will not allowed when calculating the claimant’s liability. Do feel free to speak to an R&D Tax Credit specialist about your position.

Who will be impacted by the cap?

A company’s claim will also not be capped if it meets two tests. These tests require that a company’s employees are creating, preparing to create, or actively managing Intellectual Property (IP) arising from the R&D project and that its expenditure on work subcontracted to, or agency workers provided by, a related party is less than 15% of its overall R&D expenditure.

Many genuine SME claims will be affected by the introduction of the new cap. Companies that are likely to be impacted include:

  • Companies who outsource large parts of their R&D projects/activities.
  • Companies where a large proportion of the R&D costs arises from consumables (e.g. raw materials) or software costs.
  • Defining active management of IP.
  • What constitutes active management of IP is not yet clear in the draft legislation but a good technical assessment in the R&D process should lay the groundwork in helping build that IP picture. What’s more is that the identification and better management of IP could lead to greater utilisation of the Patent Box scheme that could deliver longer term benefit for many companies.

An example of the PAYE Cap

Company X, a loss-making business, has £300,000 of qualifying expenditure. And a PAYE/NIC liability of £20,000.

Because Company X is loss making, it should be able to claim 33.35% of its expenditure back as a payable tax credit worth £100,050.

However, because of the PAYE Cap, Company X will only be able to claim 300% of its combined PAYE/NIC liability, plus the £20,000 ‘grace amount’.

This means Company X’s repayable tax credit will be capped at £80,000, causing it to lose £20,050 of funding as illustrated below.

Pre - 1 April 2021

Post - 1 April 2021

QE

£300,000

Total PAYE & NIC

£20,000

Enhanced R&D

£690,000

Grace amount

£20,000

Repayable

£100,050

Repayable (capped)

£80,000

Difference

-£20,050

This is a devastating prospect for many small businesses, especially when many are still struggling to cope with the Covid-19 pandemic.

Exceptions to the cap

Thankfully, not all SMEs will be susceptible to the potentially negative impact of the PAYE Cap because HMRC have also included in the same legislation, 3 caveats which will protect legitimate businesses from losing out on claiming R&D tax credits.

Caveat 1: £20,000 grace amount

The first £20,000 of repayable tax credit claims will be exempt from the PAYE cap.

Claims under £20,000 will be completely uncapped. Claims over £20,000 will be capped according to the following calculation:

PAYE Cap = £20,000 + 300% of a company’s total PAYE & NIC liability

This ‘grace amount’ serves as a buffer and protects SMEs with directors taking little or no remuneration, and with few or no employees.

Caveat 2: Related party costs can be included

Companies will be allowed to include staff costs from connected parties (i.e. performing R&D activities on the claimant’s behalf), in their PAYE and NIC liability calculation, as long as they are attributable to the development work.

This addendum will benefit small, loss-making groups of connected businesses. Particularly where one member employs the majority of the group’s staff.

A similar facility exists for companies claiming through the RDEC scheme (Large company).

Caveat 3: The two tests

The final feature is based on two tests.

The first test looks at whether a company’s employees are “creating, preparing to create or actively managing intellectual property”.

This is similar to the criteria of the Patent Box scheme, another tax incentive scheme available to innovative companies.

The second test requires that fees for subcontractors and externally provided workers paid to connected businesses account for no more than 15% of a company’s total R&D expenditure.

If the claimant passes both of these tests, the claim will not be capped.

If you’re worried or would like more information about the potential impact of above PAYE cap on your business, the best thing to do is speak to an R&D Tax Credit specialist at The Accountancy Cloud.

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