HMRC has reintroduced the PAYE Cap to the SME R&D Tax Credits scheme, impacting thousands of startups and scaleups. This article explains who is subject to the cap and how it will affect your claim.
On April 1 2021, HM Revenue & Customs reintroduced a limit on the size of payable tax credit companies can receive from the SME R&D Tax Relief scheme. This limit is called the PAYE Cap.
Now, companies applying to the SME scheme can only claim a tax credit worth up to 300% of their combined PAYE and NIC liability, plus a £20,000 grace amount.
The reintroduction of the cap is designed to protect the R&D Tax Relief scheme from abusive claimants. However, it is also reducing the relief available to thousands of legitimate startups and scaleups.
In this blog, we’ll answer the most pressing questions about the cap, including which businesses are susceptible to the cap? Which are exempt? And why has the government brought the cap back after eight years?
What is the PAYE Cap?
The PAYE/NIC Cap limits the size of payable tax credit companies can receive through the SME R&D Tax Relief scheme.
The cap applies to unprofitable businesses, as well as companies that are taken into an artificial loss by the R&D enhancement mechanism and surrender their loss for a cash lump sum.
The cap is set at three times a business’s combined PAYE and National Insurance Contribution liability, plus a £20,000. Any amount over this limit will be forfeited.
You cannot include subcontractor costs from unconnected businesses in your cap. Or salaries for most overseas workers.
However, you can include a portion of the PAYE & NIC liability of a connected entity that is performing R&D on your company’s behalf.
When did the PAYE Cap come into effect?
The PAYE Cap came into effect on 1 April 2021.
The cap only impacts claims based on financial years starting after this date.
For example, if your financial year ended in September 2021, you don’t need to prorate your upcoming FY21 claim.
You would only need to apply the cap for the period starting from 1 October 2021, assuming you are subject to it.
An example of the PAYE Cap
Company A, a loss-making business, has £300,000 of qualifying expenditure. And a PAYE/NIC liability of £20,000.
Because Company A’s loss is greater than its R&D spend, it should be able to claim 33.35% of the expenditure back as a payable tax credit. A credit that should be worth £100,050.
However, because of the PAYE Cap, Company A will only be able to claim 300% of its combined PAYE/NIC liability. Plus the £20,000 ‘grace amount’.
This means Company A’s tax credit will be capped at £80,000. A reduction of £20,500.
This is a deeply worrying prospect for many small businesses.
Exceptions to the PAYE Cap
Thankfully, lots of businesses are exempt from the PAYE Cap.
On 12 November, HMRC announced that the cap will have three ‘features’. Which are essentially caveats to a piece of legislation.
These features are designed to prevent the cap from unfairly penalising legitimate businesses.
Here are the full details of these features.
Feature 1: £20,000 grace amount
The first £20,000 of payable tax credit claims are exempt from the PAYE cap.
This means that claims under £20,000 are not subject to the cap at all.
Claims over £20,000 are capped according to the following calculation:
PAYE Cap = £20,000 + 300% of a company’s PAYE & NIC liability
This ‘grace amount’ protects small companies with few or no employees, and directors taking little or no remuneration.
Feature 2: Related party costs can be included
Companies are allowed to include PAYE/NIC staff costs from related parties in their cap calculation. So long as these costs can be attributed to qualifying R&D projects.
This feature benefits small, loss-making groups of connected businesses with limited payroll in-house. It is especially beneficial to groups where one member employs most of the group’s staff.
The same facility is applied to the PAYE/NIC cap of the RDEC calculation.
Feature 3: The two tests
The final feature is based on two tests.
The first test looks at whether the claimant company’s employees are “creating, preparing to create or actively managing intellectual property”.
This mirrors the criteria of the Patent Box scheme, another form of government aid for 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 R&D expenditure.
If a company passes both of these tests, it will not be subject to the PAYE Cap.
The two tests are designed to protect companies that are actively developing IP in-house.
Will the three features be enough to protect companies?
Despite the introduction of these features, GrantTree’s analysis shows that hundreds of SMEs could still be impacted by the PAYE Cap. This will cost them thousands in urgently-needed funding.
This could have damaging consequences for British startups and UK innovation as a whole.
Why has HMRC reintroduced the PAYE Cap?
The purpose of the PAYE Cap is to protect the R&D Tax Credit scheme from fraud and abuse. This includes shell companies that extract government funding while contributing nothing to the UK economy.
These artificial corporate structures usually don’t have many employees, leaving them highly vulnerable to a payroll-based limitation.
We applaud the government’s efforts to protect the R&D Tax Credits scheme, which is vital to the country’s tech ecosystem.
However, we are concerned that many eligible businesses, especially those who subcontract a good deal of their development work, will miss out on a critical source of funding.
The cap returns after 8 years
Those familiar with R&D Tax Relief will remember that HMRC operated a PAYE/NIC cap for the first 12 years of the scheme’s existence.
The government removed the PAYE Cap in 2012 in order to provide more aid to growing businesses. But it has since determined that the scheme has become vulnerable to fraud and abusive filings.
In 2018 then Chancellor Phillip Hammond announced that the cap would be reinstated, following a period of consultation.
After two rounds of feedback, HMRC developed the three features mentioned above to spare legitimate businesses from losing out on R&D Tax Credits.
Questions about the PAYE Cap?
If you have any questions about the PAYE Cap, and how it will affect your R&D Tax Credits claim, GrantTree is here to help.
Our team of seasoned tax and technical experts would be happy to help you navigate the cap and make the right decision for your business.
