HMRC has reintroduced the PAYE Cap to the SME R&D Tax Credits scheme, impacting the R&D Tax Credits claims of thousands of startups and scaleups. In this article, GrantTree explains who will be subject to the cap and it will affect your funding
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.
Now, companies applying to the small and medium business-focused scheme will only be able to claim tax credits worth up to 300% of their combined PAYE and NIC liability, plus a £20,000 buffer.
This regulation, which is known as the PAYE Cap, is designed to protect R&D Tax Credits from abusive claims. However, it also reducing the relief available to thousands of legitimate startups and scaleups.
In this blog, we answer the most pressing questions about the cap, including: which businesses will have their claims capped? Which are exempt? And why is HMRC bringing this mechanism back after eight years in the wilderness?
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 is set at three times a business’s combined PAYE and National Insurance Contribution liability. Plus a £20,000 grace amount.
Any amount over this limit will be forfeited.
Companies are not allowed to include subcontractor fees from unconnected businesses, or salaries for most overseas workers, when calculating their liability.
However, businesses are permitted to include a portion of the PAYE & NIC liability of a connected entity that is performing R&D on their behalf.
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 is unprofitable, it should be able to claim 33.35% of its 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, reducing its funding by more than £20,000.
This is a devastating prospect for many small businesses.
Exceptions to the cap
Thankfully, not all small businesses are subject to 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 protect legitimate businesses from receiving less funding.
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.
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 whose directors taking little or no remuneration.
Feature 2: Related party costs can be included
Companies are allowed to include staff costs from related parties in their PAYE and NIC liability calculation. So long as they are attributable to development work.
This addendum benefits 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.
Feature 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 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.
When does the 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 you have a September year end, you do not need to pro-rata your upcoming claim.
You would only need to apply the cap from 1 October, assuming you are subject to it.
Why has HMRC reintroduced the PAYE Cap?
The purpose of the PAYE Cap is to protect the R&D Tax Credit scheme from abusive or fraudulent claims.
Specifically, the cap is designed to defends against 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 published a list of features designed to spare legitimate businesses from financial hardship.
Will these provisions be enough?
Our analysis shows that hundreds of SMEs may still be impacted, costing them thousands in desperately-needed funding.
This could have damaging consequences for UK startups and innovation as a whole.
Time will tell, of course. But if that is the case, GrantTree will campaign for more protection for growing businesses.
If you have any questions about the PAYE Cap, and how it will affect your business, don’t hesitate to get in touch.
Our team of tax experts would be happy to help you navigate the cap, and make the right decision for your business.