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SME R&D Tax Relief: How Does It Work?

SME R&D Tax Relief is a generous scheme that provides innovative small and medium sized businesses with thousands of pounds worth of tax reductions and cash credits. Here are the key things you need to know about how the scheme works, including how it generates relief, and how it benefits companies in different financial situations.

Over the last 20 years, SME R&D Tax Relief has become a vital source of innovation funding for small and medium-sized businesses across the UK. 

By allowing companies to claim back up to 33% of their R&D expenditure as a cash credit or corporation tax cut, the scheme helps smaller businesses invest in cutting-edge development work while incentivising startups and scale ups to develop new products and services. 

The amount of relief offered by SME R&D Tax Relief makes it a highly accessible and generous source of capital. However, it is not the most straightforward scheme to navigate. So before you file your claim, there are some things you need to know about how the scheme works. 

In particular, it’s important to understand two mechanisms the scheme uses to create its financial incentive. They are R&D enhancement and surrendering your loss. 

In this blog, we’ll look at both mechanisms in closer detail, and explain how they play a role in your R&D Tax Credits claim. 

We’ll also explain how the PAYE Cap will affect your claim, now that it has come into force.

The enhancement mechanism

Fundamentally, SME R&D Tax Relief works by artificially increasing the value of your company’s qualifying expenditure. This increases your company’s costs. 

All on paper, of course. 

This process of increasing the value of your expenditure is called the R&D enhancement or the enhancement mechanism. This is one of the most important elements of the SME R&D Tax Relief scheme. 

The amount you can enhance your eligible expenditure is determined by the enhancement rate, which is currently 130%. 

This means that if your qualifying expenditure was £100,000, your Enhancement would be worth another £130,000. 

You then combine the two figures to get your enhanced expenditure, equal to £230,000 in this example. 

Your enhanced expenditure is what you enter into your company’s CT600 when it comes time to file. 

This might seem like a strange thing for the government and HMRC to allow companies to do, but it’s how the SME scheme works. 

How enhancement affects your company and your claim depends on your financial position. Let’s look at some examples.

How enhancement affects profitable SMEs

As mentioned, R&D enhancement artificially increases your company’s costs.

If your company is profitable, the increase in its costs will decrease its profits. Lower profits mean your company won’t have to pay as much corporation tax. 

This is how the SME scheme generates tax relief.

Let’s look at an example of how the enhancement mechanism affects the balance sheet of a profitable company.

Profitable SME Before Enhancement After Enhancement
Revenue
£7,500,000
£7,500,000
Expenditure (incl. R&D)
£2,500,000
£2,500,000
Qualifying R&D Expenditure
£1,000,000
£1,000,000
130% Enhancement
£0
£1,300,000
Net Profit Before Tax
£5,000,000
£3,700,000
Corporation Tax Due
£950,000
£703,000
R&D Tax Relief
£0
£247,000
% of R&D Reclaimed
0%
24.7%

Here, we can see how the enhancement mechanism creates a tax relief worth £247,000. 

That is the equivalent of 24.7p for every £1 of eligible expenditure. This is the maximum amount of relief profitable companies claim through the SME scheme. 

Now, let’s look at how R&D enhancement affects companies making a loss.

How enhancement affects loss-making SMEs

If your company is making a loss, it doesn’t have to pay any corporation tax. So, how does the SME scheme benefit you?

Well, if your company is unprofitable, the enhancement mechanism will artificially increase the size of its loss.

Here’s an example.

Unprofitable SME Before Tax Relief After Tax Relief
Revenue
£1,000,000
£1,000,000
Expenditure (incl. R&D)
£2,400,000
£2,400,000
Qualifying R&D Expenditure
£1,000,000
£1,000,000
130% Enhancement
£0
£1,300,000
Net Profit Before Tax
(£1,400,000)
(£2,700,000)
Corporation Tax Due
£0
£0

As you can see, the enhancement mechanism has increased company B’s loss by £1,300,000. 

But how does a larger loss help the company? 

We can answer that question by explaining the second mechanism SME R&D Tax Relief relies upon to generate its financial incentives – ‘surrendering your loss’.

Understanding this is another important aspect of seeing how SME R&D Tax Relief works. 

Surrendering your loss

Under the SME R&D Tax Relief scheme, you are allowed to swap – or surrender – losses associated with your enhanced qualifying expenditure at a rate of 14.5p per £1. 

In other words, for every £1 of enhanced expenditure you surrender, HMRC will give you a cash credit worth 14.5p. 

This is how the SME scheme generates a payable cash credit. 

Taking the example above, Company B could choose to surrender its enhanced expenditure of £2,300,000 for a cash credit worth £333,500. 

That translates to 33.35p per every £1 of qualifying expenditure. 

33.35% is the maximum amount of relief available through the SME scheme.

Should you surrender your loss?

You don’t have to surrender your loss. 

You can also carry losses forward and use them to decrease your corporation tax liability in future financial years.  

Doing this actually yields a larger financial windfall for your business.

Surrendering a loss generates a cash credit worth 14.5p per pound of enhanced expenditure. But using a loss to offset future tax liabilities creates a tax saving worth 19p per pound of expenditure. 

Does this mean you should always carry your losses forward? Not necessarily. 

A loss can only be used to offset corporation tax if your company actually generates a taxable profit. So, if you’re not expecting to be profitable in the near future, it may well be better to surrender your loss. 

Also, it’s important to consider your cash position. 

If you need cash now to cover debts, invest in growth, or extend your cash runway before a new funding round, surrendering your loss for a cash credit may be the better choice.

You can read more about whether your company should surrender its losses here.

How enhancement affects companies at break-even

If your company is breaking-even, the enhancement and loss-surrendering mechanisms have a slightly different impact on your claim. 

As you have broken even, you don’t have to pay any corporation tax. So you don’t have any tax to ‘relieve’. 

Also, as your revenue and costs have cancelled each other out, you won’t have any R&D-related loss to surrender as a cash credit.

The good news is that the enhancement mechanism will take you into a loss. However, you will only be able to surrender the enhanced amount, worth 130% of your eligible expenditure. 

In other words, you will be surrendering your 130% enhancement for a payable cash credit at a rate of 14.5%. 

This works out to a cash credit worth just 18.85% of your eligible expenditure. 

Why companies breaking even receive the least amount of relief is anyone’s guess. But we’ve come to call this unfortunate situation ‘the valley of death’.

The PAYE Cap

If your company is looking to claim a cash credit rather than tax relief, there’s another mechanism that could affect how much funding your company will receive. It is called the PAYE Cap

The PAYE Cap limits the size of payable cash credit you can access through the SME scheme. 

The limit is 300% of your combined PAYE and NIC liability, plus £20,000. 

So, if you had a PAYE/NIC liability of £20,000, the largest cash credit you would be able to claim would be £80,000. 

The PAYE Cap only affects companies claiming a payable credit. It does not affect companies claiming tax relief. Also, some companies are exempt from the PAYE Cap, even though they are claiming a cash credit.  

You can read more about which companies are exempt, how the cap works, and why it was introduced in this detailed article

Questions about how the SME R&D Tax Relief scheme works?

Hopefully, this article has given you a better understanding of how the SME R&D Tax Relief scheme works and how much relief your company could receive from the scheme.

If you have any questions about SME R&D Tax Relief or would like some support preparing your claim, our R&D Tax Credits specialists are standing by to help.

Just drop us a line, and we’ll be right with you.