HMRC is set to reintroduce the PAYE Cap to the SME R&D Tax Credits scheme, potentially impacting thousands of startups and scaleups. GrantTree explains who will be affected and how the cap will change your tax credits claim.
HM Revenue & Customs is set to reintroduce a limit on the size of payable tax credit that companies can receive from the SME R&D Tax Relief scheme.
From 1 April 2021, businesses will only be able to claim tax credits worth up to 300% of their combined PAYE and NIC liability, plus a £20,000 buffer.
Known as the PAYE Cap, this regulation is designed to protect R&D Tax Credits from abusive claims but could reduce the relief available to thousands of legitimate startups and scale-ups.
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 will be 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.
You are not allowed to include subcontractor fees from unconnected businesses, or salaries for most overseas workers, when calculating your liability.
However, you are permitted to include a portion of the PAYE & NIC liability of a connected entity that is performing R&D activities on your behalf.
An example of the PAYE Cap
Let’s say 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, meaning it to lose more than £20,000 worth of funding.
This is a devastating prospect for many small businesses.
Exceptions to the cap
Thankfully, not all small businesses will be susceptible to the PAYE Cap.
On 12 November HMRC announced that the cap will have three ‘features’. Features are essentially caveats to a piece of legislation.
In this case, the features are designed to protect legitimate businesses from losing out on R&D Tax Credits.
Here are the full details of these features.
Feature 1: £20,000 grace amount
The first £20,000 of payable 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 PAYE & NIC liability
This ‘grace amount’ protects small companies with directors taking little or no remuneration, and with few or no employees.
Feature 2: Related party costs can be included
Companies will be allowed to include staff costs from related parties in their PAYE and NIC liability calculation. So 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.
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 branch 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 your company passes both of these tests, your claim will not be capped.
When does the cap come into effect?
The PAYE Cap comes into effect on 1 April 2021.
However, it will only impact claims for financial years that start after this date.
In other words, the PAYE Cap won’t affect your claim for your current financial year.
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 susceptible.
Why is HMRC reintroducing 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 will defend against shell companies that are designed to 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 cap.
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 later determined that the scheme had become vulnerable to fraud and abusive filings.
In 2018 then Chancellor Phillip Hammond announced that the cap would be reinstated, following a period of industry consultation.
Then, after two rounds of feedback, HMRC published a final list of features that will spare many 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.