If you’re unprofitable, you can use a mechanism called “surrendering your losses” to get some cash out of R&D Tax Credits even though you have no profits to offset. But should you?
The short answer is: in most cases, yes, but not always.
If you had all the time in the world, it would be more advantageous to carry the loss forward and offset it against future profits, at a rate of 20%, than to surrender it immediately at a rate of 14.5%. However, in order to be offset successfully in future years, there need to be actual profits in those years (and there needs to be future years, but let’s stay away from disaster scenarios here).
The key concept is: if you are expecting continued tax losses in future years (and don’t forget to factor in future R&D claims in this!) then you should definitely surrender the present loss.
Even if you are expecting profits some time in the future (who doesn’t!) you should consider how far, how certain, and how large those profits will be. The formula for discounted cash flows is relevant here.
Discounted Cash Flows
Discounted cash flows allow you to represent the fact that cash in a year’s time is less valuable than cash in hand today. The way it works is by proposing that if you had the cash in hand today, you would be able to invest it wisely in productive projects within the company, that would provide a return on investment. So if you can only get the cash in a year’s time, that means it needs to provide at least as much of a return as it would have if you had been able to invest it.
Assuming your business is able to make use of funds to get a fairly reasonable 10% “internal rate of return” (IRR) on its own assets, then £100k today will be worth £110k in a year. Conversely, £100k received in a year is only worth £90.9k today. This means that at a 10% IRR, 14.5% today is worth 15.95% next year, 17.54% in 2 years, 19.29% in 3 years and 21.22% in 4 years. This means that at a 10% rate of return, if you have to wait 4 years to be able to exercise your loss it is definitely better to surrender it today, because you will get more money over that period, by getting the 14.5% today and investing it in your company immediately.
IRR for tech companies
Most tech companies (and particularly startups, but also more mature businesses) that are loss-making and spending money on R&D tend to be looking at either a much higher than 10% growth rate, or no profit prospects at all. At a still fairly reasonable 50% growth rate, 14.5% today is worth 21.75% next year – so for a company with high growth potential it is always worth surrendering the losses today, no matter what might happen next year.
The above calculation doesn’t even take into account uncertainty. If you think you’ll be profitable next year, you may be… but you may not be. Factoring in the risk, we find that it is almost alway worth surrendering any amount of loss you can, for cash today.
There is one exception, which is very rare, but which is a very high-growth, high expense startup that has been spending a lot every year and is just about to stop increasing their expenses and switch into “profitable” mode, and is very well managed and very certain about what they’re doing. If you are convinced that you’re about to go from a £500k tax loss to a £1.5m profit, and you have plenty of cash in the bank to fund every project that has a return, then it will be better to keep the loss unsurrendered and exercise it the next year. This case is, unfortunately, quite rare, though we have seen it.
If you need guidance about anything written in this article, please get in touch. Surrendering losses and predicting profitability can be very nuanced and we at GrantTree are here to help you make the most out of your funding.