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R&D Tax Credits: The Unclaimed Expenses Costing Manufacturers Millions

Despite claiming more R&D Tax Credits than any other industry, many manufacturers are failing to claim relief on two of their most important expenses.

In September, HMRC released its R&D Tax Credits statistics report for the year ending March 2020. It revealed that, once again, UK manufacturing earned more tax relief and submitted more filings than any other industry. 

Manufacturing hoovered up a quarter of the £7.4 billion delivered through the scheme during the 2020 fiscal year. That is more than professional, scientific and technical services, which claimed 24% of funding, and information and communication, which claimed 20%. 

All told, manufacturing companies filed just under 19,000 claims – a 10% increase on the previous year – based on £14 billion worth of research and development spending. 

These figures make happy reading for one of Britain’s most important sectors. They are also a pleasing reminder that, while software developers and biotechnology companies are more readily associated with innovation, it is in fact manufacturers that lead the way in research and development investment.

UK manufacturers are still underclaiming

Still, these statistics are bittersweet. 

Yes, they show that manufacturers have benefited handsomely from the R&D Tax Credits scheme. But when combined with other government data, such as this recent analysis of the industry’s contribution to the British economy, HMRC’s numbers also tell us that UK manufacturing companies are neglecting to claim hundreds of millions of pounds worth of cash credits and tax relief. 

One of the main reasons businesses are leaving this wealth of funding untapped is that they are not claiming their full entitlement of R&D Tax Relief. This is usually because they are not including all of their eligible expenses or projects in their submission. 

While it can be tricky to identify every penny of eligible expenditure, manufacturers are particularly likely to overlook two kinds of costs. These are the expenses associated with constructing prototypes and first of class items. 

Most of the time, this is because manufacturers simply aren’t aware that these costs are eligible for relief. Sometimes, it’s because claimants aren’t sure which expenses they should file for, so, to avoid trouble with HMRC, they avoid the issue altogether. 

Either way, it’s safe to say things could be a lot clearer. That’s why I wanted to share a few tips for working out when your prototype and first of class costs are eligible for R&D Tax Relief.  

You must be looking to solve a scientific or technical uncertainty

When HMRC looks at a project’s eligibility for R&D Tax Relief, one of the key factors it considers is whether it attempted to solve a ‘scientific or technical uncertainty’. 

In simple terms, this means ‘did the project seek to close a gap in knowledge that can only be solved through experimentation’. 

Only prototypes and first of class products built as part of a project designed to solve this kind of uncertainty will qualify for R&D Tax Relief. Construction based on well-known scientific or technical principles will not.

Prototypes must be created solely for R&D purposes

You can only claim R&D Tax Relief on prototypes that were constructed for research and development purposes.  

HMRC says that prototypes are a way to codify R&D. In other words, to cement the outcomes of your development work with a real-world proof. 

That means if you are planning to sell, or have already sold, your prototype, you cannot claim R&D Tax Relief on its construction costs.

Separate commercial and eligible development costs for first of class items

As with prototypes, you cannot claim R&D Tax Relief on first of class items you built solely to sell them. 

However, HMRC acknowledges that constructing first of class items can require a significant level of innovation. As can the overarching commercial project a first of class item belongs to. 

This means that if constructing your first of class item involved significant R&D, the costs associated with it may well be eligible for R&D Tax Relief. 

If that is the case, you will need to separate costs related to your research and development work – relevant staff costs, subcontractor fees, raw materials, etc – from those associated with ‘routine’, non-innovative work and commercial activities like marketing and sales. 

Separate commercial and eligible development costs for first of class items

Because prototypes and first of class items often aren’t eligible for R&D Tax Relief, it’s good practice to explain why you have included them in your claim in your technical narrative. 

A technical narrative is a document that explains your research and development work to HMRC. You don’t have to submit one. But doing so will dramatically reduce your chances of facing an enquiry–a lengthy investigation which could slow down your relief by several months or even years. 

You should explain why you built the prototype or first in class product, how it helped you overcome scientific or technical uncertainties, and what happened to them after the work was completed.

Conclusion

I hope this article clears up some of the confusion around claiming R&D Tax Relief on first of class and prototype expenses.

If you would like some help incorporating these costs in your claim, our tax credits team is standing by to help.