A common misconception about R&D Tax Credits is the idea that you have to be profitable for them to be worthwhile. This has been false for many years now. In reality, the scheme is actually more favourable for loss-making SMEs than it is for profitable ones, offering a 33% relief instead of 26%.
Here’s how claiming works if you’re unprofitable. Plus a couple small caveats and a big one that I like to call The Valley of Death.
How it works
The way that tax credits are calculated is that first you add up the “qualifying expenditure”. This is the amount that you’re declaring has been spent on “qualifying R&D”.
The primary mechanism of the scheme is that this qualifying expense is then “enhanced”. This artificially increases your R&D expenses for the year, and therefore reduces your taxable profit for the year, perhaps even taking you into a loss (or increasing your loss if you were already loss-making).
The way that this helps profitable companies is obvious: instead of paying tax on their taxable profit, they pay less tax on a diminished (or potentially eliminated) profit. However, the scheme also allows companies to do something with the loss that’s generated. This is called “surrendering” the loss.
In effect, any loss generated by the scheme can be surrendered for cash. This means that the loss is not carried over to future years, and instead you get some cash for it right now. This is music to the ears of many loss-making startups.
Of course, this wouldn’t be HMRC if there weren’t a long list of caveats, as well as a big conceptual problem (I’ll save that one for the end).
First of all, the government is planning to reintroduce a cap on the amount of cash that can be obtained via the “surrender” mechanism. The cap is expected to be set at 300% of a company’s PAYE and NI contribution (note that this includes the amounts paid on behalf of employees, strangely enough). This will mean that unprofitable companies which mostly employ subcontractors won’t actually be able to surrender much loss.
The second caveat is that this is not cumulative with loss carried forward from earlier years. HMRC’s view is that R&D Tax Credits are applied first, and then the loss from earlier years is applied. In other words, if you had a £100k profit for the year, and you cancelled it out with a £100k of loss carried forward from a previous year, you would end up with zero profit and no tax due. But if you had, say, a £80k reduction in your profit by enhancing R&D spending, you couldn’t then carry forward previously losses to generate an artificial loss this year. This means there would be no loss to surrender.
Instead the net effect is that you will only need to use £20k of the loss from previous years to reduce your profits to zero. So in effect, you create £80k of loss for future years. This is still very useful, particularly for a profitable company, but much less exciting than cash in hand.
This also has another effect: ‘The Valley of Death’.
The Valley of Death
How HMRC ended up with this situation is anyone’s guess. I’m going to be nice and assume plain oversight. There’s no reason I can think of why HMRC would seek to penalise companies that are breaking even, right?
Anyway, here’s the situation: the “surrender” mechanism relies on you surrendering some (usually all) of your “enhanced expenditure”, but you can only surrender an actual loss. Sounds innocuous enough, but here’s how it works in practice.
Let’s say you have £100k of qualifying expenditure. The enhancement and surrender rates are 230% and 14.5% respectively. You enhance the expenditure by 230% – another £130k – so the total expenditure rises to £230k. So far so simple (for a given definition of “simple”).
Let’s further assume that before the claim, you started with a £100k of tax loss. In this situation, the tax credit enhancement would lower your loss to £230k. You would then be able to surrender the whole £230k at a rate of 14.5%, meaning you’d receive a cash lump sum of £33.35k based on your £100k of R&D expenditure.
Here’s the devil, though: if you started off breaking even instead of making a large loss, the situation after the enhancement will be that you are showing a £130k loss. And that’s all you can surrender – still at 14.5%. So by making a great effort to break even, your tax credit has suddenly gone down from £33.35k to a much less appetising £18.85k. Ouch.
In effect, the closer you are to breaking even (relative to the size of the expense), the worse it gets, with a 15% return being the worst possible. Ideally you will want to either have a loss that is equal to or larger than your qualifying expenditure, or a profit that is equal to or larger than the enhancement. Anything else will result in a lower claim.
Unprofitable companies can, do, and should claim R&D Tax Credits – but beware the Valley of Death!
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