With early startups and smaller companies, most of the costs of doing R&D are not payroll. Many small companies do part-time consulting or contracting to pay the bills, and pay themselves through the tax-efficient means of a basic, minimal salary plus dividends. Moreover, as they are very cost- and tax-conscious, they do their best to pass costs like subsistence and travel, where appropriate, through the company.
Since those same small companies tend to do a lot of qualifying R&D (usually, most of the technical uncertainty is dealt with by the time commercial scale is reached and more people are hired), the question naturally arises whether they can claim dividends, travel and subsistence costs, incurred while working on R&D projects, in the cost of the R&D projects, and therefore get R&D relief on it, in the form of some much needed cash back.
Unfortunately, the answer is no. You can’t claim dividends, subsistence, business entertainment, advertising, travel, rent, or any of a host of other categories that you might think could be argued to fit into the costs of an R&D project.
Four categories of costs
The reason is that HMRC’s regulation clearly stipulates 4 qualifying categories of costs, and no others.
The first is direct labour. This covers any directly employed people who are working on the project in either a direct capacity (e.g. developers and engineers) or as a “qualifying indirect activity” (e.g. project managers and technical analysts).
The second is subcontracted work. This covers any part of a project that was subcontracted out and that was necessary to the R&D. The work itself doesn’t need to be qualifying work from the point of view of the subcontractor. HMRC give the example of a biotech startup that subcontracts DNA sequencing to another company as part of a qualifying project. Even though the DNA sequencing is “routine” to the second company, it is a qualifying cost because it is done within the context of a qualifying project performed by the first company. However, please note that a consultant who’s brought onto the project to advise it, rather than to perform specific work as part of the project, will not count as a subcontractor.
The third category is external staff. This is external staff that are brought in to do specific bits of work. In most of the business world, these would typically be known as “contractors”. But be aware that there is a possibility that HMRC might dig into this type of work to find out whether those contractors should really be liable to PAYE via IR35, and include external staff only if their PAYE situation is clear.
Finally, the fourth category is R&D Consumables. This is meant to cover any kind of item that is consumed during the project. An example from the hardware world would be materials, e.g. metal and glass and wires and gases, but also energy, consumed in the development and testing of a new type of light bulb. In the software world, this would include software licences necessary to the R&D (e.g. IDEs), hardware costs which have not been capitalised (e.g. mobile handsets that had to be bought to test a mobile application). It does not, however, include rent, or data/communication costs, or even virtualised hosting (which is considered a form of rent).
Across all four categories, the final requirement is that the expense must be deductible for tax purposes, which disqualifies dividends (which are paid out after tax).
Anything that doesn’t fall within one of those four categories or is not deductible, does not count.
A generic process for figuring out if it counts
One series of questions to ask yourself to figure out if this counts is the following:
- Is it directly or indirectly related to solving the technical problem?
- Is it labour, subcontracted, external staff, or can it be said to have been consumed in the R&D in the same way that a software licence or a piece of wood would have been?
- Is it a tax-deductible expense?
If the answer is “no” to any of these questions, then it almost certainly won’t qualify.