R&D Tax Credits: Which costs qualify?

Innovative

Let’s say you’ve identified a project (perhaps the only project your company is undertaking) and you’re trying to figure out what costs to include in the project. How do you do that?

Four main categories

The first thing to note is that HMRC defines only 4 categories of qualifying costs:

  • Direct labour: that is, employees paid directly by the company (e.g. on the payroll, in the UK or elsewhere) to work on the project.
  • External staff: staff hired from an external staff provider, but otherwise similar to employees – i.e. directly employed on the project.
  • Subcontracted R&D: parts of the project that have been extracted and parcelled out to a subcontractor, typically with a specification for what needs to be delivered and a subcontractor agreement or contract.
  • R&D Consumables: things that were consumed in the R&D.

The first 3 sections are relatively straightforward, though it’s worth noting that external staff that’s provided by a connected party can count as direct labour. A connected party is another company that is “connected” to the claiming company. For example, if you own 100% of company A and of company B, they are connected. If company A subcontracts some R&D to company B, you can look directly into company B and use the costs incurred by company B, in company A’s claim. There is, of course, a caveat: company A must still be paying for the work ultimately – i.e. it must be deducted from company A’s taxable profit. If the two have a completely separate P&L and are doing work for each other pro bono, you will either forfeit part of the costs, or need to file two claims.

R&D Consumables

R&D Consumables is the complex one, and full of exceptions. Luckily, this is also, for software, the least lucrative one to focus on.

The original thinking behind R&D consumables is easily understood if you think of R&D for physical products. In the process of building a physical, technically complex product, you will create numerous prototypes to test the technology. These prototypes will not be sold to consumers – they are a clear R&D cost. After the R&D, you may keep some prototypes for sentimental reasons, but most of them will be scrapped.

Labour to create those prototypes is already covered by the other types of costs, but the materials are covered in this category. For example, if you used £10k worth of aluminium to build your prototypes, and scrapped all those prototypes, your R&D claim should include the cost of that aluminium.

It’s important that the prototypes are actually scrapped. If you end up selling them to consumers after all, they should not be considered part of the R&D project.

Exceptions

Of course, this wouldn’t be fun without exceptions!

Even though HMRC will happily declare, in an audit meeting, that these are the only 4 categories of costs that qualify, and use that to reject various costs that you want to include, their own web page states otherwise.

Additional costs that are explicitly states as qualifying are:

  • software licences
  • utilities (power, fuel – but not data or telecommunications costs!)
  • payments to clinical trial volunteers (of relatively little relevance to startups)

In practice there are some other costs that will qualify as well, even though they are not listed here, and may be rejected by some R&D units.

As for why heating and lighting qualify for R&D relief, but data costs do not, I leave that up to the reader to divine.

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