New rules were introduced by HM Revenue & Customs (HMRC) on 12 November 2020 regarding a new cap on payable R&D tax credits.
This change was not wholly unexpected as such changes were first proposed in the 2018 Budget and there have been two formal consultations since to help iron-out the finer details to prevent abuse without prejudicing companies with genuine claims.
If a company incurs a loss for tax purposes in an accounting period, and that loss is attributable to enhanced research and development tax relief, then it can elect to surrender the loss for a payable credit payment from HMRC. This is an important source of funding for many UK small or medium-sized enterprises (SMEs).
There is currently no cap or limit on the amount of payable R&D tax credit to a claimant company in an accounting period.
What is the PAYE/NIC liability cap?
With effect from 1 April 2021, this new measure limits the amount of the payable SME R&D tax credit to £20,000 plus 300% of the company's total Pay as You Earn (PAYE) and National Insurance Contributions (NICs) liability for the period.
There is a further exemption from this PAYE cap as explained further below.
Which businesses are impacted by the new SME R&D PAYE/NIC liability cap?
- Early-stage unprofitable businesses with minimal payroll expenditure and therefore relevant staff costs
- Companies that are structured to incur expenditure on workers who are subcontractors and/or agency workers (including overseas workers)
- Connected companies that seek to recharge relevant expenditure between connected parties
- Innovative loss-making business(es) seeking to claim payable credits in excess of £20,000.
What is the £20,000 PAYE cap exemption or buffer?
For payable claims of less than £20,000, these new restrictions are not invoked — so there is no need to calculate the 3x total PAYE/NIC liability for the company or consider the further exemption (below).
However, given that average claims are in excess of £50,000, then this automatic exemption may not benefit more established companies but it should at least help some smaller companies and early stage start-ups.
How does the 300% of PAYE and NIC liabilities cap work?
For those eligible businesses that are claiming payable amounts in excess of £20,000, then they will have to compare their liabilities attributable to the total PAYE and NIC cost (plus £20,000) with the amount of the R&D payable tax credit claim — they can then claim the lower of these two amounts.
Note that when calculating the PAYE/NIC cap, it is not limited to PAYE and Class 1 NIC associated with its qualifying R&D staff — it should include all staff.
Businesses can also include some PAYE and NIC liabilities of any connected persons doing subcontracted R&D for, or providing workers to, the company — this is helpful for group structures where certain companies may perform R&D activities on behalf of other companies in the group.
PAYE and NIC liabilities for a period for these purposes are defined as amounts which the company is required to pay to HMRC in the period.
UK Ltd is a loss-making innovative company seeking to claim an SME tax credit of £56,000 on its tax credit claim for its year ended 31 March 2022.
This repayable amount claimed exceeds £20,000 and therefore, UK Ltd should calculate its total PAYE and NIC liabilities for the year as a first step.
UK Ltd has a total PAYE/NIC liability of £36,000 for the year.
Calculation: 3 x £36,000 = £108,000 i.e. 300% of the total PAYE & NIC and, therefore, the 'PAYE cap' is £128,000 for the period (£20,000 + £108,000).
The company can claim the lower of £56,000 (R&D relief claimed) or £128,000 (PAYE cap) so there is no restriction in this case i.e. the full £56,000 can be claimed as a cash payment.
How much qualifying expenditure can be incurred before the £20,000 PAYE cap is exceeded?
A £20,000 payable tax credit equates to qualifying relevant expenditure of approximately £60,000 for a loss-making company claiming a tax credit.
What if my company exceeds the £20,000 automatic exemption AND falls short of the 300% of total PAYE & NIC test?
There is one further exemption that might come to your rescue if your claim exceeds the £20,000 automatic exemption yet your total PAYE & NIC liability multiplied by three (300%) + £20,000 is insufficient to cover your claim amount...
A company is exempt from this cap on their tax credits claim if:
- its employees are creating, preparing to create or managing Intellectual Property (IP) and
- it does not spend more than 15% of its qualifying R&D expenditure on subcontracting R&D to, or the provision of externally provided workers (EPWs) by, connected persons.
When will the new SME PAYE/NIC cap rules take effect?
This new measure will have effect for accounting periods beginning on or after 1 April 2021.
This means that if your company has a financial year end of 31 December, then the first accounting period that these new rules will apply to will be your year ended 31 December 2022.
The SME R&D tax relief aims to incentivise UK innovative companies to invest in R&D. This tax relief claim incentive forms a core part of the UK Government’s support for innovation and, in particular, supporting the Industrial Strategy target of UK spend on R&D totalling 2.4% by 2027.
However, HMRC fears that the SME tax credit has become a target for fraudulent claims and abuse, in particular, where structures or arrangements are set up with the intention of claiming R&D tax credits (typically via subcontracted work) where there is, as a result, little substance in the way of R&D activities in the UK. It has therefore, followed consultation responses to issue these new rules.
These new rules seek to ensure that the payable SME tax rebate goes to those genuine claimants who have actual substance in the way of employees and genuine business activities in the UK.
This change was first announced in the 2018 Budget followed by two formal consultations on how it might be implemented that were held during 2019 and early 2020.
Regulatory bodies, such as the ICAEW, and advisers expressed concern on initial proposals - including us.
Here's a short video that we released shortly after the 2018 Budget announcement to express our concerns regarding the PAYE cap as originally announced (note that this video was created before the HMRC consultations and the subsequent introduction of the new exemptions outlined above):
The concerns were primarily on the basis that early stage legitimate start-ups might be adversely affected as they may have insufficient numbers of employees to meet the PAYE cap (this was before the £20k exemption was announced). Startups frequently engage the services of subcontractors and freelancers during the early stages of growth as a temporary measure to keep payroll costs low (yet this is a crucial stage of a company's development where the R&D tax relief scheme can be as important as ever).
Also, there were concerns for companies that might have a relatively small workforce (and therefore low expenditure on workers) yet incur significant costs on other areas such as prototype parts and other consumables, so these genuine innovative businesses might also be unfairly disadvantaged by the proposed PAYE cap rules.
Fortunately, HMRC has listened to these concerns and introduced a £20,000 buffer before the 3x PAYE cap rules are invoked, plus an exemption for companies that satisfy the two conditions as noted above.
The combination of these adjustments from the initial proposals should ensure that the majority of UK companies should still enjoy the full (uncapped) benefits of the relief.
These changes to the R&D SME tax relief will be introduced via legislation in Finance Bill 2021.