You may have heard of the SME Research and Development (R&D) Tax Credit incentive but may be unaware or unsure of how exactly it is calculated.
In this short guide, we will walk you through a typical claim calculation so that you can understand the ins-and-outs of how to calculate an R D tax credit claim.
Note that the calculation for the Research and Development Expenditure Credit ('RDEC') is different and you can find a detailed guide here.
Here is the quick overview of how to calculate R D tax credits:
- Calculate profits/losses subject to corporation tax (before R&D tax relief)
- Apply the SME R&D tax enhancement relief to qualifying costs (at a rate of 230%)
- Deduct the R&D enhanced expenditure within the tax computation
- Determine the optimum treatment for the revised (post R&D tax relief) taxable profits or losses
SME R&D tax credit calculations - Detailed Example
Step 1: Calculate profits/losses subject to corporation tax (before R&D tax relief)
The preparation of a company's tax return ('CT600') is an annual exercise to calculate any tax due or to quantify tax losses if loss-making.
A company's costs are typically deducted against its income (if any) in calculating its profits subject to tax (or tax losses) for each financial accounting period.
The application of the R&D tax relief simply adds an extra step to the process of quantifying any company tax due or resulting losses as part of the tax filing process.
In each case, the R&D tax relief will typically reduce tax payable or increase available tax losses (the latter which may be surrendered for a tax credit rebate from HMRC - see further below).
Step 2: Apply R&D tax enhancement relief to qualifying costs (at a rate of 230%)
The R&D tax relief is applied as an 'enhancement' to the eligible costs that relate to qualifying R&D projects.
What do we mean by an 'enhancement' on costs?
You will sometimes see it referred to as an 'uplift' or a 'super-deduction' or an 'enhancement', but in all cases they refer to the same principle:
The SME R&D tax relief adds a notional additional tax deduction at a rate of 230% on eligible costs.
Example: 230% enhancement on eligible costs
UK Ltd has total staffing costs of £120,000 that relate to a qualifying R&D project.
Ordinarily, UK Ltd would simply deduct the £120,000 against its income in the normal way (before considering any R&D relief) to reduce any tax payable.
So say it had turnover/revenue totalling £250,000 then it would have profits of £130,000 subject to tax (ignoring any other costs, to keep things simple).
With current corporation tax rates at 19%, there would be tax payable of £24,700.
If we apply the 230% super deduction or enhancement to the eligible costs then we need to deduct a further £156,000 as a notional deduction (£120,000 * 130%). Note that we deduct an additional 130% (not 230%) as the original 100% of the unadjusted expenditure has already been deducted in the normal way. i.e. £276,000 is the total amount of R&D enhanced expenditure deducted in the tax computation being:
230% or 2.3 x £120,000 made up of
the original deduction of £120,000 (100%) plus
the notional enhancement of £156,000 (130%).
Note that the additional 130% or £156,000 deduction in our example above is purely notional. There is no actual additional cost paid out by the company. This notional cost is not reflected in the company accounts either - it is a pure tax adjustment only.
Step 3: Deduct the R&D enhanced expenditure within the tax computation
The notional additional 130% R&D tax deduction is deducted within the company tax computation.
So our (simplified) example tax computation would show:
Before R&D tax additional deduction:
Taxable profit (before R&D): £130,000 (i.e. Turnover: £250k less costs of £120k)
Tax payable @ 19% = £24,700
Post R&D additional deduction
Taxable profit (before R&D): £130,000 (Turnover - £250k less costs of £120k)
Less R&D enhanced deduction: £156,000
Revised taxable profit/(loss): (£26,000)
Step 4: Determine optimum treatment for revised (post R&D tax relief) taxable profits or losses
So in our example, the R&D additional deduction has eliminated the taxable profits and generated a tax loss.
This has resulted in a tax saving of £24,700 in our example before we consider the optimum overall treatment for the resulting tax loss.
There are two typical scenarios that SME companies will face after applying the R&D tax adjustment:
a) Profitable (post enhanced R&D deduction)
If the company has taxable profits even after deducting the R&D enhancement, then it will be subject to tax on these remaining profits - the R&D tax saving will have been reflected in the reduction in profits subject to tax calculated at the prevailing corporation tax rate (currently 19%).
b) Losses (post enhanced R&D deduction)
In this scenario, the company has a choice:
i) it can carry the enhanced tax losses back to reduce taxable profits in the prior 12-month accounting period
ii) it can carry them forward to offset against future taxable profits
iii) it can surrender the enhanced tax losses to a group company ('group relief')
iv) it can surrender the enhanced tax loss for an R&D tax credit payment from HMRC at a rate of 14.5% ('surrenderable loss')
Options (i) - (iii) will generally save corporation tax at a rate of 19% (current headline rate) whereas the option (iv) results in a tax saving at a rate of 14.5%.
Why choose the lower R D tax credit 14.5% tax saving option?
Many companies elect to surrender their enhanced tax losses for an R D tax credit at the lower rate of 14.5% as they can recover the cash from HMRC typically within just 4-6 weeks from filing.
Compare this to carrying forward the enhanced tax losses (potentially indefinitely) and most companies therefore choose to 'bank the cash' now (albeit at a lower effective rate) by electing to claim the payable credit.
If a company has taxable profits in its prior accounting period or it is part of a tax group where there are taxable profits in a fellow group company, then these options are likely to be preferable to surrendering the losses for a payable tax credit - as tax relief is obtained at a higher effective rate.
Note also that the surrenderable loss is capped at the lower of the trading loss after the additional deduction and the enhanced expenditure - this can sometimes lead to lower than expected tax credit claims if, for example, the company is break-even or has some profits (pre R&D adjustments).
In our example, UK Ltd could surrender its enhanced tax loss of £26,000 for a payable tax credit of £3,770 (at 14.5%). This tax rebate is in addition to the £24,700 CT saving also secured.
Quick Rule of Thumb for SME R&D calculations
There is a quick shortcut that can help you quickly work out your potential R&D tax savings
Profitable SME - R&D tax savings equate to approx 25% of the eligible spend
Loss making SME - R&D tax savings equate to approx 33% of the eligible spend
So on say £100,000 of eligible costs, a profitable company could save approx £25,000 and a loss-making company could recover approx £33,000 as a payable credit.
You still need to reflect the detailed calculations in your claim but this is a useful rule of thumb to quickly estimate your potential tax savings.
How to file an R&D tax credit claim?
You must file your claim via your CT600 tax return and supporting tax computation and this should be accompanied by a detailed technical narrative and supporting claim calculations.
And, of course, you can reach out for specialist help.