Background and Introduction

This note sets out a brief overview of the corporate tax regime for spending on research and development.  The UK offers relief under the capital allowance regime for capital expenditure and there have historically been two types of relief for income expenditure, depending on whether the entity was a small or medium enterprise (SME) or a large company.  From 1 April 2013 an above the line tax ("ATL") tax credit has been brought in for large companies. This is to run in tandem with the historic large company relief until it replaces it in April 2016.  In addition there is a vaccine research relief for large companies (which we do not consider in detail in this note).  In more detail, the R&D reliefs are as follows:

Income expenditure could fall within one of the following reliefs depending on whether the company is an SME or not and the type of R&D

R&D relief for SMEs

R&D relief for large companies

ATL Tax credit

  • 225% deduction for qualifying R&D expenditure
  • Generally for trading SMEs.  However a non trading SME which intends to carry out a trade derived from the R&D, can make an election to create a deemed trading loss
  • The enhanced loss can be surrendered to HMRC for a (tax free) cash payment that is equal to 11% of the amount surrendered
  • 130% deduction for qualifying R&D expenditure for trading companies
  • LCs cannot surrender a trading loss in return for a cash payment from HMRC
  • SMEs can claim under the large company schemes for R&D expenditure in certain circumstances (e.g. where acting as subcontractor)
  • Taxable 10% tax credit (8% on after tax basis) for trading companies
  • Restricted to PAYE and NIC liabilities of relevant R&D staff
  • Applies to large companies and in certain circumstances to SMEs
  • Runs in tandem with large company scheme until 2016 and then replaces it

Capital expenditure on R&D can qualify for 100% R&D allowances under the capital allowance regime.  There is no distinction made between small and medium enterprises (SMEs) and large companies for capital allowances purposes.

What is an SME?

The European Commission’s SME definition is used for R&D tax purposes and applies to spending from 1 August 2008. The SME is a company, (together with any 25% (or more) subsidiary), which has less than 500 employees and either an annual turnover not exceeding €100 million, or a balance sheet of not more than €86 million. A company must satisfy the SME criteria over two consecutive financial years. The SME must also be independent (25% or more joint ownership) of one or more LCs.

Pursuant to the Finance Bill 2013, the Large Company Scheme is to include an ‘above the line’ credit which has been introduced for expenditure incurred on or after 1 April 2013. It will run alongside the enhanced-deduction scheme which it will replace in April 2016. Despite the widespread assumption that the ATL will only benefit large companies, the draft legislation also applies to SMEs. HMRC has confirmed that soon SMEs who are carrying out sub-contracted R&D will be able to claim ATL credit. From 1 April 2013, the rate of relief is 10% of qualifying R&D expenditure.

What is R&D?

“Research and development” means “activities that fall to be treated as research and development” in accordance with generally accepted accounting practice”

Guidelines have been issued with statutory effect by the Department of Trade and Industry (now the Department of Business, Innovation and Skills).  These "BIS  Guidelines" provide detailed information on the definition of R&D.  

According to the BIS Guidelines:

  • R&D for tax purposes takes place when a project seeks to achieve (but may not achieve) an advance in science and technology;
  • R&D involves those activities that directly contribute to achieving the advance through the resolution of elements of scientific or technological uncertainty;
  • Certain qualifying indirect activities related to the project are also R&D. 

Science for this purpose is the systematic study of the nature and behaviour of the physical and material universe.    It does not include work in the arts, humanities, social sciences or economics, nor does it include mathematics in its own right.  Technology is the practical application of scientific principles and knowledge

Scientific or technological uncertainty exists where knowledge of scientific possibility or technological feasibility or how to achieve it is not, in practice, readily available or deducible by a competent professional working in the field.  System uncertainty is included in this respect.

An advance in science or technology means an advance in the overall knowledge or capability in a field of science or technology including adaptation of knowledge or capability from another field where such adaptation was not readily deducible.  A company's own state of knowledge/capability are not relevant.  However where the advance has already been made but it is not known then work on seeking to achieve the advance can be R&D.

The following will be R&D:

  • Projects which seek to extend overall knowledge or capability
  • Projects which seek to create a process, material, device, product or service which incorporates or represents an increase in overall knowledge or capability
  • Projects which seek to make an appreciable improvement to a process etc. through scientific or technological changes
  • Projects which seek to use science or technology to duplicate the effect of a process etc. in a new or appreciably improved way.

Appreciable improvement is something more than minor or routine which a competent professional working in the field would acknowledge as genuine and non-trivial.

A product does not become an advance simply because it has been created using science/technology, and activities of a routine nature, or the use of routine methods is not R&D.  Routine analysis, copying or adaptation of an existing product, process, service or material would also not fall under R&D.

A direct contribution to achieving an advance in science or technology would require an activity which must attempt to resolve an element of scientific/technological uncertainty associated with achieving the advance.  For example creating or adapting software or equipment needed for the resolution of the uncertainty solely for use in the R&D, scientific or technological planning activities, design, testing and analysis undertaken to resolve the uncertainty. 

Direct contributions do not include commercial or financial steps, development of non-scientific or non-technological aspects of new/improved processes etc., administration and general support.

The following activities if forming part of the project would be qualifying indirect activities:

  • Scientific and technical information services conducted for R&D support
  • Indirect supporting activities such as maintenance, security, admin, finance and personnel activities undertaken for R&D
  • Essential ancillary activities
  • Training to directly support the project
  • Research carried out by students and researchers at universities
  • Research (including data collection) to devise new scientific or technological testing, survey or sampling methods (if not itself R&D)
  • Feasibility studies to inform strategic direction of specific R&D activity

The BIS Guidelines provide further details and examples of what is meant by R&D.

What R&D is relevant?

To make a claim the R&D must be relevant R&D, i.e.:

  • the R&D must relate to a trade carried on by the company; or
  • the R&D must be R&D from which it is intended that a trade to be carried on by the company will be derived

What expenses qualify?

There are detailed rules for which expenses qualify depending on the type of relief.  There are also anti-avoidance provisions within the R&D tax credit legislation to prevent companies making artificially inflated claims for relief.

Generally however qualifying expenditure for R&D purposes includes revenue spending on:

  • Staffing costs - employing staff directly who are actively engaged in carrying out relevant R&D. Costs include payments by the company in respect of:
    • cash earnings of the employee/director
    • employer’s secondary Class 1 NICs/social security contributions in the EEA/Switzerland
    • pension fund contributions

Computer software or consumable or transformable materials - which are employed directly in relevant R&D. Where partly employed directly in R&D, the appropriate proportion is treated as attributable to the relevant R&D

  • Externally provided workers - payments to a staff provider e.g. an agency, for externally provided workers, subject to detailed rules.  Where the agency is connected with the company, one looks through to the underlying expenses to determine the amount of qualifying expenses.  Where not connected only 65% of the payment to the agency qualifies unless an election is made for connected party treatment to apply.
  • Relevant payments to clinical trial subjects

Benefits in kind paid to employees are not qualifying costs.

R&D relief for SMEs

A trading SME may deduct 225% of its qualifying R&D expenditure for a 12 month accounting period when it calculates its taxable profits/losses if the expense relates to its trade.

The deduction can be set against the profits of the SME and therefore, create an enhanced trading loss for the accounting period.

A non trading SME which intends to carry out a trade derived from the R&D, can make an election to use the 225% deduction to create a deemed trading loss for the accounting period. This election must be made within two years from the end of the accounting period to which the election relates.

An SME’s trading loss arising as a result of the enhanced R&D relief can be surrendered to the Inland Revenue in return for a (tax free) cash payment that is equal to 11% of the amount surrendered (i.e. 24.75% of the R&D cost). The tax credit is also first offset against any corporation tax liability of the SME before being paid by the Revenue.  Once surrendered, the remaining amount of the unrelieved losses (for either a trading or non-trading SME) can be carried forward.

SME relief is not available where R&D is contracted out to an SME or where expenditure is subsidised or subject to the project cap (see below).  In these circumstances, the SME may still be able to claim relief at the large company rate (with no payable credit).   

The tax credit used to be restricted to the total of the company’s PAYE/NIC liabilities for the accounting period.  This restriction was removed for accounting periods ending on or after 1 April 2012.   There also used to be a requirement that any IP from the R&D was owned by the SME.  This restriction was removed with effect from  9 December 2009

Finance Act 2008 introduced a cap of €7.5 million on the maximum amount of aid that can be given to a particular R&D project.   Aid for this purpose means the amount by which the SME relief exceeds what would have been available as relief if the company had been a large company.  This cap only applies to expenditure incurred on or after 1 August 2008.

R&D relief for large companies

A large company can deduct 130% of qualifying R&D expenditure if it is carrying on a trade in the period. However, large companies cannot surrender a trading loss in return for a cash payment from the Revenue.

Relief is available for in-house R&D, contracted out R&D and also for expenditure on contributions to independent R&D.


Generally, the rules aim to ensure that R&D relief is only provided once. 

Outsourcing by an SME

SME relief at 225% is available where the SME subcontracts work in respect of the payments to the sub-contractors (including where the subcontractor is an SME or a large company).

Where the subcontractor is connected with the SME, one looks through to the subcontractor's expenses to determine which expenses qualify.  Where not connected only 65% of the payment to the subcontractor qualifies unless an election is made for connected company treatment to apply.

Outsourcing to an SME

In the case of work outsourced to an SME, the SME sub-contractor can claim at the large company rate of relief (130%) for its spending on R&D work which it carries out for:

  • a large company; or
  • any other person other than in the course of carrying on a trade subject to UK tax (e.g. a charity or overseas company)

The SME can claim the large company rate of relief for R&D work outsourced to it by a large company which the SME then sub-contracts to a qualifying body, an individual or a partnership made up of individuals.  Qualifying bodies include charities, higher education institutions, scientific research associations and health service bodies.

Outsourcing by a large company

A large company can claim relief for work outsourced to third parties but only where outsourced to a qualifying body, individual or partnership of individuals.  A large company cannot claim any relief for expenditure on R&D work it outsources to an SME or another large company.

Under the large company scheme, relief is also available for qualifying expenditure on contributions to independent research and development undertaken by an individual, partnership of individuals or qualifying body.

Where the subcontractor is connected with the SME, one looks through to the subcontractor's expenses to determine which expenses qualify.  Where not connected only 65% of the payment to the subcontractor qualifies unless an election is made for connected company treatment to apply.

Outsourcing to a large company

To claim relief, a large company can be a sub-contractor for:

  • another large company; or
  • any other person other than in the course of carrying on a trade subject to UK tax (e.g. a charity or overseas company)

In the case of work outsourced to a large company that large company can claim relief if it further sub-contracts work to an individual, partnership of individuals or a qualifying body as mentioned above.

Group treatment

For the purposes of large company relief (or SME relief where the SME is a subcontractor and therefore subject to the 130% relief only), where a group company subcontracts to another group company, the subcontractor is treated as carrying out relevant R&D work if the work would have been R&D if carried out by the main contracting company.  This means that, even if a subcontractor is merely carrying out work of a routine nature (i.e. routine testing procedures), relief can be claimed if the R&D work forms part of a wider R&D project of the group.  Essentially, the activities of the group contractor and sub-contractor are taken together to assess whether the sub-contractor is carrying out relevant R&D.

As R&D relief for both SMEs and LCs gives rise to a trading deduction, the trading losses created are potentially available for group/consortium relief.  However, where a company is owned by a consortium, SME R&D relief can only be surrendered as group relief to any members of the consortium that are also SMEs.

In summary the potential outsourcing scenarios are as follows:


* ie an individual, partnership all of whose members are individuals or a qualifying body

ATL tax credit

Finance Act 2013 introduced the ‘above the line’ credit for research and development incurred on or after 1 April 2013. This ATL credit is introduced alongside the existing additional relief for R&D for large companies (and SMEs in circumstances where the large company relief only applies) but will replace the existing large company scheme from 1 April 2016.

The idea behind the ATL tax credit stems from  the idea that as many R&D departments in large organisations have bonus pots linked to the organisations profits before tax, then R&D tax credits which feed into the organisations tax charge do not have any impact on behaviours in such departments.  The idea is that a credit which impacts a company's PBT should have more positive behavioural impact.

The ATL rules are the same in so far as they determine what a qualifying activity is and what constitutes qualifying expenditure.  The manner of relief has however changed.

Relief is now given as a taxable credit calculated as a percentage of the qualifying expenditure (currently 10% other than for companies within the oil and gas ring fence regime).  There is a clear step process to any claim

  • Step 1 - The credit is first used to discharge the CT liability of the claimant company for the same accounting period.   
  • Step 2 - The balance is then subject to an adjustment such that only the net amount after reduction by corporation tax at the main rate that would be payable on such sum (if it constituted taxable profits) is available.  The amount deducted by this mechanism is available to discharge future CT liabilities.
  • Step 3 -Any balance remaining is capped by the PAYE/NIC  costs of the R&D staff (with no restriction for time spent on qualifying R&D activity) and R&D group provided externally provided workers restricted to time spent on qualifying R&D activity) Any capped amount is carried forward and treated as an expenditure credit for the next accounting period.
  • Step 4 -The amount remaining discharges corporation tax liability for any other period.
  • Step 5 - If the company is a member of a group it may surrender any amount remaining for a corresponding accounting period.
  • Step 6 - The payable credit element remaining is applied in discharging any other outstanding liability of the company to HMRC.
  • Step 7 - Finally, any amount remaining after the above steps is payable by HMRC.  Claims are subject to a ‘going concern’ test.  Payment can also be postponed if there is an enquiry into the company's tax return.

Making a claim

Once a company establishes that its operations qualify for R&D purposes, it will then need to produce detailed documentation (covering all possible qualifying expenses) to justify its R&D claim to the Revenue. The relief must be claimed within one year of the filing date for the self-assessment return for the accounting period to which the claims falls in.

Capital Allowances

Capital allowances at 100% are available for expenditure incurred by a trading company or a company that subsequently commences a trade connected with the R&D.   Allowances are available on capital expenditure incurred on R&D including all capital expenditure incurred for carrying out R&D and for providing facilities for carrying out R&D.  Allowances are not available for acquiring rights in R&D, provision of a dwelling or for acquiring land (as distinct from buildings or structures).

This article is part of the International Tax Bulletin for July 2014