A Comprehensive guide to qualifying R&D Expenditure for HMRC R&D tax credits

September 26, 2023 | eBook

Introduced in 2001, research and development (R&D) is a corporation tax relief designed to reward UK companies that invest in innovative projects. HMRC R&D tax credits don’t just represent a great opportunity for companies to reduce their corporation tax bills, but also free up funds so you can focus on improving your processes and honing your industry expertise.

But while it pays to reap the rewards of this tax break, the rules surrounding R&D expenditure can be difficult to navigate, especially if you dedicate most of your time to your projects. If you want to improve your chances of making a successful claim, you’ll need to know which activities you can claim tax credits for — and which costs you’ll need to foot the bill for yourself.

As accountants for R&D-intensive industries like tech, manufacturing and construction, we’re here to help you get the most out of your claim. In this guide, we’ll enhance your understanding of R&D and give you more clarity on the claims process, from breaking down what counts as qualifying expenditure to offering expert advice on how to make the most of your claim.

Let’s get started.

Reviewing the R&D basics

First things first, let’s go over the R&D basics.

What are HMRC R&D tax credits?

R&D is a corporation tax relief, which means only companies can claim R&D tax relief or credits. There are two different R&D schemes available in the UK: the SME R&D scheme for smaller companies, and the R&D expenditure credit (RDEC) for larger firms.

SME R&D tax relief scheme

If you’re a small business owner, you’ll usually need to claim SME R&D tax relief. To qualify for this scheme, a company must have the following:

• fewer than 500 employees
• a turnover of under €100m or balance sheet assets of under €86m.

As of 1 April 2023, the SME scheme allows companies to deduct a total of 186% of qualifying costs from their annual profits. Or, if your firm is loss-making, you can claim a tax credit worth up to 10% of its surrenderable loss.

The rates vary, however, when claiming R&D relief for accounting periods before 1 April 2023.

RDEC

Meanwhile, companies will need to sign up for the RDEC scheme if they have:

• 500 employees or more
• or a turnover of over €100m and balance sheet assets of more than €86m.

Firms claiming RDEC can receive a tax credit worth 20% of all qualifying expenditures incurred from 1 April 2023 onwards. Again, different rates apply for R&D expenses incurred in earlier accounting periods.

Connected businesses

If your company is part of a business group or in a partnership-linked enterprise, HMRC will look at the total sum of employees owned by businesses in the group, as well as common shareholders, to determine which scheme it can use.

Working out which R&D scheme your company qualifies for isn’t always straightforward, so we’d recommend speaking with a professional if you’re unsure.

What qualifies as an R&D project?

Before we dive into what does and doesn’t count as qualifying expenditure, it’s important to understand the R&D project criteria set out by HMRC.

Above all else, your R&D project must seek to “make a technological advance” — but that doesn’t mean the scheme is just for pharmaceutical companies and software developers.

HMRC’s definition of a technological advance can cover a diverse range of activities. Examples of eligible R&D projects include trying out new manufacturing methods, experimenting with alternative building materials or even improving existing processes in your industry.

Another key requirement is that you must set out to achieve an advance from the outset of your project. That means you won’t be able to claim R&D relief if you just stumble on a breakthrough accidentally.

You should also ensure that:

• The advance was relative to the industry baseline. Your project needs to benefit your industry as a whole, not just bring your company up to the same standards as your competitors.
• The advance related to an area of science and technology. This broad definition could cover a wide range activities but excludes any advances in the arts, humanities, social sciences and economics.
• The advance involved technological uncertainty. HMRC will consider a project to have technological uncertainty if a competent professional could not determine its outcome.
• These uncertainties could not have been easily deduced by a professional in the field. If the advance you’re seeking is already common knowledge or easily worked out by an industry expert, your project won’t qualify.

Interestingly enough, your project doesn’t need to be successful to be eligible for R&D. If you try and fail to make a breakthrough, HMRC will still recognise that R&D took place — so long as it meets the criteria above.

An R&D project can also be part of a wider commercial project within your company. In this case, you should only claim for the costs of the R&D project itself.

What counts as qualifying expenditure?

Once you know your project meets the criteria for HMRC R&D tax credits, you can start looking at the qualifying costs. So which expenses count as R&D expenditure?

Generally speaking, the work involved with an eligible R&D project can be split into two qualifying criteria: directly contributing activities and indirectly contributing activities.

Direct contributing activities

These activities directly contribute to R&D and are usually (but not exclusively) undertaken by individuals in the central R&D team. Direct contributing activities can include costs related to:

• project management
• interpreting results
• raw materials
• software
• utility bills
• carrying out experiments and trials.

Indirect contributing activities

While they don’t directly contribute to R&D, many indirect activities will qualify if R&D could not take place without them. Examples of indirect contributing activities include:

• security
• training costs
• running of machinery
• specialist cleaning.

However, you can usually only claim for a small amount of time spent on these activities, as most of it will not relate to R&D.

Ineligible works

Not all activities fall inside the scope of R&D. For example, you cannot claim HMRC R&D tax credits for routine tasks that you perform in the same financial year, such as marketing or cosmetic design.

Other ineligible expenses include (but are not limited to):

• capital expenditure
• the cost of land and rent
• patents and trademark registration
• any costs incurred in the production and distribution of goods or services.

Essentially, only activities that contribute towards answering a technological uncertainty will qualify as R&D expenditure.

Breaking down your expenses

Let’s look at what does and does not qualify as R&D expenditure in different categories.

Staffing

If you’re an employer, chances are that employee expenses account for a large chunk of your annual budget. The good news is you can include many of these costs in your R&D claim.

When it comes to staffing, there are very clear lines surrounding which expenses do and do not qualify as R&D expenditure. Companies can usually claim for:

• salaries
• bonuses
• employer’s NICs
• pension scheme costs.

Employee expenses also fall under the scope of R&D, so long as:

• those expenses are incurred in order for the employee to fulfil the requirements of their employment, and
• your company reimburses said employee in full.

Calculating qualifying staffing expenditure

You’ll need to apportion your staffing costs depending on how much time each employee spends on the R&D project. Keeping detailed employee records and using tools like time management software can make this task much more straightforward.

In some circumstances, you may even be able to include administrative or support staff expenses in your claim — for example, if specialist cleaning services are necessary for R&D to take place. If you want to get your claim right, you’ll need to look at all of your staffing costs on a case-by-case basis.

However, the following staffing costs will not qualify:

• dividend payments to directors and shareholders
• redundancy payments
• staffing costs related to routine activities that would take place regardless of any R&D projects (such as general administrative tasks or payroll management).

Working with contractors

The staffing costs you can claim are slightly different if you hire contractors, subcontractors or externally provided workers (EPWs) to work on your R&D project.

Under the RDEC, firms cannot claim tax credits for most subcontractor costs unless the subcontractor is one of the following:

• a qualifying body (such as a charity, higher education institute or scientific research organisation)
• an individual
• a partnership of individuals.

RDEC claimants can claim up to 65% of their total qualifying subcontractor costs.

The rules for claiming these costs are more relaxed for SME R&D scheme claimants. Small businesses can claim different amounts depending on the company’s relationship with the subcontractor:

• In cases where the parties are connected, companies can claim 100% of the relevant subcontractor costs.
• In cases where the parties are not connected, companies can only include 65% of the relevant subcontractor costs.

Resources and consumables

Raw materials

If your company uses, consumes or destroys raw materials as part of the R&D project, you can claim these costs in your claim.

Let’s say you’re a food manufacturer and purchase ingredients to experiment with a new manufacturing process. These are your raw materials.

If your project meets the R&D criteria, you’ll be able to claim for any ingredients or other raw materials you use for this purpose. This includes all materials destroyed during R&D activities as well as any waste left over at the end of the project.

However, if you later use excess materials to manufacture a product intended for sale, the costs of those materials will not qualify as R&D expenditure.

Costs associated with the creation of a prototype needed to test R&D are also claimable — unless you intend to sell that prototype.

Utilities

When used in the R&D process, some utility costs such as water, heat and electricity bills count as qualifying expenditure.

In most cases, utilities are classed as apportioned expenses. That means the amount you can claim is based on the proportion of the cost attributed to your R&D project.

However, rent is not classed as R&D expenditure.

Clinical trials

If you conduct a clinical trial as part of your R&D project, any payments you make to volunteers are usually eligible for HMRC R&D tax credits.

Software costs

Companies can also claim for the cost of computer software needed to conduct R&D. This can include specialist computer-aided design software or manufacturing systems you use in your project, as well as subscriptions to programs like Microsoft Excel.

What’s more, for accounting periods starting on or after 1 April 2023, the cost of data licences and cloud computing services will qualify for R&D relief. Cloud computing expenses include everything from the provision of data storage and software platform fees to the costs of operating systems and software platforms.

Recent legislative changes

Qualifying overseas expenditure

The Government recently introduced new rules to encourage firms to conduct R&D inside the UK.

Under this legislation, the majority of costs incurred in accounting periods starting on or after 1 April 2023 will only qualify for R&D if they take place in the UK. Works undertaken outside of the UK will only qualify if they could not have taken place anywhere in the UK.

Let’s say your UK-based company is conducting research into volcanic activity. As there are no volcanoes in the UK, it stands to reason that some R&D activities may need to take place overseas. In this case, these costs may fit HMRC’s definition of “qualifying overseas expenditure” — although there are other conditions you’ll need to meet first.

Additional information form

From 8 August 2023 onwards, all R&D tax credit claimants must submit an additional information form to support their claim. HMRC won’t be able to process your claim unless you submit the form in advance of your corporation tax return.

 Among other details, you’ll need to include:

• a summary of qualifying expenditure by cost category
• descriptions of each R&D project you’re claiming for
• total qualifying expenditure being claimed for each project.

While this information aids the Government in cracking down on fraudulent R&D claims, it also places a greater administrative burden on businesses. If you don’t have time to meet this requirement yourself, your tax agent can offer expert advice and submit the form on your behalf.

How to make the most of your HMRC R&D tax credits

With the R&D goalposts always moving and the UK Government taking steps to crack down on fraud, it’s more important than ever to get your claim right. While you can appeal an unsuccessful claim, making a mistake in your calculations could prove costly. 

Keep detailed business records

We can’t stress this point enough: if you want to maximise your R&D tax credits, you’ll need to maintain excellent bookkeeping practices.

That means keeping detailed employee records outlining how much time each employee spends on R&D activities and tracking all business transactions related to R&D. If you purchase items or raw materials to use in your R&D project, you should also implement a solid inventory management system to help you monitor stock levels.

The more detailed and accurate your business records are, the easier it will be to prove your R&D claim is legitimate.

Embrace technology

If you’re in the business of innovation, you’ll know how essential technology can be in streamlining your processes. Making use of cloud accounting software can allow you to automate many time-consuming tasks and help you keep track of your R&D expenditure.

Online payroll services, meanwhile, can give you a detailed overview of your staffing costs. We’d also recommend encouraging your team to use time-tracking tools to measure how much time they spend on R&D projects.

And remember: you may be able to claim a portion of these costs as R&D expenditure.

Do your research

The fact that you’re reading this guide means you’re already doing your due diligence when it comes to R&D — but there’s a lot of information out there.

We’d recommend scrutinising guidance on the Government website to help you understand whether a project meets the criteria and which activities qualify for R&D tax relief. You’ll also need to make sure you claim for the right scheme and make accurate calculations based on the relevant financial year.

You can also find useful online resources from organisations such as the Institute of Chartered Accountants in England and Wales (ICAEW) and the Association of Accounting Technicians.

Perhaps most importantly, you should consult an accountancy firm with experience navigating R&D claims. A tax adviser who specialises in your industry can use their expertise to guide you through the process, advising you on how to stay compliant and get your claim right the first time.

Work with R&D specialists

The rules surrounding HMRC R&D tax credits can be complicated, but you don’t need to navigate them by yourself.

As R&D accountants, we can offer expert advice and bespoke tax planning services whenever you need, from helping you prepare detailed R&D project descriptions to communicating with HMRC on your behalf.

Your innovation should be rewarded, so maximising deductions on your corporation tax bill is our top priority. While the R&D legislation is always changing, you can rely on us to keep you compliant with the latest requirements.

Furthermore, with us staying on top of your books, you’ll know that every penny your company spends on qualifying R&D expenditure is accounted for. 

Are you thinking of claiming HMRC R&D tax credits in your corporation tax return? Contact us to discuss your R&D project and find out how we can help you make the most of your claim.