This post is part of our Entrepreneurial team’s regular series of blogs.
First Tier Tribunal cases and their decisions can provide useful clarification about R&D tax relief and how HMRC expects the guidance and legislation to be applied.
In this blog, I’ve summarised the facts of the Hadee Engineering Co Ltd v HMRC case from October 2020, looking at why the taxpayer lost and the key points to take away so you don’t fall foul of the same mistakes.
The court found that the taxpayer had, incorrectly, overstated salary costs and claimed for bonuses that were actually in the accounts for a previous period.
It was also found that there was a lack of evidence in relation to payments for materials and subcontractors. The taxpayer could not provide any evidence that these costs were incurred by the company or within the time period of the claim.
In addition, time and expenditure incurred on non-qualifying, routine activities were being claimed for, and the apportionments applied could not be justified.
Key points to take away:
- It is important to remember that costs are only eligible for R&D tax relief if they are deductible for corporation tax purposes within the accounting period of the relevant R&D claim. Including costs from a different period or costs that are not deductible in calculating the profit of the trade is a breach of the rules (HMRC guidance CIRD81450).
- While HMRC don’t require companies to keep detailed records, at a minimum a claimant company should be able to produce invoices and bank statements to confirm that these costs were incurred and within the relevant period. The “competent professionals” involved in the projects must understand what activities qualify for R&D tax relief, so they can arrive at ‘just and reasonable’ percentages to be applied to costs, that reflect the extent to which they were involved in the qualifying activities. If they are ever asked, they can then justify the approach taken to HMRC.
What is a competent professional?
Only one individual was provided by the company as a competent professional, but was unable to provide the relevant technical detail to allow HMRC to assess the qualifying nature of the projects. This meant that HMRC was unable to confirm that the projects included in the claim did actually qualify as R&D for tax purposes.
Key points to take away:
- We often refer to competent professionals in the course of preparing an R&D claim, because HMRC sets this as the test for assessing whether an activity meets the criteria of qualifying R&D. Although the term ‘competent professional’ is not explicitly defined, they are qualified or time-experienced members of staff within the area of science or technology of which the advance is being sought.
- These individuals need to be involved in the R&D claim process to some extent as they are required to provide the necessary supporting technical detail to enable HMRC to assess the eligibility of the projects. They are also required to provide the qualifying percentages that are applied to costs.
The case raised issues with the level of evidence provided by the appellant in support of their claim. HMRC argued that it was inconsistent, incomplete and did not address the key criteria which need to exist for activities to qualify for R&D tax relief.
Key point to take away:
- While there is currently no standard format or template in which supporting evidence for a claim should be submitted to HMRC, it is pushing for more consistency. As such, HMRC has recently provided guidance for the type of information that should be included and clarified how many projects evidence needs to be submitted for.
Existence of a project
One of the requirements for qualifying R&D activities to be taking place is for the existence of a project. HMRC argued that there was no evidence that any projects existed within the claimant company. They stated that, for a project to exist, companies should have detailed evidence and records in-house that substantiate the plans and activities carried out.
Key points to take away:
- Again, there is no specific definition of what constitutes a project in the R&D guidance or legislation. The judge in this case referenced the dictionary, stating that a project was a “plan or scheme; a planned undertaking” and agreed with HMRC that a formulation of a plan is required for a project to exist.
- Companies claiming, or planning to claim, R&D tax relief should be aware that some form of record or documentary evidence is expected and, if that’s not possible, a competent professional is required to provide a detailed explanation. This again highlights the need for technically-detailed and structured supporting evidence to be submitted in support of a claim.
What constitutes subcontracted R&D?
A number of the taxpayer’s projects were undertaken in conjunction with customers. HMRC argued that the projects would be considered to be subcontracted because the company was commissioned to design bespoke products for customers. This meant that, if the projects did involve qualifying activities, they would be only eligible for relief under the RDEC scheme. (The RDEC scheme is open to large company and SMEs which do not qualify for the more lucrative SME R&D Tax Credit scheme. It is notably less lucrative, but still worth considering submitting a claim for.)
The judge referred to the contracts in place between the two parties and primarily focused on the economic risk, where in this case the claimant company was paid on an hourly basis for the work undertaken. As the taxpayer did not bear any economic risk, it was ruled that the projects were subcontracted. To further support the ruling, the customer on one project had successfully filed a patent for the design work carried out by the claimant company.
Key points to take away:
- There is limited guidance available to assist in determining whether a project is subcontracted or in-house for R&D purposes. The three main points that should be considered are:
- The ownership of the arising intellectual property;
- Who bears the economic risk; and
- The degree of autonomy enjoyed.
- These points should always be considered when drawing up a contract with a customer when you will be undertaking qualifying R&D activities. If, for example, the contract supports that you retain any arising IP, you bear the cost of any project overrun and you have autonomy over how the work is conducted, then the project will still be eligible for relief under the more generous SME scheme.
Ultimately, the court found that only one of the projects was eligible for R&D tax relief (though the amount of qualifying expenditure on that project is still in dispute).
In light of the coronavirus pandemic, HMRC is dedicating more staff to process R&D claims. While this means that we are generally seeing HMRC pay out claims quicker, it also means that HMRC has more resources to look into, and potentially enquire into, claims.
Here at C+T, our report format is designed to give HMRC all of the information it requires to assess the eligibility of a claim, to prevent an enquiry being opened to request more details. We also have experience in dealing with all of the complex factors that need to be considered when preparing an R&D tax relief claim, including contractual arrangements, which HMRC specifically scrutinised in this case.
Our team of experts are on hand to help you through the claim process, to give you peace of mind that all of the relevant factors have been considered and the risk of enquiry is significantly reduced. If you have any questions, get in touch and we can advise.