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Tottel's Corporation Tax Annual 2006-07 by Juliana Watterston

Juliana Watterston, author of Tottel’s Corporation Tax Annual 2006-07, outlines a potentially valuable tax incentive for companies.

Introduction

Relief is available for capital research and development (R & D) through the capital allowance rules and for revenue R & D through the tax relief for expenditure on research and development.

Capital expenditure

Capital allowances

Capital allowances on research and development allowances may be claimed by any size of company but only if the company carries on a trade. If the company does not already carry on a trade it must set up and commence a trade connected with the R & D after incurring the expenditure (CAA 2001, s 439(1)). The company need not carry on the research itself; a third party may carry on the research on the company’s behalf. The R & D must be related to the trade that is being carried on, known as ‘the relevant trade’. R & D capital allowances can neither be claimed against investment income nor against professional and vocational income. Capital R & D expenditure qualifies for 100% initial allowance for capital allowance purposes. R & D is also available on oil and gas exploration. Thus the company is able to write off the full cost in the accounting period in which it is incurred (CAA 2001, s 437).

Meaning of research and development

For the purposes of claiming 100% capital allowances on R & D, the definition of R & D follows the accounting definition given in UK GAAP SSAP 13 (accounting for research and development) or IAS 38 (intangible assets) as appropriate (ICTA 1988, s 837A).

The SSAP 13 definition

 Pure (or basic) research: experimental or theoretical work undertaken primarily to acquire new scientific or technical knowledge for its own sake rather than directed towards any specific aim or application.

 Applied research: original or critical investigation undertaken in order to gain new scientific or technical knowledge and directed towards a specific practical aim or objective.

 Development: use of scientific or technical knowledge in order to produce new or substantially improved materials, devices, products or services, to install new processes or systems prior to the commencement of commercial production or commercial applications, or to improving substantially those already produced or installed.

The IAS 38 Definition

 Research is original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding.

 Development is the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services before the start of commercial production or use.

Allowances are given for pure and applied research in order to gain new or scientific knowledge. Oil and gas exploration is included. The trade related R & D may be of a sort that may lead to or facilitate an extension of the company’s trade. It may also be of a medical nature, which has a special relation to the welfare of workers employed in that trade (CAA 2001, s 439(5)). If the research is carried on by a third party on the company’s behalf, the company must retain responsibility for the research and the expenditure must be undertaken directly.

Example 1

S Ltd had a part share in a petroleum exploration license. It arranged for G Ltd to provide the funds and the equipment to conduct operations. In return S Ltd gave G Ltd the rights to the ownership of all the petroleum won and saved to which it was entitled. G Ltd claimed that the expenditure incurred under that agreement qualified as R & D capital expenditure because it was incurred on scientific research directly undertaken on its behalf.

G Ltd is not entitled to the R & D capital allowance because the research was not directly undertaken by or on behalf of G Ltd. The facts are those of Gaspet Ltd v Ellis (1987) 60 TC 91, [1987] STC 362, [1987] 1 WLR 769.

Medical research undertaken for the benefit of the community as a whole may qualify as R & D allowance if it may lead to or facilitate an extension of the trade. For example, medical research undertaken by a drug company for the purpose of its trade may qualify because it is related to its trade of manufacturing drugs (HMRC Capital Allowances Manual CA 60400).

Qualifying expenditure

Relief may be claimed on providing facilities to carry out the research (CAA 2001, s 438). Land does not qualify for relief, nor does the cost of a dwelling that is more than 25% of the cost of the building (CAA 2001, s 438(4)). Expenditure on the acquisition of rights in research and development or rights arising out of research and development does not qualify for R & D (CAA 2001, s 438(2)).

Example 2

Novotech plc is engaged in a qualifying research project and incurs the following expenditure:

 A building for £2.5m excluding the cost of the land. The cost of the building is apportioned between research laboratories £2m and living accommodation £500,000.

 A car for each researcher who is required to travel about the country carrying out research activities.

 The patent rights to a patented invention that Novotech considers may be of assistance with the current project.

The building, including the living accommodation, will qualify for R & D. This is because the living accommodation is less than 25% of the cost of the whole building. The motor cars qualify as expenditure on research and development. The cost of acquiring the patent rights does not qualify for R & D because it is expenditure incurred in acquiring rights arising out of research and development.

Allowances

A 100% capital allowance may be claimed on the expenditure during the accounting period in which the expenditure is incurred. A reduced claim may be made (CAA 2001, s 441(3)) but there is no facility to claim further allowances (such as WDAs) in subsequent accounting periods.

If ownership of the asset changes hands or if it destroyed, a disposal value must be included within the company’s corporation tax computation. On sale it will be the net proceeds of sale or market value in other cases. If the asset is demolished or destroyed any insurance or compensation monies received are taken as the disposal value. In the accounting period of disposal a balancing charge will be included being the smaller of the difference between the disposal value and the balance of unclaimed expenditure and the R & D allowance claimed (CAA 2001, s 442). There is no facility in the legislation for claiming a balancing allowance.

The balancing charge and R & D allowance are treated accordingly as receipts and expenses of the trade (CAA 2001, s 450).

Example 3

In the year of acquisition of a £2.5m research building, Novotech plc makes a claim for £1m R & D. Some years later it sells the building for £5m. The balancing charge is the smaller of:

 the difference between the disposal value and the balance of unclaimed expenditure:
£5m - £(2.5m – 1m) = £3.5m

and

 the R & D allowance claimed:
£1m

The balancing charge is £1m, the R & D claim made.

If the company ceases to use the asset for the R & D purpose this is not a disposal for R & D purposes. The R & D allowance is eventually recouped when the asset is sold. On a change of use the asset may qualify for plant and machinery allowances or industrial buildings allowance (see Chapter 6). The R & D allowance is not clawed back at this stage. It is only clawed back on the eventual sale of the asset.

Disposal value

If an R & D asset on which an R & D allowance has been claimed is demolished and the demolition costs exceed the disposal value, (which in many cases may be nil), the excess demolition costs may qualify for R & D allowance. They will only qualify if the asset has not begun to be used for any purpose other than research and development (CAA 2001, s 445). The excess is not to be treated as expenditure on any property that replaces the demolished asset.

Any additional VAT liability incurred on the R & D asset qualifies for R & D allowances provided that the company, which incurred the original expenditure on the asset, still owns it and the asset has not been demolished or destroyed. Any additional VAT rebate is treated as a disposal value provided that the company that incurred the original expenditure on the asset still owns it and the asset has not been demolished or destroyed. If there is no unclaimed R & D allowance the VAT rebate is treated as a balancing charge. If there is unclaimed R & D allowance and the additional VAT rebate is less than the unclaimed R& D allowance the additional VAT rebate is deducted from the unclaimed R & D allowance and the result treated as the unclaimed R & D allowance for future disposal events. If the additional VAT rebate is more than the unclaimed R & D allowance the difference is treated as a balancing charge (CAA 2001, ss 448, 449). (See also HMRC Capital Allowances Manual CA 60750.)

Revenue expenditure

Revenue deductions

The tax relief for expenditure on research and development provisions may be claimed by all companies. In general the small company rules are contained in FA 2000, Sch 20 and the large company rules in FA 2002, Sch 12. The relief only apply to companies and for this purpose the company definition given in TA 1988, s 832(1) applies being ‘any body corporate or unincorporated association but does not include a partnership, a local authority or a local authority association’. The company must also be within the charge to corporation tax (HMRC Corporate Intangibles Research and Development Manual CIRD 81200).

Companies qualify for an enhanced deduction if expenditure incurred is more than £10,000 in an accounting period. The enhanced deduction is included within the adjusted trading profits. Companies claim the enhanced relief by completing boxes 99 to 102 as appropriate. The following paragraphs provide a summary of the detailed rules.

Meaning of research and development expenditure

The same GAAP definitions are used as above. In addition the research must be within the DTI guidelines. HMRC recommends that the DTI guideline tests be applied before the SSAP 13 and IAS 38 tests. Essentially a project will qualify as an R & D project if it is carried on in a field of science or technology and is undertaken with an aim to extend knowledge to which the relief applies (HMRC Corporate Intangibles Research and Development Manual CIRD 81300). The DTI Guidelines are reproduced in HMRC Corporate Intangibles Research and Development Manual CIRD 81900. Paragraph 19 of the DTI Guidelines defines the meaning of a project:

‘A project consists of a number of activities conducted to a method or plans in order to achieve an advance in science or technology. It is important to get the boundaries of the project correct. It should encompass all the activities that collectively serve to resolve the scientific or technological uncertainty associated with achieving the advance, so it could include a number of different sub-projects. A project may itself be part of a larger commercial project, but that does not make the parts of the commercial project that do not address scientific or technological uncertainty into R & D.’

Therefore, in practice, every research activity should be broken down into its separate parts to ascertain whether or not it will qualify as R & D.

Relevant research and development

Relief can only be claimed on relevant research and development. Relevant research and development is defined in FA 2000, Sch 20, para 4 (which essentially deals with small companies) to mean that it is research and development related to a trade carried on by the company, or from which it is intended that a trade to be carried on by the company will be derived. The same meaning is adopted in FA 2002, Sch 12, para 4(4) and FA 2002, Sch 12, para 9(3), which deal with all company and SME research respectively.

The R & D expenditure may relate to a trade already carried on by the company or the expenditure may lead to or facilitate an extension of that trade and if medical research it has a special relation to the welfare of workers employed in that trade (FA 2000, Sch 20, para 4).

Staffing costs include salaries and wages for all employees actively engaged in the research, together with employer’s NIC and employer’s pension fund contributions relevant to them. Benefits are not included in staff costs with effect from 1 April 2004. Costs for employees only partly engaged in research are apportioned appropriately (FA 2000, Sch 20, para 5). (Employees in this context includes directors). Secretarial and administrative costs are excluded.

Qualifying R & D expenditure

Qualifying R & D expenditure for both the small and the large company schemes is similar but not identical. It can be summarised as follows:

The expenditure:

 must not be capital;

 is attributable to relevant R & D directly undertaken by the company or on its behalf;

 is incurred on staffing costs or on software or consumable items or on qualifying expenditure on externally provided workers or is qualifying expenditure on sub-contracted R & D, and from 1 April 2006 on clinical trials;

 is not incurred by the company in carrying on contracted out activities;

 is not subsidised (SME scheme only);

 any intellectual property created as a result of the R & will be, vested in total or in part in the company (SME scheme only); and

if the expenditure is incurred in carrying on activities contracted out to the company, they are contracted out by:

 a large company, or

 a person otherwise than in the course of a trade, profession or vocation the profits of which are chargeable to tax under Case I or II of Schedule D.

(FA 2000, Sch 20, para 3; FA 2002, Sch 22, para 4).

Intellectual property

Intellectual property includes:

 any industrial information or technique likely to assist in:

- the manufacture or processing of goods or materials, or

- the working of a mine, oil well or other source of mineral deposits or the winning of access thereto, or

- the carrying out of any agricultural, forestry or fishing operations;

 any patent, trade mark, registered design, copyright, design right or plant breeder’s right or overseas equivalent (FA 2000, Sch 20, para 7).

The intellectual property if vested should be vested at the time when the intellectual property is created.

Subsidised expenditure

Subsidised expenditure is any expenditure for which a grant or assistance is directly or indirectly received.

Externally provided workers

Externally provided workers are those engaged on the project who are not employed by the company but are under the company’s supervision. The external workers’ services must be supplied to the company through a staff provider. Self employed consultants are not externally provided workers, although their costs may form part of sub-contracted R & D (HMRC Corporate Intangibles Research and Development Manual CIRD 84100).

Where the staff provider and the company are not connected, 65% of the staff provision payment cost is treated as qualifying expenditure on externally provided workers.

If external workers are provided by a connected person, and the whole of the fee is included in the relevant providers GAAP accounts for a period ending not more than 12 months after the end of the accounting period in which the company claiming the R & D allowance makes the payment, then the company may claim R & D tax credit on the lower of:

 the qualifying payment for staff that it makes to the staff provider, and

 the amount that the staff provider includes as relevant expenditure in its accounts (FA 2000, Sch 20, para 8C).

If the staff provided and the company are not connected they may jointly elect in writing, within two years of the end of the accounting period in which the contract arrangement is entered into, for the connected persons treatment to apply. This election must apply to all staff under the same arrangement (FA 2000, Sch 20, paras 8A–8E and FA 2002, Sch 12, para 17(d)).

Sub-contracted research & development

An SME can claim relief on the payments that it makes to sub-contractors. The treatment is similar to the externally provided workers treatment. If the parties are not connected, only 65% of the costs are deductible by the company.

If the contractor is a connected person, and the whole of the amount that is paid to the sub-contractor is included in the sub-contractor’s GAAP accounts for a period ending not more than 12 months after the end of the accounting period in which the company claiming the R & D allowance makes the payment, then the company may claim R & D tax credit on the lower of:

 the payment that it makes to the sub-contractor, and

 the amount that the sub-contractor includes as relevant expenditure in his ore her accounts.

If the sub-contractor and the company are not connected they may jointly elect, in writing, within two years of the end of the accounting period in which the sub -contract arrangement is entered into, for the connected persons treatment to apply (FA 2000, Sch 20, paras 9–12).

A large company R & D expenditure that its sub-contracts to other parties is generally not allowable (see HMRC Corporate Intangibles Research and Development Manual CIRD 84200) although it can have work sub-contracted out to it.

Definition of an SME

An SME is defined in accordance with the European recommendation (FA 2000, Sch 20, para 2).

Definition of a Micro, Small and Medium- sized company

					Medium		  Small		  Micro

If the company has fewer than	      250 employees    50 employees    10 employees	

And

EITHER an annual turnover 

not exceeding          			€50m               €10m		   €2m

OR

A balance sheet total not exceeding     €43m               €10m            €2m

(2003/361/EC)

The staff head count is based on the number of full-time person years attributable to people who have worked within or for the concern during the year in question. Part-time, seasonal and temporary workers are included on a pro-rata basis.

‘Employees‘ includes actual employees, persons seconded to the enterprise, owner-managers and partners (other than sleeping partners). Apprentices or students engaged in vocational training with an apprenticeship or vocational training contract, or any periods of maternity or parental leave are excluded.

Turnover is taken per the accounts (net of VAT). The balance sheet total is the gross amount of assets shown in the accounts. Results are converted from sterling to euros to ascertain whether the tests are met.

The EC defines the enterprise as either autonomous, linked or partner. Autonomous means that there are no partner or linked enterprises. A linked enterprise is an enterprise whereby one company is able to exercise control directly or indirectly over the other. A partner enterprise exists where the enterprises are not linked but where one enterprise is able to exercise control either directly or indirectly over the affairs of the other. If a company has partner or linked enterprise relationships the results are aggregated. (See Flow Chart HMRC Corporate Intangibles Research and Development Manual CIRD 92850).

The conditions are relaxed for public investment corporations, and venture capital companies, ‘business angels’, provided the total investment of those business angels in the same enterprise is less than €1.25m, universities or non-profit research centres, institutional investors, including regional development funds and autonomous local authorities with an annual budget of less than €10m and fewer than 5,000 inhabitants.

A company may change its status from SME to large company. This will only take place if the conditions are satisfied for two consecutive years.

Small or medium-sized company

Tax relief for expenditure on research and development

A small or medium-sized company (SME) will qualify for an enhanced deduction from trading profits of 150% of its qualifying R & D expenditure if this expenditure amounts to £10,000 or more during a 12-month accounting period. The amount is reduced proportionately if the accounting period is less than 12 months (FA 2000, Sch 20, para 1). (The £10,000 limit was introduced for accounting periods ending on or after 27 September 2003. Previously the limit was £25,000). Qualifying expenditure is expenditure that would be allowable as a deduction in computing the taxable profits of a trade carried on by the company, or would have been allowable if the trade were being carried on at the time that the expenditure was incurred. Pre-trading expenditure is not treated as incurred on the first day of trading (ICTA 1988, s 401) but when it is actually incurred.

Relief

150% relief can be obtained by the company if it is carrying on an R & D trade during that accounting period. An adjustment is included in the Schedule D Case I computation under the heading ‘Deductible expenditure not included in the accounts’ (FA 2000, Sch 20, para 13).

If the company has not yet started the trade it may elect to treat 150% of the expenditure as a trading loss of the accounting period in which the expenditure was incurred. The relief for pre-trading expenditure (ICTA 1988, s 401) is ignored. The election must be made in writing within two years of the accounting period to which the loss relates (FA 2000, Sch 20, para 14). However, this deemed trading loss may not be set off against profits of a preceding accounting period (where ICTA 1988, s 393A(1)(b) applies) where the company is also entitled to a deemed trading loss for that earlier period.

Alternatively, the company may surrender the loss for a cash payment of 16% of the loss for the chargeable period. The cash payment cannot exceed the total of the company’s PAYE and NIC liabilities for the period. Employee child tax credits, working tax credit, statutory sick pay and statutory maternity pay are ignored in these calculations (FA 2000, Sch 20, para 17). The relief claimed is included in box 89 of the company tax return. Trading losses carried forward are restricted accordingly.

The relief is only available to SMEs. If the SME is owned by a consortium no R &D may relief may be surrendered to any group company that is not an SME (FA 2000, Sch 20, para 22).

Large company

Tax relief for expenditure on research and development

A large company will qualify for an enhanced deduction from trading profits of 125% of its qualifying R & D expenditure if this expenditure amounts to £10,000 or more during a 12-month accounting period. The amount is reduced proportionately if the accounting period is less than 12 months (FA 2002, Sch 12, para 1). (The £10,000 limit was introduced for accounting periods beginning on or after 9 April 2003. Previously the limit was £25,000). Qualifying expenditure is expenditure that would be allowable as a deduction in computing the taxable profits of a trade carried on by the company, or it would have been allowable if the trade were being carried on at the time that the expenditure was incurred. Pre-trading expenditure is not treated as incurred on the first day of trading (ICTA 1988, s 401) but when it is actually incurred.

Qualifying R & D expenditure

Large company R & D not only includes direct research and development expenditure but also sub-contracted research and development and contributions to independent research and development (FA 2002, Sch 12, para 3).

Sub-contracted research and development

Sub-contracted R & D may qualify for relief if it is sub-contracted to an individual, or a partnership made up of individuals. It may also qualify for relief if it is subcontracted to a qualifying body. A qualifying body is a charity, a higher education institution, a scientific research organisation or a health service body.

The research carried out must be relevant revenue research directly undertaken on the company’s behalf. In addition if the work is sub-contracted out to the company it must be subcontracted by a large company or by a person in the course of that person’s trade (FA 2002, Sch 12, para 5).

Contributions to independent research and development

Contributions to independent relevant research and development qualify for relief if the expenditure known as ‘funded R & D’ is incurred in making payments to an individual, or a partnership made up of individuals or a qualifying body. The company must not be connected with an individual or any individual in the partnership when the payment is made. In addition the funded R & D must not be contracted out to the qualifying body, the individual or the partnership concerned by another person (FA 2002, Sch 12, para 6).

Work subcontracted to small or medium-sized enterprise

An SME can make a claim under FA 2002 large company rules, for sub-contract work that it carries out. The revenue expenditure concerned must consist of expenditure on staffing costs, software or consumable stores or externally provided workers.

It can also claim R & D on relevant research work that it subcontracts to others. The work must be contracted to an individual, a partnership made up of individuals or a qualifying body consisting of a charity, a higher education institution, a scientific research organisation or a health service body (FA 2002, Sch 12, paras 9, 10).

If the company claims under the large scheme rules the reliefs detailed above will be available.

Location

There is no statutory provision restricting the location of the R & D work carried out. In fact, the ECJ has ruled that article 49 EC precluded legislation of a member state, which restricted the benefit of a tax credit for research to research carried out in that member state (Laboratoire Fournier SA v Direction des Verifications Nationales et Internationales Case C-39/04).

Tax relief for expenditure on vaccine research

Similar rules also allow for companies to deduct an additional 50% of research and development expenditure on vaccines and medicines, from taxable profits or to claim a 16% tax credit (FA 2002, Sch 13).

Juliana Watterston
September 2006

Juliana Watterston is author of ‘Tottel’s Corporation Tax Annual 2006-07’, from which the above article is extracted. The book is part of the ‘Tottel’s Core Tax Annuals 2006-07’ series. The series is due to be launched in September 2006. Each of the new Core Tax Annuals costs just £19.95, or all six cost just £99.50! The Core Set comprises:

o Tottel's Corporation Tax 2006-07;

o Tottel's Capital Gains Tax 2006-07;

o Tottel's Income Tax 2006-07;

o Tottel's Inheritance Tax 2006-07;

o Tottel's Trusts and Estates 2006-07; and

o Tottel's Value Added Tax 2006-07.

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