Define R&D — a taxing question

Posted on 4 Jan 2010 by The Manufacturer

What qualifies as research and development for tax purposes? The Government has taken a bit of stick this year for its handling of R&D tax credits claims, but there is little hard evidence that it tightened its rules.

Can business expect to get more clarity on this expensive but valuable tax credit process? Will Stirling asks.

A superyacht can cost £1 million per metre to build, if you choose a reputable Northern European shipyard. As these luxury goods are mainly one-offs, calculating what constitutes R&D and what is real ‘production’ for tax purposes is somewhat tricky. Particularly if the yard builds a prototype hull that is used in the development of the final yacht’s hull, which at some point is sold to another customer. A yacht uses design, materials, sea trial time etc that are consumed in development (R&D), but if the prototype is sold, it is not really consumed and should not qualify for R&D tax relief. So says Her Majesty’s Customs and Revenue (HMRC).

Stuart Lisle, a tax partner at business advisers BDO LLP agrees with this definition – but it took he and his team 18 months to do so. They submitted a six-year claim for R&D on behalf his yacht builder client in March 2008 that has only just got satisfactory closure. “The company effectively uses the ‘first in class’ hull as their prototype, but this is always sold as it costs millions to build and fit out and it would be a waste of money to discard as a prototype.” The sold prototype, in the eyes of HMRC, is seen as the first production model, which – quite correctly – should not qualify as R&D.

Another client of BDO’s, a yacht designer, builds highly accurate and costly scale models of yachts for tank testing. The development costs of these models do qualify for R&D. But for some the distinction has never been very clear cut. Formula One is another industry where there is frequent blurring between what counts as R&D and final production. “F1, shipbuilding, any area where large amounts of expensive materials go into something that is effectively being used commercially, does that then represent something that is consumed in R&D?” says Lisle, who thinks where HMRC now draw the line is correct.

Bad press
For many manufacturers R&D represents a big proportion of their costs. Think of pharmaceutical companies, aerospace, motorsport – some of the UK’s strongest manufacturing sectors. The Government introduced the R&D Tax Credit Scheme in 2002, amended in 2004, and it was hailed as a good scheme for business by trade organisations including EEF and the CBI. However, this year there has been much negative press about the application of the scheme, with numerous anecdotal stories of companies frustrated by HMRC in their attempts to claim what they saw as legitimate tax relief on R&D spending. These same trade bodies, with accountants, lobbied the Government in July to revise the scheme to bring clarity to their definition of real ‘R&D’, and what qualifies as ‘production’.

The main contention concerned the definition of prototypes. “You’re producing a good, but it’s something that is up for trial and you might sell it to a customer for feedback,” says Jeegar Kakkad, senior economist at EEF. “It’s not the final product but somewhere in that trialling process the prototype does, or can, become the final product. So there is a very fine line about whether a good being sold is still in the R&D stage or it is actually finished.” The body of anecdotal complaints was large enough to suppose that HMRC tightened its qualifying rules on R&D; where in previous years they had accepted, for example, late stage prototypes and other items in an advanced stage of development, now they did not. There was a perceived clampdown. HMRC denies this, an official stating: “Further to articles in the press recently about a “change of practice” relating to the treatment of expenditure on production, HMRC’s view, and practice, on this has not changed.

Production expenditure is excluded from being R&D by the BIS Guidelines that define R&D for tax purposes.” Easy enough to say, but a manufacturer will understandably want to test those guidelines in grey areas such as prototypes. And, as Simon Broadbent, managing director of solid-liquid separation equipment manufacturer Broadbent says, how are they or the accountants expected to know? “They are only bean counters and don’t necessarily know all the nuances of manufacturing. There has to be some give and take in applying the guidelines.”

Bending the rules
This point – understanding the manufacturing business – is crucial. One point of view claims that some companies try to stretch the rules by submitting ambitious claims for items which would never reasonably sit inside R&D. The other says in the past HMRC coughed up for such items and it has since closed the door under instruction from the Treasury as the volume of revenue flowing back to industry rose. Kakkad has had several discussions with HMRC, the Treasury and EEF members about the perceived changes. The problem he says lies in communication. “It’s not a change in the rules, in the guidelines or HMRC’s interpretations of the guidelines. The real problem is in the application of how they enforce those guidelines — taking a blanket approach to inspecting claims whereas they should have been a little more collaborative with businesses, working with them before and after claims are submitted to identity the offenders upfront rather than a taking blanket approach that punishes this kind of prototyping activity.”

Few would dispute the authority of the basic definition, which BDO’s Lisle supports, that R&D includes items and research consumed in the development of a product, but not a stage-good that is sold commercially in that process. But claiming an R&D tax credit is not a 10-minute operation. “HMRC is generally demanding a lot more convincing evidence to support an R&D claim and it is ultimately for the taxpayer to convince HMRC that the activities satisfy the tax definition of R&D,” says Maureen Penfold, senior tax partner at accountants Kingston Smith.

That seems fair enough. But some companies may feel that they’ve done their due diligence, painstakingly completed the forms with all relevant details, followed the BIS guides on what qualify as R&D and still get knocked back.
Enough stories like this in circulation puts off smaller companies from claiming, or fuels the rumour that the system is broken.

Simon Broadbent who sits on EEF’s policy committee, says the onus is on the company to claim properly but adds “the whole issue is this: because the rules are not so clearly defined, the distinction between pure research, research and development, innovation and production is blurred; one man’s production is another man’s pure research. From a business point of view we will put forward documents we think is eligible for R&D under our interpretation of the rules but a professional accountant will say I’ve seen this in three or four cases and they weren’t allowed, or “I don’t know – try it”.

Work to do
Broadbent points out that it is harder for smaller businesses to produce finely detailed claims when they don’t keep the records that large companies are obliged to, so when they hear of the scheme they cannot always capitalise on it adequately.

Overall, however, his experience with R&D claims has been positive. HMRC sent an inspector to oversee completion of their recent 2006/2007 tax credit claim, who was competent and thorough.

One area where Broadbent (the company) would like to have been more successful is where its customer has incurred costs trying out a prototype but there is still no true sale. “We found when we’ve tried to test a prototype at a customer site, and they have costs, if we pay those costs sometimes they’re eligible and sometimes they’re not – there’s a blur about how prototypes are tested and how eligible you are for wriggling a tax rebate on it.” Broadbent applied for a claim like this a few years ago and it was knocked back.

Whether or not it consciously or deliberately tightened the rules on R&D credits this year or not, HMRC has listened to industry and plans to publish new, clearer rules on what constitutes R&D, with an emphasis on prototypes, in the early part of 2010.

Stuart Lisle’s article on the R&D tax credit scheme can be found at:

Scientific uncertainty

Maureen Penfold, head manufacturing at accountancy firm Kingston Smith, provides advice on making R&D tax claims as effective as possible.

“If the costs are on the border between R&D and production it is important for companies to ensure that they have good evidence and arguments to support the inclusion of those costs in a claim. HMRC are generally demanding a lot more convincing evidence to support an R&D claim and it is ultimately for the taxpayer to convince HMRC that the activities satisfy the tax definition of R&D.

Our advice to companies concerned about R&D tax claims is as follows:

• Keep all documentation to show that scientific uncertainty remains and that the R&D activities are effectively continuing.

• Even where the R&D activities have ended and the manufacturing process has started, it is possible that problems may arise later and this could trigger a further R&D activity to resolve the scientific or technological uncertainty. Documentary evidence to show why this additional work qualifies as R&D should be retained.

• Ultimately, it is important to demonstrate to HMRC that the activity including tests on the prototype is carried out to seek an advantage over possible competitors and that this requires further work from a scientific and/or technological dimension. There is merit in focusing on the purpose or objective of the activity, why it was carried out and why it has not ended.

• To the extent that the work on production prototypes are merely aesthetic and or minor modifications to enhance the commercial life of the product, these activities are unlikely to meet the tax definition of research and development and hence the associated costs are unlikely to qualify for this relief.

In addition to questions over the start and end of R&D we have indirect evidence of HMRC questioning the ownership of Intellectual Property Rights, which is a requirement under the Small and Medium sized company scheme. There are particular concerns where a project is developed jointly, and advice on any IPR licences should be sought prior to the commencement of qualifying R&D work.”