The rules regarding R&D (research and development) tax credit claims for the SME scheme are changing from 1 April 2021 and it could affect the ability of some businesses to obtain the full benefit from this important tax relief.
The Government is introducing a new PAYE cap on qualifying R&D expenditure, which will attempt to prevent abuse of the R&D tax credit system.
The new measures will limit the amount of payable R&D tax credit that an SME can claim to just £20,000, plus 300 per cent of its PAYE & NIC liabilities for the period.
A company making a small claim for payable credit below £20,000 will not be affected by the cap, but those that are not exempt from this rule will face challenges.
Which firms are exempt from the cap?
A company’s claim will be exempt from the new measures if it meets two tests:

• a business’s employees are creating, preparing to create or actively managing intellectual property (IP); and

• its expenditure on work subcontracted to, or externally provided workers (EPWs) provided by, a related party is less than 15% of its overall R&D expenditure.

While many businesses may be unaffected by these changes, companies that are heavily reliant on subcontracted work for their R&D projects may find that they are limited as to how much tax relief they are eligible for.
This will be a worrying sign for many start-ups, IT and tech companies, who often rely on subcontractors and outside experts when conducting R&D work. 
How will this work in practice?
To help you understand how the new rules are applied here is a worked example:
ITC Limited is loss-making with R&D enhanced expenditure.
The majority of the R&D work is subcontracted out to another company and ITC mas minimal wage cost.
The qualifying spend on R&D is £250,000 and the company’s PAYE and NIC liability for the year is just £5,000.
Under the existing rules, the maximum loss which could be surrendered for a tax credit was £250,000 times 230%, which would equal £575,000. This would result in a 14.5% tax credit of £83,375.
However, the PAYE Cap restricts this to £20,000 plus three times the PAYE & NIC of £5,000, which would equate to £35,000. In this example, the business could lose out on as much as £48,375 of tax credits under the PAYE cap.
Other considerations
Claims based on tax years ending before 1 April 2021 will not be affected. However, if a business’s financial year straddles this change, they will need to divide their claim into two accounting periods.
The portion of the claim based on eligible expenditure incurred in the first period before 1 April will not be subject to a cap, while the portion of a claim based on expenditure after 1 April may be capped where necessary.
All eligible expenditure should be apportioned based on when the eligible expenses were incurred.
It is important to note that the PAYE Cap only applies to the surrendered tax credit. It does not apply to claims where the R&D enhanced expenditure reduces a business’s Corporation Tax liability, or where losses are carried forward or relieved.
The new rules surrounding intellectual property also create additional checks and processes when making a claim, which makes it all the more important for businesses to seek professional advice from experienced R&D tax advisers when assessing R&D projects.
We are supporting businesses with this upcoming rule change – helping them to find the most successful path to R&D funding.
To find out how this change may affect you and your business, please contact us.