This On the Subject summarises the planning opportunities that exist for multi-national and UK groups who carry out Research and Development (R&D) in the UK.
Companies can now delegate their R&D effort to the UK and attract more than 100 per cent tax relief for their expenditure, in many cases without ownership of the fruits of that R&D becoming locked in the UK.
These developments stem from recent extensions of the R&D regime by the 2000 and 2002 Finance Acts.
The extent of the relief available depends upon the status of the claimant company as a "Large Company" or a "Small or Medium Sized Enterprise" (SME).
A Large Company is any company that is not an SME. An SME is defined very broadly as any company with:
(i) less than 250 employees; and
(ii) either an annual turnover of €40 million or less or an annual balance sheet total of €27 million or less; and
(iii) is independent of one or more large enterprises
The 2002 provisions give Large Companies who incur their own R&D expenditure a new relief for R&D amounting to 125 per cent of certain revenue expenditure (i.e. as opposed to capital expenditure). The relief allows a Large Company to deduct an extra 25 per cent of its qualifying revenue expenditure on R&D (which may include staffing costs and consumable stores) in computing the taxable profits of its trade.
There is also a new separate 125 per cent relief given to both Large Companies and SMEs which undertake R&D as a sub-contractor to a Large Company (and certain other persons).
Accordingly, where a Large Company contracts out R&D, it is usually the sub-contractor who can claim the 125 per cent relief.
Furthermore, since a UK company carrying out R&D need not own the fruits of the R&D for the new 125 per cent relief to be available, it is entirely possible to obtain relief in the UK, whilst at the same time owning and charging royalties from the company that actually owns the IP elsewhere.
In the case of SMEs, relief for their direct qualifying revenue expenditure on their own R&D has been available since 2000 at 150 per cent - giving an extra 50 per cent deduction in computing the taxable profits of the SME's trade.
Loss-making SMEs may also, within certain limits, surrender losses arising from R&D to the UK Exchequer in return for a cash payment.
Where an SME contracts out R&D however, it is the SME (not the sub-contractor) which is entitled to claim relief. The amount of the relief may depend on whether the SME and the sub-contractor are connected.
Limited changes to extend the SME and Large Companies relief have also been proposed in this year's Budget.
What will qualify as R&D?
A new definition of R&D for tax purposes was introduced by Finance Act 2000.
Activities which qualify are those that fall to be treated as research and development in accordance with UK Generally Accepted Accounting Practice (UK GAAP), as qualified by guidelines issued by the UK Department of Trade & Industry (DTI) on the meaning of R&D. These guidelines are given statutory force by regulations made under the 2000 Finance Act.
The guidelines illustrate the boundary between R&D and non-R&D activities which can often give rise to difficult questions in practice. To qualify as R&D, the activity must be both R&D as defined by UK accounting standards and also satisfy the conditions set out in the guidelines.
R&D can extend from broadly pure (or basic) and applied research to experimental development which is directed towards a practical aim or a new or substantially improved product. Commercial development is generally outside R&D.
R&D activity is distinguished from non-research activity by the presence of an appreciable element of innovation in the field of science or technology. Furthermore the activity concerned must be undertaken with a view to achieving a scientific or technical advance and the resolution of scientific and/or technological uncertainty. It must also comprise creative work or investigation undertaken on a systematic basis.
Subcontracting R&D to the UK
There are many features of the relief, and the principal ones follow:
A Large non-UK company ("non-UK Co") may contract out part of all its R&D to an appropriate company (say, a Large Company or SME) in the UK ("UK Co"). UK Co may be another company in the group.
UK Co can qualify under the R&D relief scheme that applies to Large Companies or SMEs. UK Co will therefore be able to claim a tax deduction for 125 per cent of its qualifying R&D expenditure. Assuming the non-UK Co contracting out the R&D covers 100 per cent of the cost, this will result in a net additional deduction in the UK of 25 per cent of that expenditure.
To the extent that non-UK Co also obtains a deduction in its jurisdiction for payments made to UK Co to cover the cost of the R&D, there will be a total deduction available to the group globally of 125 per cent.
If R&D is subcontracted to a company in the UK, the UK company may then in turn further sub-contract the R&D to certain types of research organisations and claim relief for the payments it makes to that organisation.
Relief for Own R&D Expenditure
Alternatively, the Group could make one of its UK companies responsible for carrying out all research at its own expense. The UK company will then get a deduction for 125 per cent (or 150 per cent, if it is an SME) of its own qualifying R&D expenditure.
As it is not a requirement for the 125 per cent relief to be available that a UK company must own the fruits of its research, the ownership of any IP can be vested in another group company of the client's choosing to fit in with its strategy.
By contrast, however, for an SME to claim the 150 per cent relief, it must own the fruits of that R&D.
Although the Inland Revenue cannot deny the new statutory based 125 per cent R&D relief on account of the fact that the UK company does not own the product of the research, the terms on which R&D is carried out will need care and attention.
If there is no financial support, and no interest in subsequent ownership, or the terms on which any fruits of the R&D become the property of a non-UK group member, this could potentially give rise to different tax issues (e.g. under the UK transfer pricing code).
It is possible that some form of joint ownership of the fruits of R&D might be possible which would alleviate any further transfer pricing challenge risks.
For these reasons, it may be preferable in practice for R&D to be subcontracted out for a consideration rather than for one of the UK group entities to be wholly responsible for carrying out all research at its own cost.
A full analysis of the regimes which give tax relief in the UK for expenditure on R&D can be obtained by contacting Sylvia Choi.