R&D Tax Credits: A Complete Guide I Startups.co.uk

Research and development (R&D) tax credits are designed to encourage UK businesses to invest in and design new products, as well as innovate and improve services. Then, tax relief can be claimed on the money invested into R&D.

The R&D tax credit system works in one of two ways: either by reducing a company’s corporation tax bill, or by providing a payment of part of a company’s R&D expenditure.

In April 2024, changes were made to how R&D tax relief operates in the UK, with the two previous schemes, the R&D expenditure credit (RDEC) and small and medium-sized enterprises (SME), merging

Understanding and appreciating R&D tax credits and what the changes mean is important for business owners, if their work involves innovation in the scientific or technology sectors, allowing them to develop and grow their business in a cost-effective and tax-efficient manner.

This article will provide an overview of what R&D tax credits are, how they work, the changes made in 2024 before and after the election, and what these will mean going forward, as well as guiding business owners through the vital areas they need to know about.

Example of what you can claim under the new scheme

Under the new integrated RDEC scheme, businesses can claim 20% tax relief on qualifying R&D expenditure.

So, if the company spends £68,000, they are entitled to 20% tax relief and the calculation will be

£68,000 x 20% = £13,600

The business then presents this as an expenditure credit in their profit and loss account. Corporation tax is applied to total taxable profits. But this total will be reduced by the R&D tax credit, £13,600 in this example. If your tax bill is less than the credit amount, the difference will be repaid by HMRC.

If your SME is loss-making and qualifies for ERIS and has £40,000 of qualifying R&D expenditure, a business deducts the full 100%, plus an additional 86% to calculate the adjusted trading loss.

So, £40,000 x 1.86 = £74,400

This figure will be included in the company’s accounts as a trading loss. The company can then claim a tax credit worth up to 10% of the surrenderable loss or 14.5% if the company meets the intensity conditions for qualifying R&D expenditure on or after 1st April 2023.

So, the payable tax credit the company would receive in this example is either:

£74,400 x 10% = £7,440 OR £74,400 x 14.5% = £11,532

This article will cover:

What are R&D tax credits and why are they helpful?
Eligibility for R&D tax credits
What can't be claimed?
Key benefits of claiming R&D tax credits
What size of business tends to benefit?
Changes to the R&D tax credit scheme
Controversies around the R&D tax credits scheme
The R&D tax credits claim process
Common pitfalls to avoid
Conclusion

What are R&D tax credits and why are they helpful?

R&D tax credits are a company tax relief for research and development. A government incentive designed to reward UK companies for investing in innovation, they can either reduce a company’s corporation tax bill or, for most SMEs, provide an R&D tax relief payment of up to 27% of R&D expenditure.

Businesses must be registered in the UK as a limited company and have worked on R&D-qualifying projects in the last two financial years can make a claim once during each financial year, and they can also claim retrospectively for the two previous years. This means the new and old systems will apply to qualifying companies for the next two tax years, 2025/26 and 2026/27.

R&D tax credits encourage innovation because tax relief allows companies to not only claim the usual 100% deduction of qualifying R&D costs from their annual profit, but also for SMEs making a loss.

The Enhanced R&D Intensive Support (ERIS) Scheme provides an 86% enhancement to loss-making SMEs qualifying expenditure, allowing losses to be surrendered for a 14.5% credit. This results in a net credit of approximately 27%, so many different business sizes can be catered for.

Eligibility for R&D tax credits

If a company has spent money developing a new product or service, or has significantly improved an existing one, the business can claim R&D tax credits.

R&D tax credits can only be claimed for qualifying projects that “resolve identified uncertainties” and advance science or technology in any sector. The relief extends to unsuccessful qualifying projects, with the government wanting businesses to avoid confusing commercial projects with qualifying projects.

Within a commercial project, there may be elements or sub-projects that involve resolving uncertainties, but if so, businesses will need to separate out the qualifying cost to use for an R&D tax credit claim.

Eligible qualifying costs as part of a project can in certain circumstances include staffing costs, software, consumables and other costs.

The core eligible activities to qualify for R&D tax credits are:

Overcoming technical challenges
Creating and testing prototypes
Streamlining processes
Trialling new (or substituting) materials
Developing bespoke software
Trial and error
Industry firsts

Find out more: What does R&D mean for tax purposes?

What can’t be claimed?

Costs excluded from an R&D tax credit claim can include rent or rates, the cost of land, the costs of patents and trademarks, capital expenditure and the production and distribution of goods and services.

What changes have been made to R&D tax credits under Labour?

Significant changes to R&D tax credits occurred under the previous Conservative government in April 2024, for the 2024/25 tax year, partly as a response to a National Audit Office report published in January 2024, which highlighted high levels of error and fraud.

The two previous schemes RDEC and SME were merged in April 2024. The changes apply for accounting periods starting after April 2024.

Pre-April 2024, R&D tax relief differed depending on company size. Companies with fewer than 500 staff, annual turnover below €86m and a balance sheet of less than €86m were classified as SMEs and therefore qualified for the SME scheme. Businesses larger than this were entitled to R&D tax credit under RDEC.

A summary of the changes:

The two previous R&D tax credit schemes, RDEC and SME were merged
A R&D tax credit of 20% (the same as the previous RDEC scheme) has been applied
SMEs will now receive a 27% tax credit under the enhanced R&D -intensive scheme (ERIS), part of the new merged scheme
The only exception applies to SMEs making a loss who have been classified as “R&D intensive”, i.e. spend at least 30% (previously 40%) of total revenue on R&D. These may qualify for ERIS, claim a further 86% of qualifying costs, for a 186% total deduction. This forms the basis to claim a payable tax credit, which is not liable to tax and worth up to 14.5% of the surrenderable loss.

Under the merged, or integrated scheme, the claims process has been simplified and offers the same rates to most businesses. Businesses of all sizes will qualify for 20% R&D tax relief. Loss-making SMEs who meet the same criteria as under the pre-April 2024 SME scheme and who spend at least 30% of turnover on qualifying R&D and qualify for ERIS can get an R&D tax credit rate of 27%.

The Autumn 2024 Budget did not include many additions to the changes made to the scheme in April 2024, including to rates.

Key benefits of claiming R&D tax credits

SMEs can claim up to 27% of qualifying expenditure on R&D if 30% or more of their total revenue has been spent on R&D innovations or opportunities. Larger businesses can claim up to 20% of qualifying R&D expenditure.

1. Reduced corporation tax liability

By claiming R&D tax credits, businesses can reduce their corporation tax bill or receive a refund, which enables them to invest in other parts of the business.

Claimants must notify HMRC that they plan to make a claim. Once approved, businesses process the claim via their company tax return.

Before making a claim, businesses must submit an additional information form about the projects. Once approved, businesses apply for R&D tax credits and inform HMRC about costs spent on qualifying projects via their company’s tax return.

2. Increased cash flow

Cash flow is crucial for SMEs, and R&D tax credits provide a source of this. They allow businesses to invest in certain projects with confidence, knowing that they can recoup some of the costs. The impact on cash flow helps businesses invest in other parts of the business, reinvest faster in other R&D opportunities, and target growth.

3. Encouraging innovation

R&D tax credits can stimulate innovation and growth that otherwise may not be explored, acting as a key incentive. By covering qualifying costs, businesses can test new ideas and systems to increase the chances of developing successful new products or services.

Find out more: Full expensing for SMEs

What size of business tends to benefit?

R&D tax credits have different impacts depending on your business size.

SMEs

Proportionately R&D tax credits can benefit SMEs more than large businesses. Firstly, if they meet the qualifying criteria, they receive a higher R&D tax credit rate of 27%.

Secondly, cash flow is tighter for SMEs so the relief aids cash flow in a way that an SME would struggle to achieve without the relief. Smaller businesses can often adapt and take advantage of new opportunities quicker than large businesses, without too many obstacles standing in the way, so an innovative project can be brought to fruition quicker, become early adopters and reap the benefits.

Eligible SMEs can apply for advance assurance to confirm that their claim will be accepted. This reduces the time it takes to process their claims.

Large businesses

Those businesses that are bigger are likely to save more money in total because there are no limits on the value of qualifying expenditure for qualifying projects. This is despite only being able to claim R&D tax relief at 20%, below the top rate of relief for some SMEs.

Large businesses may have more complex segments of expenditure that could form part of an R&D tax credit claim. However, from April 2024, subcontracted R&D costs can be included in claims, but the rules are complex and need to be presented accurately to qualify.

Changes to the R&D tax credit scheme

As the economic environment and governments change, so this tax credit scheme is ever-evolving.

Recent changes

The aim of merging the two schemes was to simplify the process of claiming R&D tax credits, to stop error and fraud, and expand the cost base of what can be included in a claim.

There were two other significant announcements that will affect businesses.

When claiming subcontracted expenditure, the company deciding to use subcontractors must make the claim for tax relief. The aim is to stop both parties claiming which has contributed to fraud levels.

The R&D PAYE and national insurance (NIC) cap of £20,000, plus 300% of a company’s overall PAYE and NIC contributions for the relevant accounting period, is to be maintained as it was under the old scheme.

Future of the scheme

The Labour government pledged in its manifesto in July 2024 to maintain “the current structure of R&D tax credits over the next parliament, while cracking down on fraudulent claims and those made in error.”

The UK government will continue to support R&D tax relief because it supports growth in the wider economy. Part of the aim of the reforms was to reduce fraud and error, so the government will monitor these areas and decide if further changes are needed.

Controversies around the R&D tax credits scheme

This scheme has not been implemented without its fair share of issues.

Abuse of the scheme

Part of the reason for the 2024 revamp was concern about fraud and errors in processing by HMRC. Media reports suggest some tax agents were encouraging clients to make fraudulent claims that went unchecked by HMRC. This included cases where companies were set up to claim tax credits, even though they did not conduct any R&D activity. The problem was more evident in SME-based R&D tax credit claims.

HMRC’s own figures for 2021/22 identified that of the £7.6bn claimed by 90,135 companies, the overall level of error and fraud was £1.3bn, or 17.6%. Of this £1.2bn was related to the SME scheme, equivalent to 25.8% of the expenditure in this scheme and £134m was linked to the RDEC scheme, just 4.6% of the total.

Government measures to combat abuse

As well as the revamp of the scheme, the government has tasked HMRC with extra monitoring and analysis of data to understand the types of error and fraud occurring, and which claimants and agents are committing them. Other policy changes to combat R&D-related fraud and error that have been introduced include:

PAYE-related cap on size of claims by SMEs
Requirements to notify HMRC of named company officer with responsibility for claims
Requirement to give HMRC advance notification of claims
Requirements to claim digitally and provide additional information

Complexity of the scheme

Tax law is complicated, and R&D tax credits are no exception, particularly as the scheme changed considerably in April 2024. Also, because R&D tax credits can be claimed for the previous two years, businesses claiming for 2022/23 and 2023/24 will have to manage R&D expenditure, planning and tax relief under two schemes while they co-exist.

The potential sums involved and complexity of calculating the R&D intensity percentage mean it is sensible to use a specialist tax agent or accountant to comply with the rules.

Find out more: Best accounting software for small businesses

The R&D tax credits claim process

Stage 1: Identify either R&D qualifying projects or ones that include qualifying R&D expenditure

Stage 2: If you are a loss-making SME, calculate if you spent 30% or more of annual revenue on qualifying R&D to see if you qualify for ERIS

Stage 3: Calculate your R&D qualifying spend by working out costs directly attributable to R&D. Add these figures together

Stage 4: Then for a normal RDEC claim, multiple the figure by 20% to get the tax relief figure OR

Stage 5: If you qualify for ERIS, add the costs together and multiply by 86% and add this to the original R&D expenditure figure

Stage 6: Inform HMRC that you will submit an R&D tax relief claims notification form

Stage 7: You may then need to submit an additional information form to support your claim

Stage 8: Once HMRC has approved your application, submit your R&D claim to HMRC via your company tax return

Common pitfalls to avoid

Avoid making ambiguous claims where it is difficult to identify or prove that the expenditure was strictly R&D related. HMRC specifically states that it wants companies to avoid confusing commercial projects with qualifying projects.

With renewed focus and resources for HMRC to identify errors and fraud, companies will have to ensure claims are entirely valid, clear and meet all qualifying rules.

Obviously, businesses need to ensure they only include qualifying expenditure, so no claiming for rent or premises costs, for projects linked to the arts, humanities or sciences and, under the new rules if the work is subcontracted to a business.

It is also important to be accurate about dates and timelines, and claim under the right scheme, especially for the next two years while the old and new schemes work alongside each other.

Conclusion

R&D tax credits can help businesses innovate, experiment and create new products and services, and support enterprise in the wider economy, which is why successive governments back the policy and put resources into it.

For businesses, R&D tax credits provide a valuable way to access cash flow, freeing up other resources to fund other parts of the business.

The rules and qualifying criteria for R&D tax credits are complex.For most businesses, it is worth consulting with an R&D tax specialist, particularly the first time a business makes a claim. Business owners should understand the tax laws, when to utilise the tax relief and how to treat it compliantly for accounting purposes.

Find out more: How to choose an accountant

Benjamin Salisbury - business journalist

Benjamin Salisbury is an experienced writer, editor and journalist who has worked for national newspapers, leading consumer websites like This Is Money and MoneySavingExpert.com, business analysts including Environment Analyst, AIM Group and written articles for professional bodies and financial companies. He covers news, personal finance, business, startups and property.