UK R&D tax relief - practical considerations for overseas companies


David Ward

David Ward

Tax Partner


This article originally appeared in Taxation Magazine.

The UK’s research and development (R&D) tax incentive regimes are designed to promote private sector investment in innovation. What do overseas companies need to consider if they are looking to claim UK R&D relief?

Small and medium-sized enterprises (SMEs) can claim under the R&D tax credit scheme; large companies and SMEs carrying out funded or contract R&D can claim under the research and development expenditure credit (RDEC) scheme. Small and medium-sized enterprises can claim up to 33p for every pound of eligible expenditure on in-house, unfunded R&D and can receive a cash payment even if they are loss-making or pre-trading. 

Common overseas company scenario

A Canadian company (A Inc) is seeking to develop advanced battery technology to improve storage of electricity generated from renewable energy so that it can be made available to the grid during peak demand. A Inc has been developing this technology for a couple of years, focusing on lithium-ion batteries. It has 30 staff and, although it is some way from commercialisation, it has obtained a patent.

Six months ago, A Inc’s chief technology officer (CTO) met an academic research team at a UK university which is pioneering research into another battery technology (flow batteries). The CTO recognised the potential advantages for renewable energy storage, in terms of longer lifespan and better scalability. After discussions, A Inc decided to start parallel development of flow batteries for renewable energy storage, in collaboration with the UK university. A Inc decided to base its R&D on flow batteries within the UK to make use of the university’s leading facilities and equipment and be close to the academic team.

A Inc has already engaged some UK individuals and has sent some of its staff from Canada to the UK to begin this project. It is now considering how best to continue and expand this R&D activity in the UK. It will require more UK-based personnel to be engaged, as well as longer term secondment of some existing A Inc staff to the UK. Some specific aspects of the R&D will be subcontracted to the university and the university will further subcontract some elements of this to a private company in Holland. 

Access to UK R&D

Can A Inc access support through the UK’s R&D tax credit schemes?

Overseas companies can claim R&D tax relief in the UK, but only if they are within the territorial scope of corporation tax. Broadly, a non-resident company is only subject to UK corporation tax if it carries on a trade in the UK through a UK permanent establishment (PE).

This would require that A Inc is trading – applying the badges of trade – in the UK and doing so through a UK PE. It is worth pausing here to note that this imposes a more stringent trading status requirement on a claim for R&D tax relief by a non-resident company. In effect, if a non-resident company has not begun its trade, the gateway into the UK corporation tax legislation is not passed, so the provisions that allow a UK resident SME company to make an election to treat its pretrading expenditure as a trading loss and claim the payable R&D tax credit would not be available to the non-resident company.

Preparatory activities – for example, research activities in preparation for trading – are not enough to constitute trading in the UK. HMRC has published guidance in relation to high technology businesses in its Business Income Manual at BIM80515. A high technology business that holds an item of intellectual property (IP), such as a patent, may be treated as commencing its trade once it has decided how to exploit that IP, for example through licensing it out.

However, in the present case, A Inc’s IP relates to the lithium-ion battery technology, which will continue to be developed in Canada and there has been no decision on how to exploit that IP and certainly no indication of doing so in the UK. 

As such, A Inc’s activities in the UK would appear to be preparatory in nature, as a result of which it would not be within the scope of UK corporation tax and unable to claim a payable R&D tax credit. 

Incorporate a subsidiary in the UK

Incorporating a UK subsidiary (UKSub) to undertake the flow battery R&D in the UK would address many of the challenges highlighted above. If there is an intention to commercialise the technology being developed in the UK, carrying out the R&D in a UK company that will ultimately hold and exploit the IP would also be advantageous from a patent box perspective.

UKSub would be resident in the UK and subject to UK corporation tax. Also, given the low staff numbers and lack of any turnover in A Inc, UKSub would be an SME. As such, it may be able to claim the payable R&D tax credit in respect of its pre-trading expenditure. To do so, UKSub would need to be undertaking its own ‘in-house’ R&D and this R&D must be relevant to a trade carried on by the company or from which a trade will be carried on by the company.

In addition, UKSub’s expenditure must not be subsidised. This does not just cover grant funding but also any situation where the expenditure is met (directly or indirectly) by another person (such as A Inc). Consideration should be given to how the UK company will be funded. 

In-house R&D versus contract R&D

Whether or not UKSub is carrying out in-house R&D will be a question of fact and will depend on the commercial terms. Relevant questions will include the extent to which:

  • UKSub has autonomy to lead the direction of the flow battery R&D.
  • UKSub is entitled to benefit from the fruits of the R&D, including ownership of IP or knowhow derived, and the ability to commercialise the technology.
  • UKSub will bear the economic risk of the success or failure of the R&D.
  • A Inc bears any of the costs, directly or indirectly and, if so, the payment terms.

While intragroup arrangements would be expected to be less formally documented, it will be important for the above points to be agreed commercially and to be documented so as they can be evidenced. As ever, this will be a matter of substance as well as form. For UKSub to be undertaking in-house R&D, it must have the people and resources necessary to assess and control the risk associated with the R&D project and its expenditure. UKSub must also have the capability to control risks associated with the R&D activity and do so in practice.

For instance, the following types of activity might be expected of UKSub:

  • deciding on the type of research that should be carried out and objectives assigned to it;
  • deciding to stop research or change direction;
  • taking the decision to perform part of the development work itself or alternatively to outsource it appropriately;
  • seeking specialist input;
  •  hiring a particular researcher; and
  • assessing progress against objectives and allocating budgets to development tasks.

When these activities are undertaken by individuals seconded from A Inc, it will be necessary to be able to demonstrate that they were acting for and on behalf of UKSub.

It will be important that UKSub has a full board of directors that acts on behalf of and in the interests of UKSub in the UK. It would also be expected that any IP and knowhow generated by UKSub in relation to the flow battery project would belong to UKSub.

A Inc and UKSub will also need to consider their transfer pricing policy. In the early stages it may be that A Inc and UKSub benefit from exemptions such as the UK’s SME exemption from transfer pricing rules. However, not every country has such exemptions and, even where they do, they will not always apply. Similar factual considerations to those discussed above will apply when considering the transactions between A Inc and UKSub from a transfer pricing perspective and it will be important that the position adopted reflects those facts consistently. If UKSub is performing in-house R&D the transfer pricing policy should reflect that UKSub will benefit from the IP that it develops and owns.

Pre-trading expenditure

Assuming UKSub is undertaking in-house and unfunded R&D, can it claim for pre-trading expenditure?

Potentially, yes, but there are some other conditions to consider. The expenditure must be incurred by UKSub itself – any contracts and invoices should be in the name of UKSub. The R&D must also be relevant to a trade that UKSub is preparing to carry on, which clearly requires that UKSub intends to commence a trade in the UK.

In that case, UKSub should be able to claim for its R&Drelated expenditure in the relevant eligible cost categories, including:

  • staff costs;
  • subcontractors;
  • externally provided workers (EPWs);
  • consumables (including water, fuel and power); and
  • software licences.

The staff supplied by A Inc will not represent staff costs of UKSub, because their employment contract is with A Inc. The fact that UKSub is recharged for the use of these employees does not make this recharge into UKSub’s own staffing expenditure. However, it may qualify as expenditure on EPWs. The EPW definition contains very prescriptive conditions and the case of Gripple v CRC [2010] STC 2283 demonstrates the lack of scope for a purposive interpretation. Key questions will be whether:

  • they are subject to supervision, direction or control by UKSub (a requirement for EPWs), which requires that UKSub has other staff or directors to undertake that supervision; and
  • the individuals are not appointed as directors of UKSub (which would prevent them being EPWs).

If the conditions are met, because A Inc and UKSub are connected, the normal 65% statutory restriction would not apply and UKSub would look through to the underlying staffing costs incurred by A Inc. Note that this would be somewhat narrower than the ‘staffing costs’ that would apply for UK employees – for example, any Canadian equivalent of compulsory social security contributions paid by A Inc would not be eligible. It is worth noting for these EPW costs, that there is an additional requirement that UKSub actually makes payment to A Inc before claiming relief. Simply recognising recharged amounts as an intercompany debt would not be enough.

If any A Inc director will work on the flow battery R&D in the UK, UKSub should consider if it would be appropriate to employ those directors directly and pay them a salary in respect of this work. In this way, their salary, employer pension and employer National Insurance contribution costs should represent potentially eligible ‘staff costs’ for R&D tax relief purposes.

Alternatively, it may be possible to subcontract specific R&D activities to A Inc. That is, UKSub would engage A Inc to carry out these R&D activities on its behalf in exchange for payment. To be eligible, this would need to involve the outsourcing of a specific part of the R&D activities, not simply involve the provision of more general services. If the facts support it, payments made by UKSub to A Inc should be eligible as connected subcontractor payments. The effect of this is similar to connected EPW costs, in that UKSub would not be subject to the normal statutory 65% restriction, but would look through to the underlying eligible costs within A Inc. Again, UKSub would need to make payment to A Inc before claiming relief, not just recognise recharged amounts as an intercompany debt. 

In future, it would be beneficial for UKSub to engage staff through an employment contract direct with UKSub. In this way, their salary, employer pension and employer National Insurance contribution costs will represent potentially eligible staff costs for R&D tax relief purposes. It is also worth noting the Budget 2018 announcement that the amount an SME can receive through the payable tax credit in any one year will be capped at three times the company’s total PAYE and National Insurance liability for that year. Having UK payroll would assist when this PAYE cap is reintroduced. 

UKSub would also be able to claim for expenditure on specific R&D activities that it subcontracts to the university, subject to the 65% statutory restriction. Because UKSub and the university are not connected, there would be no restriction as a result of the university further subcontracting a subset of the work to the Dutch company. 

Contract R&D

What if UKSub is carrying on contract R&D? 

The facts may support that the UK activities are akin to the provision of contract R&D services. For example, it may be that the technology being developed in the UK will ultimately be exploited by A Inc in Canada, that the IP will belong to A Inc and that A Inc will bear the economic risk of the UK R&D activities. In that case, UKSub could not claim the SME R&D tax credit. However, as the R&D is contracted to UKSub by an overseas company, it should be able to claim under the RDEC scheme.

The rate of relief under the RDEC scheme is significantly lower and the categories of eligible spend are narrower. However, UKSub’s immediate concern is likely to be that there is no ability under the RDEC scheme to elect to claim for pre-trading expenditure. Instead, RDEC relief would only be obtained once UKSub started to trade. 

It is possible that UKSub could be carrying on a trade of contract R&D, in which case it would be able to claim the RDEC immediately. However, if that is the case, the consequences of transfer pricing should also be considered. Applying the arm’s length principle, A Inc should reward UKSub as it would a third party providing the same contract R&D service. A reward based on UKSub’s costs plus a mark-up may be appropriate. This could result in taxable profit in the UK despite no profits existing at group level and could result in a net liability to pay UK corporation tax, rather than to benefit from an RDEC payment. 

Conclusion

Overseas companies can claim UK R&D tax relief. However, HMRC is rightly concerned about abuse of the SME payable tax credit, including by companies artificially set up to claim even though they have little or no employment or activity in the UK. Companies planning to undertake R&D in the UK for genuine commercial reasons need to be aware of the prescriptive requirements of the UK R&D tax incentive regimes and structure their arrangements accordingly. They should also ensure that the factual position in support of their claim is documented properly and evidence can be provided if required. This will include the terms on which the company engages individuals and procures services, also, that the company has the people and resources in the UK necessary to assess and control the risk and expenditure associated with the R&D activity and does so in practice.

To support a claim, it will be important to be able to have evidence of the intragroup contractual and commercial terms, including: the ownership of IP; ability to direct the R&D; and assumption of economic risk. The business plan and intended means of commercialising the technology under development should also be agreed and documented. It will be important that the factual position in support of the R&D tax relief claim is also reflected consistently in the transfer pricing policies adopted.

For more information, get in touch with our Innovation Taxes team.