A common misconception about tax credits is the idea that you have to be profitable for them to be worthwhile. That has been false for many years now. In fact, the SME scheme used to be much more favourable to loss-making SMEs than profitable ones (25% vs. 15% return). Over the last couple of years, the schemes have become more equal, and now both profitable and unprofitable companies can get up to 25% return.
Here’s how it works, along with a couple small caveats and a big one that I like to call the Valley of Death.
How it works
The way that tax credits are calculated is that first you add up the “Qualifying Expenditure”. This is the amount that you’re declaring has been spent on “qualifying R&D”.
The primary mechanism of the scheme is that this qualifying expense is then “enhanced”. This artificially increases your expenses for the year, and therefore reduces your taxable profit for the year, perhaps taking you into a loss (or increasing your loss if you were already loss-making).
The way that this helps profitable companies is obvious: instead of paying tax on their taxable profit, they pay less tax on a diminished (or eliminated) profit.
However, the scheme also allows companies to do something with the loss that’s generated. They call it “surrendering” the loss. In effect, any loss generated by the scheme can be surrendered for cash. This means that the loss is not carried over to future years, and instead you get some cash for it right now. This is music to the ears of loss-making startups.
Of course, this wouldn’t be HMRC if there weren’t a long list of caveats, as well as a big conceptual problem (I’ll save that one for the end).
First of all, until April this year, the amount of cash that could be obtained via the “surrender” mechanism was capped to the company’s PAYE and NI contribution (note that this includes the amounts paid on behalf of employees, strangely enough). This meant that companies that employed mostly subcontractors could not surrender any loss.
Luckily, for accounting years ending on or after 1st April 2012, this cap is no longer applicable.
The second caveat is that this is not cumulative with loss carried forward from earlier years. HMRC’s view is that R&D Tax Credits are applied first, and then the loss from earlier years is applied. In other words, if you had a £100k profit for the year, that you negated with a £100k from an earlier year, you ended at £0 of profit, and no tax due. If you get, say, £80k of reduction of your profit via R&D Tax Credits, you will not get to -£80k for the year - i.e. you cannot surrender any loss.
Instead the net effect is that you will only need to use £20k of the loss from previous years to get to zero profit. So in effect, you create £80k of loss for future years. This is still very useful, particularly for a profitable company, but much less exciting than cash in hand.
This also has another effect on what I like to call the Valley of Death.
The Valley of Death
How HMRC ended up with this situation is anyone’s guess. I’m going to be nice and assume plain oversight. There’s no reason I can think of why HMRC would seek to penalise companies that are breaking even, right?
Anyway, here’s the situation: the “surrender” mechanism relies on you surrendering the entire “enhanced expenditure”, but you can only surrender an actual loss.
Sounds innocuous enough, but here’s how it works in practice.
Let’s say it’s 2010 (the enhancement and surrender rates are 75% and 14% respectively), and you have £100k of qualifying expenditure. You enhance it by £75k, and it becomes £175k.
Let’s further assume that before the claim, you started with -£100k of tax loss. In this situation, the tax credit enhancement would lower your loss to -£175k. You would then be able to surrender the whole £175k at a rate of 14% - i.e. get £24.5k back on your £100k of expense.
Here’s the devil, though: if you started off breaking even instead of making a large loss, the situation after the enhancement will be that you are showing a -£75k loss. And that’s all you can surrender - still at 14%. So by making a great effort and breaking even, your tax credit has suddenly gone down from £24.5k to a much less appetising £10.5k. Ouch.
In effect, the closer you are to breaking even (relative to the size of the expense), the worse it gets, with a 10.5% return being the worst possible. Ideally you will either have a loss that is equal to or larger than your qualifying expenditure, or a profit that is equal to or larger than the enhancement. Anything else will result in a lower claim.
Unprofitable companies can, do, and should claim R&D Tax Credits - but beware the Valley of Death!