Avoid costly mistakes when making software R&D tax credit claims

The UK’s R&D tax credit scheme represents a generous and lucrative tax incentive aimed at innovative UK companies engaging in research and development. SMEs can receive up to 33 pence for every £1 spent on R&D expenditure, a fact showing just how quickly claims can mount up to thousands of pounds for businesses.

However, the process of claiming R&D tax credit for software innovation – which is incredibly fast-moving by its nature – can differ from other sectors in that it is not always easy to ascertain which projects qualify for R&D tax credit, and which do not.

Recent statistics show that 95% of software claims are completed by specialist R&D tax advisors and accountants, compared with just 5% which are done in-house – figures that demonstrate how wary most software companies are to ‘give it a go’.

HMRC guidance on software development claims was updated in 2018 to provide an idea of how HMRC perceived state-of-the-art in software technologies, and what was once considered as a qualifying activity a few years back no longer does.

This occurred in recognition of the fact that software, as all information technology, is continually changing and expanding, with a number of well-established branches of software that continue to develop.

These include advances in artificial intelligence, cloud or mobile computing, plus new branches forming such as software robots, augmented reality, and the Internet of Things.

In October 2019, it was revealed that the ‘professional, scientific and technical’ and ‘information & communication’ sectors received £990m and £805m respectively during 2016-17, while the average paid out for software development stood at £64,236 for an SME and £682,242 for an RDEC scheme.

The latest HMRC guidance and case studies can be found on the Government website via the manuals CIRD 81960 - Conditions to be Satisfied and CIRD 81980 - Case Studies Demonstrating R&D Tax Credit Claims for Software Projects.

The three key takeaways from these documents are:

1. Claimants must be very clear about the actual scientific or technological uncertainties which their project addresses.

2. Regarding software claims specifically, the technological input needs to be highlighted, rather than focusing on the commercial output.

3. To help ascertain what the technological uncertainties are, businesses need to make sure the challenges have been identified accurately.

There are two points which need to be considered with this: Has the feasibility of the project been thoroughly considered, and is it more about the practical application? Both of these could include R&D, but successful claims lie in identifying the exact extent of technological uncertainty.

Software developers should have a firm grasp of the Department for Business, Energy & Industrial Strategy (BEIS) guidelines in respect of their R&D project. These guidelines apply to software projects in the same way as they apply to any other R&D activities, although a good understanding of R&D in this context is strongly recommended.

For example, certain eligible indirect activities related to the project may also be classed as R&D. However, work that does not directly contribute to the resolution of the project’s technological or scientific uncertainty is not considered R&D.

Additionally, it doesn’t matter whether the software developed is destined for in-house use only, or likely to be licensed and/or sold. If it is innovative, R&D tax credit should be considered.

To give some examples, activities that cannot be claimed for include the development of basic websites, front-end design, artwork, bug fixing, routine coding and minor enhancements or modifications.

HMRC regularly uses its chief technical officer under the Chief Digital Information Office to review large claims.

A first-time R&D claim is likely to be examined by HMRC, particularly if it is for a large sum, and has the potential to attract further queries. This could also lead to larger full tax enquiries into the company if they are not satisfied with the information that has been supplied.

Such tax enquiries are likely to delve deeper into the company's broader tax affairs, which can be expensive, time-consuming, and stressful.

The 2020 Budget included an announcement that HMRC will consult on whether expenditure on data and cloud computing should qualify for R&D tax credit. The consultation is currently in progress and the current position is as follows:

Cloud, storage and hosting costs are currently considered as ‘rent’ which is not a qualifying cost. Software license costs that are expensed and used directly for the purposes of R&D activities can be included in a claim. Where software is only partially incorporated indirect R&D, an appropriate apportionment of the expenditure needs to be made. Details can be found in the CIRD82500 guidance.

This government consultation is in addition to a second, which is based around preventing the abuse of R&D tax credit for SMEs. More information about this can be found on the UK Government’s website.

Claiming R&D tax credit in relation to software development is a particularly involved area of claiming. Costly mistakes are easy to make, even for those who have made claims before. This is why it is advisable to work with an R&D specialist with software technical expertise.