Intangible assets and R&D tax credit claims

The UK government’s R&D tax credits offer vital cash-boosts to companies that have taken a financial risk in their innovation (either internally, or for clients). The tax reliefs are based on operating expenditure (i.e. revenue expenditure) for the day-to-day operational costs associated with running your business – things which appear on your profit-and-loss account.

Most commonly, the expenditure included in an R&D claim will include: staffing, consumables, outsourced labour, and software. Any costs in a claim must be considered ‘revenue in nature’ for tax purposes, and deductible in calculating your taxable profits.

As you might expect then, the costs included in an R&D claim should go through your P&L (profit-and-loss) account in the period that your claim relates to. Likewise, capital expenditure (such as plant and machinery, property etc.) from your balance sheet cannot be included in an R&D tax-credit claim.

When can costs be capitalized?

Things can get more complicated though, when companies capitalize costs which are revenue in nature for tax purposes. Companies involved in software development, for example, will often capitalize costs related to their software expenditure. This is revenue expenditure which has been capitalized in the accounts. Other costs that can be capitalized but are revenue in nature from an R&D perspective are usually: staff costs including externally provided workers (EPWs), and subcontractors.

Accounting policy dictates whether costs should be capitalized (in your balance sheet) or expensed (via the P&L). Any companies that follow the International Financial Reporting Standards (IFRS) are obliged to capitalize costs according to its protocol if these costs meet the definition of intangible fixed assets. If these IFRS-compliant companies had incurred costs developing intangible fixed assets (i.e. software platforms and/or software products) they would not be eligible costs in an R&D claim because they are not deductible in calculating their taxable profits.

Many small companies who account under FRS/UK GAAP can choose whether to capitalize these costs as intangibles.

With this in mind, the government introduced a piece of legislation to allow costs incurred within the relevant financial period which have been capitalized but are also revenue in nature to be treated as deductible in calculating your taxable profits.

From a practical perspective, this means that companies can include costs incurred on R&D that have been capitalized as intangible fixed assets during the year. This is done by deducting 100% of the cost of the asset from the trading profit of the company. NB this additional deduction is a timing benefit as the amortisation associated with the asset much added back on to the trading profit each year.

Example of capitalizing intangibles

Say a client spends £10,000 on software development – this is the time spent by a member of staff undertaking coding etc. The development is for a platform, they estimate the platform will have a “useful economic life” (i.e. will function for) 5 years.

Different outcomes shown on profit below:

Year 1

Dev costs this year: -£10,000 (not capitalized)
Amortisation: £2,000 ~ £10k costs/5 years (capitalized)
Loss: -£10,000 (not capitalized) / -£2,000 (capitalized)

Impact: When not capitalized the company’s profit is reduced by 10,000 and hence tax is reduced by 1,900. When capitalized, the company’s profit is reduced by 2,000 so its Corporation Tax is reduced only by £380.

Years 2-5

Dev costs this year: £0 (not capitalized)
Amortisation: £2,000 ~ £10k costs/5 years (capitalized)
Loss:  -£2,000 (capitalized)

Impact: Whilst there is no further impact on the profit for the non-capitalized version, the capitalized version continues to see a deduction of 2,000 for a total of 5 years. Hence if the tax rate doesn’t change then there is only a timing difference between the two approaches.

What is section 1308?

This takes what would be the capitalized version of the above and instead you have the impact on your tax profile of the non-capitalized version. However – this is a tax adjustment only – the accounts remain the same.