From 1st April 2021, HMRC has reintroduced the PAYE Cap to the SME R&D Tax Credits incentive, which will potentially impact many start-ups and scaleups. In this blog we will discuss how the cap could affect your R&D tax claims and who is most at risk of being affected.
HM Revenue & Customs has reintroduced a limit on the payable tax credit that companies can receive from the SME R&D Tax Relief incentive, with businesses only being able to claim payable tax credits worth up to 300% of their combined PAYE and NIC liability, plus a £20,000 buffer.
Known as the PAYE Cap, this regulation has been designed to protect the R&D Tax Credits incentive from fraudulent claims. However, this could have the knock-on effect of reducing the relief available to many legitimate start-ups and scaleups.
Below, we will answer the major questions surrounding the cap, including: Which businesses are liable to have their claims capped? Which are exempt? And why has HMRC brought this mechanism back after being removed from the incentive in 2012.
What is the PAYE Cap?
The PAYE/NIC Cap limits the size of payable tax credit companies can receive through the SME R&D Tax Relief incentive.
The cap applies to loss-making businesses, as well as firms that are taken into a loss by the R&D enhancement (130%) and then surrender this loss for a cash lump sum.
The cap is set at three times a business’s combined PAYE and National Insurance Contribution liability plus £20,000.
Unconnected subcontractor fees and salaries from most overseas workers cannot be included when calculating your liability. However, you are permitted to include a portion of the PAYE & NIC liability of a connected company that is performing R&D activities on your behalf.
An example of the PAYE Cap
Company X, a loss-making business (£300,000 losses in the period), has a qualifying spend of £250,000 and a PAYE/NIC liability of £15,000.
As Company X is loss-making, it would traditionally be able to claim up to 33.35% of its expenditure back as a payable tax credit. In this example, that credit would be worth £83,375.
However, now that the PAYE Cap has been introduced, Company X would only be able to claim 300% of its combined PAYE/NIC liability, plus the £20,000 buffer.
This means Company X’s payable tax credit would be capped at £65,000.
Potentially missing out on nearly £20,000 worth of funding could be devastating many small businesses.
Exceptions to the cap
Following the initial consultations, HMRC announced on the 12th of November 2020 that the cap will have three ‘features’ that were designed to protect legitimate businesses from losing out on this valuable funding. This means that not all small businesses will be affected by the reintroduced PAYE Cap.
Here is a brief explanation of these features:
Feature 1: £20,000 buffer amount.
The first £20,000 of payable tax credit claims will be exempt from the PAYE cap.
Claims under £20,000 will remain uncapped, with only payable credit claims worth over £20,000 being capped according to the following calculation:
PAYE Cap = £20,000 + 300% of a company’s PAYE & NIC liability
This buffer amount will help in protecting legitimate start-ups where directors will be taking little to no remuneration, and with few employees from missing out on valuable funding.
Feature 2: Related company costs can be included.
Companies can include relevant staff costs from connected entities in their PAYE and NIC liability calculation if the costs are attributable to the development work being undertaken.
This feature will benefit small, loss-making groups of connected businesses. Where one companies employ the majority of the group’s staff.
Feature 3: The two tests
The final feature is based on two tests.
The first test looks at whether a company’s employees are “creating, preparing to create or actively managing intellectual property”.
This mirrors criteria within the Patent Box scheme, another branch of government incentive for companies undertaking R&D.
The second test requires that costs relating to its expenditure on work subcontracted to, or externally provided workers provided by, a related party is less than 15% of its overall R&D expenditure.
If your company passes both tests, your claim will not be capped.
When does the PAYE cap come into effect?
The PAYE Cap came into effect on 1 April 2021. However, it will only impact claims for financial years that start after this date. For example, if you have a December year end, you do not need to pro-rata your upcoming claim. You would only need to apply the cap from 1 January, if your company is affected.
Why is HMRC reintroducing the PAYE Cap?
The reintroduction of the PAYE Cap is to combat the rise of abusive and/or fraudulent claims being submitted to the R&D Tax Credit incentive. Specifically, shell companies that are designed to extract government funding while contributing nothing to the UK economy. These artificial corporate structures usually do not have many employees, leaving them highly vulnerable to a payroll-based cap.
We applaud HMRC’s efforts to protect the R&D Tax Credits incentive and identifying and preventing fraudulent attempts totalling more than £300 million already.
However, the potential downside to the reintroduction of the PAYE cap is that many legitimate eligible businesses, especially those who subcontract a large amount of the development work, will miss out on a vital source of funding.