How will Revenue’s latest R&D Tax Credit Guidelines impact you?

R&D Tax Credits is shaping up to be a hot topic for 2019 with another Government review of the scheme. Furthermore, on 6 March 2019, Revenue released its latest version of the R&D Tax Credit Guidelines, which are an aid to interpretation of the legislation. It is almost four years since the last update, so Deloitte welcomes this publication. This contains a number of clarifications and additional examples, together with a suggested file layout for retaining documentation to evidence the Science and Accounting Tests.

What follows is Deloitte’s summary of the main changes and how these may affect companies conducting qualifying R&D activities and claiming R&D Tax Credits. Of particular significance are two changes that are likely to generate the highest level of interest: the addition of a suggested file layout and clarification on some issues concerning subcontracted R&D activities.

Introduction

As with previous editions, Deloitte are not in full agreement with all of Revenue’s interpretations of the legislation, and we feel that additional improvements could be made, by way of clarifications and worked examples and by addressing areas not currently covered. However, on balance, we view the update as a positive move in conveying Revenue’s current position with respect to a number of areas. They are broadly consistent with the 2015 edition, and Deloitte welcomes the stability that this brings to the manner in which companies should approach their claim preparation.

One principal learning from recent years is that Revenue is placing more emphasis on contemporaneous documents; on supporting allocation methods, especially in terms salary costs of staff with responsibility for both qualifying and non-qualifying work, and on the systems and processes used to make and record the assessments.

The trend is emphasised in the new Guidelines, which now contain a suggested file layout that is described as a basic guide to the contemporaneous documentation that should be retained when completing activities. It should be emphasised that this is a “suggested” file layout, and is not obligatory, but one concern is that this may become an expectation when Revenue investigates a claim. We would hope that Revenue audits are carried out with an open mind where companies have their own file layout or method of organising supporting documentation.

We note that the current revision does not contain a Section on “Advance Opinion,” which was removed from the 2015 Guidelines having been included in earlier versions. This was an avenue through which the Revenue Commissioners had been prepared, in limited circumstances, to give an advance opinion as to whether a proposed project would satisfy the requirements of legislation. In addition, there are no contact details to which technical queries can be addressed. Both are disappointing omissions in that they were of assistance to claimants in clarifying uncertainty.

R&D Tax Credit Claim Suggested File layout

In response to feedback from Revenue compliance officers, independent experts, and requests from claimants on what documentation is needed to support a claim, Revenue has set out a suggested file structure and the key points that the documents in each section of this structure should address. Many of the sections are familiar as they match the layout and questions set out in Revenue’s self-review questions (also known as the R&D Aspect Query) sent by Revenue inspectors. Other sections are new, however, and their underlying relevance is not always clear. In addition, certain sections do not apply to all industries, so we would hope that claimants would not be disadvantaged if these sections are missing from their documentation stores.

The impact of this addition, in that it is a suggested but not obligatory file structure for organising contemporaneous supporting documentation, is largely positive. It should be of benefit to existing claimants who don’t have appropriate documentation and who are considering upgrading their systems and processes to be audit ready, but also to potential new claimants who are assessing what needs to be done to prepare a robust claim and, in time, defend it. It can be used as a benchmark against which claimants can evaluate current record keeping. It is worth remembering that in defending the claim, the burden of proof is on the claimant to evidence entitlement to tax credits, and there is no guarantee that Revenue will not request further information from a claimant regarding either the financial or technical details of a claim.

While this is a file structure for organising contemporaneous supporting documentation, it is not clear if this will modify Revenue’s approach to Aspect Queries. Having clarification on whether inspectors will request information in this format, the current Aspect Query format or another alternative would be beneficial to assist claimants. In addition, with the Guidelines having prospective effect, claimants should expect that they will only apply to claims that are filed after their publication date.  

Subcontracting R&D activity

The Guidelines have reversed Revenue’s previous position that, “outsourced activity must constitute qualifying R&D activity in its own right.” The current position is that the activity must be R&D of the claimant company rather than the subcontracted party. This is a very constructive development as it considers entitlement to tax credit from the standpoint of the claimant and reflects the reality of subcontracting, in that the claimant company does not have the expertise in-house therefore requires outside assistance it to support its in-house R&D. The impact of the change will be the confidence that it gives claimants to include subcontracted activities that may previously have been omitted from claims.

In addition, Section 6.1 clarifies that the limits on subcontracting R&D to third parties and universities are mutually exclusive. Accordingly, if a company incurs costs to third parties and universities, both are claimable, subject to restrictions.

An issue that is not presently covered, but that would, we suggest, be helpful if included in subsequent revisions is Revenue’s insight into operational difficulties that can arise from issuing notifications, such as:

• A claimant receiving notification after it submits its own tax credit claim
• A claimant’s entitlement to claim for R&D expenditure in excess of the notification amount, etc.
   

General scheme

Section 2.5 now includes an example (Example No.9) that sets out the correct cash instalment treatment in the event that the R&D tax credit exceeds payroll liabilities. The correct treatment is that the cash refund instalments should be based on the excess tax credit, not the limit applied to the overall allowable repayments derived from the payroll figure, with the result that there may be fewer than the expected three instalments. This improves the cash flow for claimants affected by the cash repayment limits.

Section 2.7 incorporates a Tax and Duty Manual (Part 29-02-07) issued by Revenue in 2017, acknowledging that while there are differences in the definitions of R&D used for RD&I grants and the R&D tax credit, Revenue considers that the two definitions are very close. As a result, Revenue decided that it would not, as a rule, seek to challenge the Science Test in relation to funded projects for small claims (€50,000 or less of tax credit) from micro, small and medium-sized enterprises.

This is welcomed in that it reduces the claimant’s burden in defending the Science Test, and it encompasses RD&I grants administered by Enterprise Ireland, EU’s Horizon 2020 fund, and IDA Ireland. However, we feel that the concession should not have an expenditure limit, should apply to all companies irrespective of size, and should encompass other funding sources, such as the Department of Business Enterprise and Innovation’s Disruptive Technologies Innovation Fund.

Qualifying research and development activities

In Section 3.1, a small but important addition has been inserted with respect to the retention of “contemporaneous and relevant” documentation in support of the claim. The additional wording is that “in circumstances where a particular project within the claim fails to meet the requirement to have sufficient appropriate documentation available, but there are no concerns about the quality or lack of documentation for the rest of the claim, Revenue will only disallow that portion of the claim with insufficient documentation”. This indicates a pragmatic approach to audits. By extension, a further enhancement of that reasoned approach, particularly for protracted audits, would be for Revenue to be agreeable to paying tax credit entitlements without delay on projects which are not in dispute.

Section 3.6 has been updated with a reference to innovation, stating that innovative projects are not necessarily R&D projects. This reinforces the importance of understanding what constitutes a scientific or technological advancement and scientific or technological uncertainty.

Qualifying expenditure

Deloitte welcomes the removal, from Section 4.2, of the limitation on health insurance that previously excluded contributions for dependants of R&D personnel. Furthermore, Revenue has reinforced the common understanding that any payments borne by the company in relation to staff employment contracts and operated through the payroll system should be considered to be emoluments and apportioned as such.

Section 4.3.1 retains Revenue’s concession that an individual consultant hired on a short-term basis to undertake subcontracted R&D activities may be treated as a direct employee, provided certain conditions are met. Failure to meet all the conditions results in the individual being treated as a subcontractor, with the implication that claimable costs may have to be restricted when the “greater of 15%/€100,000 rule” is applied. What is encouraging is the addition of Section 4.4 that recognises that seconded individuals shall be treated as employees rather than non-qualifying connected parties. As long as the employee performs their work in Ireland the costs borne by the Irish company are now allowable. This is a welcome change, though we would consider the fact that they must contribute specialist knowledge as an unnecessary condition

In Section 4.7, three examples are provided to illustrate Revenue’s requirement that a deduction should be made for re-saleable material after its R&D usage ceases. The section opens by stating that materials may be of further commercial value after the R&D has concluded.
Revenue’s basis for this deduction is to apply the test as to whether the materials were utilised “wholly and exclusively in the carrying on by the company of R&D activities”.

While alluded to in examples 14 to 16, but not explicitly stated in the guidance, the critical factor seems to be the point in time at which this test is applied. If applied at the beginning of an R&D activity when the cost is incurred, and if unknown at this point whether these materials will have a commercial value or not (due to R&D by its nature involving technical and scientific uncertainty), it is in our view reasonable to conclude that materials were utilised “wholly and exclusively in the carrying on of R&D. And, therefore no deduction should be required.

However, if the test is applied when R&D has concluded, the original unknown as to whether the materials would have a further commercial value is now potentially known. In our opinion, this would be an unfair point to apply the test, particularly as the material may only now be of further commercial value due to successful R&D.

Another situation, not covered in the Guidelines, is where material left over from R&D trials may have a value not previously realised; for example, the sale of waste material or further transforming materials into saleable product. Again, if the quantum of this potential value is not known at the start of R&D activity, in our view no deduction should apply as a company should not be penalised for generating revenue from by-products of their R&D.

We would welcome further clarification on these points as they could be misinterpreted.

In other jurisdictions (Canada, UK, Australia) a similar deduction has a clearer legislative basis and guidance.

In summary, our view is that whether materials utilised in undertaking R&D have or do not have subsequent commercial value has no bearing on the resolution of technological uncertainty, which is the primary entitlement to claim.

A separate issue raised in Examples 15 and 16 concerns the making of deductions for known processes that form part of R&D. In Example 15, a deduction was made for some aspects of the process assessed by the company as not being qualifying R&D. Whereas in Example 16, no claim was made as no scientific uncertainties existed.

In Deloitte’s view, costs incurred in carrying out clinical trials should be considered qualifying if the trial as a whole meets the Science Test. While viewed solely in isolation, certain activities undertaken in the resolution of scientific or technological uncertainties may not constitute qualifying R&D. However, when combined with other research activities they may be fundamental to the resolution of the scientific or technological uncertainty and should therefore constitute claimable R&D activities in their own right.

Group expenditure on R&D

Where a company (predecessor company) that is claiming a tax credit under TCA s.766 ceases to trade and transfers its activities to another company (successor company), which commences to carry on that trade and continues the qualifying R&D activity related to that trade, the successor company can claim any unused credits of the predecessor company.

Example No. 27 in section 7.6 clarifies that, whether the transfer is effected by way of a transfer of a trade or a merger, the successor company may claim any R&D tax credit amounts not used by the predecessor company, but may not claim a payable tax credit in respect of any such unused amounts.

Requirements for a valid claim

Section 8.2 includes new wording concerning the bona fides of apportionment methods. This indicates that Revenue is likely to place more emphasis on ensuring that companies apply the most appropriate cost driver and allocation basis to costs being apportioned. This will be particularly relevant to companies with diverse operations on sites used for both R&D and production, where for example manufacturing operations might consume more electricity per head than purely office-based R&D activities. Of note, the bona fides of an allocation percentage is acceptable provided it has been chosen by the company’s management accountant, financial director or an appropriate director. One would hope that where an R&D technical director or project manager has assessed the apportionment, this would also be acceptable to Revenue.

Revenue’s greater emphasis on the importance of contemporaneous documentation continues in this section. We feel that consideration should be given to the administrative requirements to maintain records and a burden should not be placed on a company to maintain records that are prepared only for the purpose of supporting an R&D tax credit claim.

Section 8.2 retains Revenue’s expectation for the retention of the date where “activity associated with commercial exploitation begins”. We are concerned that this may give rise to a view that qualifying R&D activities end when commercial exploitation begins. In practice, while this is often indicative of the conclusion of R&D activities, it is not always the case, and qualifying R&D activities often occur in tandem with non-qualifying commercialisation activities. We would hope that such qualifying activities would not automatically be disallowed.

We view as progressive Revenue’s acceptance of supporting documentation in soft format and the acknowledgement of different regulatory requirements within industries. We would welcome further clarification on the definition of the “integrity of the records” and hope where electronic records are used to support claims, Revenue does not require document management systems, which can be impractical.

Consultation with other persons (Independent experts)

In section 10, Revenue has included a reference to its previously published Tax and Duty Manual (Part 29-02-05) for appointing an external assessor. This is a useful document for claimants to be familiar with as it outlines the expectation that companies should not find the outcome of an expert’s report “unexpected.” That is, the assessor’s key concerns should be raised with a company before the draft report is issued. This is not, however, always reflected in practice.

Conclusion

Overall, we welcome the updated Guidelines and the clarification that Revenue has provided in a number of areas, in particular in relation to the subcontracting of R&D activities. We believe that the updated clarifications, additional examples, as well as suggested file layout, will provide useful assistance for claimants in identifying qualifying R&D activities and the documentation to support an R&D tax credit claim.

Although we disagree with Revenue’s stance in relation to certain issues (namely, the treatment of expenditure on materials and ineligibility of certain overheads), Deloitte is a member of the R&D Revenue Discussion Group, and we anticipate that this group will be a forum in which these and other issues can be discussed and further guidance from Revenue sought.

Deloitte’s Gi³ (Global Investment and Innovation Incentives) team is ready to assist you with any queries in relation to the new guidance and how it could affect your company. The R&D tax credit is one of a number of potentially lucrative incentives that are available to R&D performing companies in Ireland. Our Gi³ team can assist and advise you with the R&D tax credit, national and EU grants, the knowledge development box and more. Please do not hesitate to contact any member of our team.