How does external investment affect your R&D tax credit claim?

Suppose you have or are in the process of securing external investment, such as from a venture capitalist or angel investor. It is a highly exciting time – somebody has seen potential in your business idea, product or service, and you know their cash injection and support can make-or-break your business dreams.

Whilst it is an overwhelmingly positive scenario for your business, it is important to know the impact external investors’ involvement can have on your R&D tax relief claim.

It is equally important to point out that, whilst external investment does not by any means preclude a business from submitting a claim, the terms of your agreement with the investing party can significantly affect the outcome of your R&D claim.

The goal here is to determine if a company can still be classified as an SME to submit a claim. If you are not classified as an SME, you may need to claim under the RDEC scheme for larger businesses which affords generally lower rates of return. It is a complicated process whose outcome can drastically influence your claim, so it is usually best to seek external support to look into it for you.

*Update – since April 2023, the gap has closed between how much SME and RDEC-classified businesses can reclaim. More on this at the end of the article. However, the SME/RDEC distinction could still affect your tax relief claim by many thousands of pounds, so the criteria below is really important.

Autonomy’ is key

HMRC has three ways of categorising your agreement with your investing party:

1. Autonomous enterprises
2. Linked enterprises
3. Partner enterprises

Let’s look at each one in turn.

Autonomous enterprises

The question of autonomy is critical in the eyes of HMRC, as this indicates how autonomous your business is. In other words, do you and your internal business team have legal control and ownership of your business?

HMRC’s threshold is 25%. So, if a combined group of external investors own more than 25% of your business, you are not considered autonomous. Investment by private investors – those that invest privately and not through a business front – do not count unless they are affiliated with corporate investors.

There are some exceptions to the 25% rule. HMRC will allow investment stakes of up to 50% in certain circumstances:

1. public investment corporations and VCs,
2. individuals or groups of individuals with a regular venture capital investment activity who invest equity capital in unquoted businesses (‘business angels’), provided the total investment of those business angels in the same enterprise is less than €1.25 million,
3. universities or non-profit research centres,
4. institutional investors, including regional development funds,
5. autonomous local authorities with an annual budget of less than €10 million and fewer than 5,000 inhabitants.

If you satisfy any of these criteria, HMRC could still classify you as an autonomous entity, though a single investing party must not have a stake of more than 50%, and there should be no link between them.

Should your investment agreement exceed any of the criteria above, it then becomes a question of whether you are a lined enterprise or a partnered enterprise.

Linked enterprises

If your investor can exercise control of your business’s operations, you will be classified as a linked enterprise. The following criteria apply if your investor:

1. owns more than 50% of your company’s voting rights
2. has the authority to appoint or remove the majority of your management team
3. can exert a ‘dominant influence’ over your company

If any of these apply, you and your investor are a linked enterprise. It also extends to individual investors if you both operate in similar industries and they own more than 50% of your company.

Why is this important for your R&D tax credit claim?

If you are deemed a linked enterprise, HMRC will take your investors’ other businesses into account with regard to their headcount and assets. This is important because HMRC apply company size tests of headcount, turnover and balance sheets to determine if a business is an SME or a large organisation. At the time of writing, the thresholds are 500 employees, €100 million turnover and a balance sheet of €86million, so if you exceed any of these figures your business will have to claim under the less-beneficial RDEC (large organisation) tax relief scheme.

Consequently, when entering negotiations with an external investor, it is important to understand firstly if you will meet any of the criteria above, and, secondly, what your investors’ situation is regarding their other business interests.

Partner enterprises

The third scenario to consider is if your enterprise could be considered a partnership. This test will be applied if your company is not considered both autonomous or a linked enterprise.

A partner enterprise is where a – generally larger – business owns between 25-50% of your company. Applying the criteria above, this would not be classified as a linked enterprise as your investor does not own the minimum threshold of 50% to be classed as linked.

Why is this important for your R&D tax credit claim?

If by applying the threshold above you are classed as a partner enterprise, their headcount, assets and balance sheet will count towards your own. This calculation is applied proportionately, depending upon their stake in your business.

So for example, if your SME has 30 employees and a balance sheet of €15m, and is 33.33r% owned by a larger business with 900 staff and a balance sheet of €300 million, the calculation would be as follows:

• Employees – your 30 employees + 300 of their staff (33.33% of 900) = 330 total staff
• Balance sheet – your €15m + €100m of their balance sheet (33.33% of €300 million) = €115 million total balance sheet

Based on this example, you would not satisfy the headcount criteria to be classified as a large business. However, you would be considered a large business as your balance sheet exceeds €86 million, and thus you would need to claim under the RDEC scheme.

Using the same example, but your investing business had a balance sheet of €100 million, that would reduce your aggregate balance sheet to €48 million (€15 million + €33 million). In this case, you would not be classified as a large business and you can claim under the SME scheme.

How much more beneficial is the SME scheme over RDEC?

SME

For eligible expenditure incurred before 1^st April 2023, the SME scheme offers rates of return at 33% for loss-making enterprises, and 25% for business in profit. For eligible expenditure uncured from 1^st April 2023, this rate has fallen to just 18% for loss-making businesses and 16% for companies in profit.

There is one exception to this rule, whereby ‘R&D-intensive’ SMEs in a state of loss can reclaim up to 27% of eligible expenditure if they can demonstrate that over 40% of their total annual costs have been spent on R&D. This applies to expenditures incurred from 1^st April 2023.

RDEC

Conversely, the amount that can be reclaimed under the RDEC scheme has increased. Pre-April 2023, the rate for profit-and-loss-making large businesses was 13%. However, this has increased significantly to 20%, with the 7% increase expected to represent many billions of pounds in additional claim value under the RDEC scheme.

From 1^st April 2023, we can see that relative parity has been achieved across both SME and RDEC schemes. However, the two schemes are taxed quite differently. So whilst the rates of return might appear similar on-paper, your final claim can be influenced substantially depending upon which scheme is claimed under.

(If you were wondering, figures quoted for the scheme are in Euros because the European Commission wrote the SME/RDEC definitions).