Ken Hardy and Gianmario Pala provide insights on how to stay on the right side of Revenue, while getting the right benefits.
Many ICT companies in Ireland avail of the Research and Development (R&D) tax credit to support their R&D activities. However, those adopting an agile software development approach in particular may find it onerous to maintain the appropriate documentation to support their technical work and related expenditure and satisfy Revenue’s science and accounting tests. Here are some tips on how developers can address this issue during their day-to-day development work.
The R&D tax credit regime encourages companies to create new and improve existing products and processes in Ireland. The incentive provides a 25% refundable tax credit on the incremental R&D costs over a base year period. In 2011, almost 1,500 companies received the benefit of the R&D tax credit, approximately 29% of which were in the Information and Communications Technology sector (Department of Finance’s review of the R&D tax credit – 2013). While the refundable tax credit is an attractive source of finance for innovative ICT companies, it is not devoid of issues. In order to make a claim, a company must not only carry out qualifying R&D activities but, equally, it must be able to provide sufficient evidence of the work carried out and the costs incurred on the R&D.
Whether the R&D activity seeks to make a quantum leap for science or a small technological improvement is irrelevant; what counts is that the activity is carried out in a systematic, investigative, or experimental manner, seeks to advance knowledge or capability in a field of science or technology, and involves the resolution of scientific or technological uncertainties. More importantly, not only does basic or applied research (the ‘R’) qualify, but so too does experimental development (the ‘D’), which according to recent surveys accounted for more than 71% of R&D expenditure in 2011 in Ireland (Business Expenditure on Research and Development (BERD) 2011/2012 – Forfás 2013).
A company is not required to provide detailed evidence when claiming the credit. However, Revenue has a timeframe of four years (after the relevant accounting period in which the claim has been submitted) to review the company’s entitlement to the credit. The review could be either a formal audit or an informal aspect query. In addition, the Revenue Inspector may decide to appoint an external technical expert, often from academia, who will scrutinise the validity of the claim from a scientific or technical perspective to ensure it meets the criteria specified in the tax legislation.
The burden of proof lies with the claimant company. Therefore, to ensure a claim can withstand a Revenue audit, companies are required to maintain ‘contemporaneous and relevant documentation’ to support the tax credit claim. The term contemporaneous documentation refers to documents generated while the R&D activity is being undertaken; all entries should be made on a timely and consistent basis. To be considered relevant, the contemporaneous documentation should provide details of the objectives of the R&D activity, uncertainties, advancements sought, hypothesis, conclusions, and experiments carried out to demonstrate that a systematic approach was followed.
In ICT companies, it is mainly project managers, software architects or software developers’ responsibility to maintain contemporaneous documentation; it is therefore crucial that these people familiarise themselves with the requirement of the R&D tax credit.
A potential weakness for software R&D tax credit claims is documentation. In the recent years, many ICT companies have embraced agile and iterative software development methodologies, including scrum, extreme programming, and adaptive software development, to create or improve their products. While these methodologies have advantages in the manner and speed with which complex software projects are managed and delivered to market, they are not without disadvantages, particularly for companies intending to claim the R&D tax credit. In particular, two of the key principles of the philosophy behind these methodologies may in fact represent a weakness for companies claiming the tax relief. Firstly, according to these methodologies the production of documentation throughout the development work should be kept to a minimum; secondly, frequent face-to-face conversations are considered more effective than written communications.
However, in the event of Revenue querying a related R&D tax credit claim, the minimal documentation generated during the development phase, such as debug logs, may not be sufficient to support the company’s claim that the R&D tax credit criteria have been met or to demonstrate the quantum of work carried out and the related expenditure claimed. Additionally, in the timeframe that Revenue has available to look at the claim, memories of verbal communications may be forgotten or lost due to staff turnover, which is not infrequent in ICT companies in Ireland.
Revenue provides general advice on the types of documentation that should be kept when claiming the R&D tax credit, but no guidance is given for specific industries, let alone the ICT industry. In general, the principle of maintaining appropriate documentation to support a tax benefit is an accepted requirement and companies are familiar with the need to keep documentation to support the business activities. However, depending on the industry, engineers performing the R&D activity may not be comfortable allocating their time to additional reporting activities, creating a situation where the routine documentation produced during the normal course of the development activity may be insufficient to back-up the R&D tax credit claim.
- Standard documentation generated during the R&D process may focus only on recording the changes made to the code or validating whether or not the final objective has been achieved. In general, no references are provided to describe the systematic activity or to provide comments as to why and how a test has been successful or not;
- Many organisations have a tendency to underplay potential failures, difficulties, and uncertainties in order to support the business case and the need for financing. The lack of a well-defined and presented technical challenge may work against the requirement to resolve technological uncertainties when claiming the credit;
- Organisations with more agile approaches may have a propensity to retain only debug and issue tracking records as they may find that valuable time can be used for further tests rather than documenting the setting and conclusions of tests already carried out;
- When the software development activity is carried out concurrently with other activities, such as routine product support and software maintenance, claimant companies may not appropriately split the time between R&D and non-R&D activities;
- Logical conclusions as to why proof of concepts and prototype tests passed or failed, and consequently why a hypothesis is valid or not, are not formulated.
- Finally, there is no evidence and rationale as to how R&D activity and costs are linked.
Failure to adequately support the R&D activity may lead to a claim being partially or totally disallowed and may have severe consequences, such as payment of interest, penalties and, in extreme cases, publication on the list of tax defaulters.
What supporting documentation should developers consider?
There is no prescribed and definitive list of supporting documentation for an R&D tax credit claim to be ‘compliant’; however, software developers may consider the following as examples of evidence that would ideally be retained in a dedicated R&D documentation file:
- Project planning documents;
- Records of resources allocated and timesheets;
- Status and/or progress reports;
- Design of experiments, feasibility plans with details of the methodology adopted;
- Sprint/scrum reports;
- Minutes of project meetings, such as weekly scrum meeting;
- Whiteboard drawings or pictures of proposed architecture or potential solutions;
- Test protocols, data, analysis, results, conclusions;
- Proof of concepts, samples, prototypes with notes on technical challenges to overcome;
- Emails or data extracted from a dedicated project management software system;
- Records from specific team collaboration software packages
Companies in doubt about how to properly record R&D activities for the purpose of an R&D tax credit claim should seek advice from an R&D tax credit professional.
Many innovative ICT companies in Ireland rely on the R&D tax credit as an important incentive to support and expand their R&D activities, which are the core of their business success.
The benefit of the credit, however, does come with an onus to prepare appropriate documentation to support the claim and avoid negative consequences in the event of a Revenue audit. Developers who are not accustomed to maintaining paperwork, particularly those adopting a lean or agile approach in their software development activity, should consider introducing (in their current workflow) appropriate steps to ensure that the R&D activity is properly recorded on an contemporaneous basis.
In an effort to address the potential issue with R&D documentation for the purposes of the R&D tax credit, KPMG has undertaken a comprehensive review of international best practice and prepared K-Doc, a tool designed to appropriately record R&D activities as they happen.