The research and development (R&D) tax-credit regime encourages companies to create new and improved 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, the State provided €261 million (1) through the tax system to support business expenditure on R&D and promote innovation and job creation in Ireland.
While the refundable tax credit is an attractive source of finance for innovative companies, it is not devoid of issues. In order to make a claim, a company must not only carry out qualifying R&D activity, but more importantly, it must be able to provide sufficient evidence of the work carried out and the costs incurred on the R&D.
The R&D tax credit can reduce a company’s corporation tax liability. In cases where there is little or no corporation tax liability, companies can receive a cash payment from Revenue (subject to conditions).
A general misconception among engineers is that R&D only relates to the notion of discovery. According to tax legislation, small incremental improvements to existing products or processes can still qualify for the credit and bear equal weight to the creation of a revolutionary new product.
Whether the R&D activity represents 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.
In addition, the activity can not only be basic or applied research (the ‘R’), but also experimental development (the ‘D’), which according to recent surveys (2) accounted for more than 71% of R&D expenditure in 2011 in Ireland.
Supporting the claim
Although a claim may satisfy the conditions mentioned above, Revenue may still challenge or disallow it if there is insufficient supporting documentation to reinforce the legitimacy of the claim. In reviewing claims, Revenue expects the claimant company to present evidence showing that the qualifying criteria have been met; the evidence must be presented in a fashion and format that facilitates the review of both the scientific and technological aspects of the claim and the related costs of same.
While no evidence is required to be provided when claiming the credit, Revenue has four years after the relevant accounting period in which the claim has been submitted to review a claim. The review could be either a formal audit or informal aspect query. In addition, the Revenue inspector may decide to appoint an external expert often sourced 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 support their application with satisfactory contemporaneous documentation. This should be presented in such a way as to facilitate a Revenue review of the claim and assist in the identification of how and why each step in the R&D process was undertaken.
Contemporaneous documents are those that are generated when the R&D activity is being undertaken. The documents are prepared while the R&D activity is in progress, and all entries are made on a timely and consistent basis. The contemporaneous documentation should provide details of the objectives of the R&D activity, uncertainties, advancements sought, hypothesis, conclusions, and experiments carried out; this will serve to demonstrate that a systematic approach (generally to a recognised methodology) was followed.
In addition, details such as the skills and competencies of the personnel involved and the reasoning behind each step in the process are also required.
Documentation can be an issue
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. In general, the principle of maintaining appropriate documentation to support a tax benefit is an accepted fact and companies are familiar with the requirement to produce documentation to support the business activities.
However, depending on the industry, engineers performing the R&D 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. For example:
Standard documentation generated during the R&D process may focus only on 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 clear details of potential technical difficulties may work against the requirement to resolve technological uncertainties when claiming the credit;
Similarly, to support the business case, engineers may underplay the need and rationale for deviating from standard engineering practice, as new alternative and unproven steps are perceived as financial risks;
Organisations with more agile approaches may find that valuable time can be used for further tests rather than documenting the setting and conclusions of tests already carried out;
When shop-floor R&D activity is carried out concurrently with non-R&D or production work, claimant companies may not appropriately split the time between R&D and non-R&D activities;
Logical conclusions as to why prototype tests passed or failed, and consequently why a hypothesis is valid or not, are not formulated. If there has been no attempt to make a conclusion, the requirement to seek to achieve a technological advancement may not be met and the claim may be disputed;
Finally, there is no evidence and rationale as to how R&D activity and costs are linked.
Failing to demonstrate due diligence and discipline in documenting 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.
Examples of supporting documentation
There is no prescribed and definitive list of supporting documentation for an R&D tax credit claim; however, engineers should consider keeping the following:
Project planning documents;
Records of resources allocated and timesheets;
Records of trial runs;
Status and/or progress reports;
Design of experiments, feasibility plans with details of the methodology adopted;
Project records, laboratory reports, notebooks, patent applications;
Iterations of designs, 3D CAD/CAM or finite element analysis;
Minutes of project meetings;
Test protocols, data, analysis, results, conclusions;
Proof of concepts, samples, prototypes;
Emails or data from a dedicated project management software system.
While the refundable R&D tax credit remains an important source of finance for innovative engineering companies, they must substantiate the costs incurred during the course of experimental activity and satisfy the burden of proof by demonstrating that they legitimately sought to achieve advancement in a field of science or technology.
As the R&D tax credit is designed to incentivise the undertaking of R&D, rather than reward it after the fact, it is not sufficient to collate documentation retrospectively. Companies must plan for their R&D tax credit claim from the outset of the R&D activity, and put in place systems to maintain contemporaneous documentation on an ‘as you go’ basis to support the resulting claim.
However, as outlined above, doing so in practice is not always straightforward and the administrative burden can often be a drain on staff resources. If in doubt as how to properly record R&D activities for the purpose of the R&D tax credit claim, companies should consider seeking competent professional advice.
In an effort to address the issue with the R&D tax credit documentation, KPMG has undertaken a comprehensive review of international best practice and launched K-Doc, a tool designed to appropriately record R&D activities as they happen. More information in relation to R&D tax credit and K-Doc can be found on KPMG’s website: www.kpmg.ie\R&D.
Ken Hardy is a partner in KPMG and leads the R&D Incentives Practice. He has prepared a large number of R&D tax credit claims for multinational corporations and small and medium-sized enterprises, and has significant experience supporting claims through Revenue audits. Ken authored the only specialist text on the topic of R&D tax credits, published by the Irish Tax Institute. He is a founding member of KPMG’s Global R&D Incentives Practice and is leader for Europe, Middle East and Africa.
Gianmario Pala is an associate director in KPMG’s R&D Incentives Practice. He is a chartered engineer with Engineers Ireland, with several years’ experience preparing R&D tax credit claims in both Ireland and the UK. He has worked with companies of all sizes, from a wide range of industries, and has supported many companies through Revenue audits of their claims.
(1) Department of Finance review of the R&D tax credit – October 2013
(2) Business Expenditure on Research and Development 2011/2012 – Forfás 2013