First-tier tribunal decision delivers lessons for taxpayers in R&D case

The dispute concerns a waste collection company, which lodged an appeal after HM Revenue and Customs (HMRC) issued closure notices disallowing research & development (R&D) tax relief for two accounting periods.

Prior to recent changes in tax legislation, a tax relief for costs incurred on R&D activities was available specifically for small and medium-sized enterprises (SMEs).

The company, Environmental Services Limited (ESL), claimed SME R&D relief on two waste handling projects for the periods ending 31 July 2020 and 2021. However, HMRC enquired into ESL’s corporation tax returns and then issued the company with closure notices during these periods, taking the view that the company was not entitled to claim R&D tax credits.

The tribunal was faced with two main questions: whether activity carried out by ESL qualified as R&D for tax purposes and, if it did, the extent to which ESL’s expenditure qualified for tax relief.

HMRC challenged whether the company’s activities linked to two waste handling projects met the statutory requirements to qualify for R&D tax relief. One project focused on “loading, agitation and separation methods effluent, toxic and recyclable materials” carried out in the year-end July 2020, while the other was centred on the “agitation of tankers” during the year-end July 2021.

The tribunal reasoned that to qualify for R&D tax relief, the projects needed “to be seeking an advance in science or technology” as outlined in government guidelines. Jake Landman, a tax disputes expert at Pinsent Masons, said: “While the guidelines are clear, it is helpful for taxpayers that the tribunal has, in this case and in the recent Tanglewood case, rebuffed HMRC’s attempts to narrow the test further. HMRC had sought to suggest in recent cases that the advance must be to overall knowledge, but the tribunal has confirmed that, as set out in the guidelines, the advance can also be to ‘capability’ in the field.” 

The FTT agreed that the burden of proving these activities fell to ESL. Although the tribunal rejected HMRC's characterisation of ESL’s projects as “merely routine”, it said the company ultimately “failed to establish that it was seeking an advance in science or technology.”

HMRC also argued that neither of the ESL personnel met the necessary definition of a "competent professional". The FTT said the guidelines did not stipulate any specific requirement for scientific or other qualifications. It reasoned that one of the directors – a person with 40 years’ experience who could clearly articulate the technical detail of the projects – met this requirement. However, it determined that the other director, who was more focussed on the commercial side of the business and had less technical knowledge, did not.  

The case also serves as an important reminder for all businesses to maintain comprehensive and contemporaneous records, as well as other relevant information to R&D tax relief claims, from the outset.

The FTT said its decision to dismiss ESL’s claim was not based on an absence of contemporaneous records, but that some gaps in records had limited its ability to “evaluate the precise activities undertaken”. Evidence, it said, should be properly prepared and presented to explain the costs that had been claimed and attribute this appropriately to R&D work.

“While the FTT did, in this case, accept the existence of a project plan from verbal evidence rather than documents,” said Landman, “there was insufficient evidence to demonstrate other requirements, including that a competent professional in the field would not have been able to identify an effective solution using existing knowledge; and that a technological baseline against which an advance could be measured. Any taxpayers appealing an assessment or closure notice regarding R&D should consider carefully what evidence they have to present and whom they are going to put forward as competent professionals.”

Although this case relates to the specific SME regime that was in place before April 2024, the definition of R&D remains the same under the new merged Research and Development Expenditure Credit (RDEC) scheme that has been in place since April 2024 and applies to both SMEs and larger companies.

Penny Simmons, a corporate tax expert with Pinsent Masons, said: “This decision is an important reminder to businesses seeking to claim R&D tax relief of the need for activities to satisfy the tax definition of R&D.”

“There is often a misconception that innovation should be R&D and qualify for R&D tax relief, but that’s not necessarily the case,” she said. “Relief is only available for projects seeking an advance in knowledge or capability in a field of science of technology – innovating to advance the operational abilities within an organisation is not necessarily R&D for tax relief purposes. All qualifying R&D is likely to be innovative, but not all innovation is qualifying R&D for tax purposes.”

She added: “Assessing whether the costs of a project qualify for R&D tax relief can be complicated. At the outset, particularly if the financial viability of a project is reliant of the availability of tax relief, businesses should consider whether a project meets the definition of R&D and whether the costs are eligible for tax relief. HMRC has developed a tool that can be used to assess whether a project involves R&D for tax purposes, which businesses may find useful.”