What are the tax implications if development costs are capitalised?

Capitalising your development costs within intangible Assets, what are the tax implications?

In the first article in this series, we considered the accounting considerations around recognising development costs as intangible assets on the balance sheet for a company.

For this insight piece, Alicia Crisp along with Nick Hayward and Scott London-Hill, take a look at the area that is most often asked about: 

What are the tax implications if development costs are capitalised?

While a detailed discussion of R&D tax credits for tech companies is beyond the scope of this article, for those interested, my aforementioned colleague Scott London-Hill covers off the recent changes to the UK R&D Schemes and its impact on the Tech Sector here - Changes to UK R&D Schemes and its impact on the Tech Sector

From a tax perspective, the starting point for capitalised intangible assets is that a tax deduction is provided for in-line with the amortisation recognised in the accounts. As a result of this, it can take several years to receive the full relief. For non-qualifying development expenditure, it is generally advantageous to expense this to the P&L to benefit from 100% relief upfront.

Tax relief for the amortisation of software that is capital in nature can be enhanced by virtue of a S815 election. The election operates by pulling the expenditure out of the intangible regime and into the capital allowance regime, potentially benefiting from 130% relief upfront (up until 31 March 23) or 100% full expensing (from 1 April 23).

A cautious approach is encouraged when considering this election. This is particularly relevant in scenarios whereby the company is considering an R&D claim in the future which could involve an amendment of the original tax return, as the election is irrevocable. We would, therefore, advise that you consult a tax professional if considering such an election.

On the basis that the expenditure qualifies for R&D tax relief, it matters not whether the costs have been expensed to the P&L or capitalised as an intangible on the balance sheet. If the HMRC criteria is met, an enhanced deduction of 86% will be realised (relevant to expenditure incurred by Small and Medium Enterprises from 1 April 2023). Assuming the company is loss making, the losses that can then be surrendered for a cash repayment are restricted to the lower of the qualifying R&D expenditure and the tax adjusted loss.

It should be noted, however, that a S1308 election is required in the tax computation to distinguish between the qualifying and non-qualifying R&D expenditure. This permits the qualifying cost and subsequent enhanced R&D deduction to be made in the year of the addition and reduces the tax base cost of the expenditure to £nil, such that future amortisation deductions will not provide tax relief.

Any non-qualifying R&D expenditure capitalised, for example, development costs that are perhaps expanding a project but not meeting the requirement for solving a technological uncertainty, will receive tax relief in-line with the amortisation over the life of the asset.

Non-qualifying revenue R&D expenditure which is expensed to the P&L should qualify for 100% relief upfront and therefore it can be advantageous to distinguish early between the qualifying and non-qualifying R&D expenditure to accelerate the tax relief available.

It should be noted that the 86% additional deduction referred to earlier is only applicable to a Small and Medium Enterprise (‘SME’).

For a company to meet the definition of a SME for R&D tax credit purposes, it must have fewer than 500 staff and either: a turnover of no more than €100 million or gross assets of no more than €86 million.

An often overlooked but nonetheless important point to consider therefore is whether capitalising the development costs could result in the company being ineligible for the SME scheme. If development costs have been expensed to the P&L, then there will be no impact on the balance sheet. If, however, the company has grown to a point whereby it exceeds the turnover limit, capitalising these costs could have the unintended consequence of pushing the gross assets over €86m such that both threshold limits are breached. A result of this being that the company could not participate in the favoured SME scheme and would be restricted to a claim under the Research and Development Expenditure Credit Scheme (‘RDEC’), thereby limiting the tax relief available.

In summary, when 100% of the expenditure is likely to qualify as R&D qualifying expenditure then it makes little difference whether this is capitalised or expensed to the P&L unless this would push the company out of the SME scheme.

In practice, this is rarely the case and there is a benefit to identifying the qualifying and non-qualifying expenditure as early as possible to accelerate the tax relief.

While the above hopefully provides a brief overview of the implications, tax legislation is a complex area, and we would always advise speaking to a qualified tax advisor as early as possible to maximise the benefit available.

In our next article we will consider the commercial considerations to be factored in when considering whether to capitalise development costs within tech companies.

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