Three months late (it was promised for mid-May), the draft of the revised HMRC guidance at CIRD81350 on “production” for the purposes of the R&D tax reliefs has finally been published (PDF).
Paragraph 28(c) of the DTI R&D Guidelines excludes the “production and distribution of goods and services” from being R&D for tax purposes. Unhelpfully, the guidelines do not define “production” and interpretation has been difficult and inconsistent to date.
The draft guidance is intended to explain HMRC’s understanding of the term “production” in the specific circumstances where R&D activity continues after a company begins making goods or services that are supplied to one or more customers. In many cases, HMRC have previously taken the view that entering into production means the scientific/technological uncertainties have been resolved and so any continuing expenditure cannot qualify for R&D purposes.
Particular areas of difficulty have included such things as bespoke products: if the product works when produced, the company carrying out the R&D will supply that product to the customer rather than go to the expense of producing yet another. HMRC could take the view that the costs of producing that bespoke product were not R&D, as it was supplied to the customer and the costs must therefore have been production costs – despite the fact that the scientific/technological uncertainties were not known to be resolved until the product had been made, and the Guidelines state at ¶34 that “… an R&D project ends … when a prototype or pilot plant with all the functional characteristics of the final process, material, device, product or service is produced.” That is, the R&D ends after the prototype/pilot has been produced and not before.
The draft guidance indicates that HMRC do now accept that “where production trials are necessary to test whether the scientific or technical advance has been made, the whole or part of the expenditure on such a trial may be on R&D, depending on the degree of uncertainty existing within the process at a particular time.” This isn’t as helpful as it could be, but it is a reasonable step forward for HMRC. It does mean more documentation – HMRC will be looking for information as to when in the production trial the uncertainty was resolved, for example, so some consideration of the point will need to be made and recorded. This extends to bespoke products (or “first in class” products, as HMRC refers to them), where qualifying “costs … would qualify for R&D relief, even though the total build costs would not.” Again, the company will need to determine where in the process the uncertainty was resolved.
The draft guidance isn’t particularly detailed, but the acknowledgment that there are some forms of production which could result in a product sold to a customer that nevertheless involve qualifying R&D costs is helpful. It’s certainly an improvement on CIRD81350’s blanket statement that “[p]roduction activity is excluded from the scope of R&D for tax purposes, and so expenditure on such activity cannot be included in claims for R&D tax credits.”
Comments on the draft guidance are sought by 30 September 2011, by email to the link at http://www.hmrc.gov.uk/consultations/rdcc.htm.