Software R&D – Common Misconceptions
It is no secret that the R&D industry has seen a monumental shake-up over the past 2 years, with HMRC opening compliance checks into circa 20% of all R&D claims submitted, up from around 1% historically. In October 2023, HMRC published its Guidance for Compliance (GfC3) to help claimants see if their work qualifies as Research and Development for tax purposes. This is comprised of 6 parts, highlighting the purpose of the GfC3 to aid potential claimants and help establish whether or not their project qualifies for R&D tax relief.
One area of R&D, often misunderstood, is software. The sector sees a huge number of companies claiming for various development activities, typically without the required level of software development expertise, which would otherwise be deemed routine for the competent professional qualified in the field. This has led to a volume incorrect interpretations and claims being made for business-as-usual, or bespoke software development, where there is no advance in underlying technology or the resolution of technological uncertainty to achieve the desired outcome. The common misconception here lies with companies developing internal platforms which offer new functionality not available on the market, but without the company seeking to achieve an industry wide advance. As outlined in the GfC3, many companies identify advances to their own business, confusing their own, commercial projects for qualifying R&D projects.
Areas of Software R&D
Of course, qualifying Research and Development projects in the software industry do not solely lie at the hands of major tech firms, but can be undertaken by a wide array of companies. The words ‘research and development’ are often used within the software sector; however, care should be taken when considering the development work that aligns with the definition of R&D as set out in the BEIS Guidelines.
One of the most poignant elements of both the BEIS Guidelines, and HMRC’s Guidance for Compliance, is the importance of the competent professional, and their understanding of the industry. Part 3 of the Guidance for Compliance, aptly named ‘Importance of a competent professional’, highlights the necessity for a competent professional to utilise their industry knowledge when considering whether a project qualifies for R&D for tax purposes. The competent professional must be qualified and experienced in the field in which the R&D is taking place, and therefore, regardless of the industry in which the company operates, if the project is software related, the competent professionals involved in the claim must have relevant software development expertise.
The concept of relevant industry experience is also very important within the context of software R&D. It is often considered that an individual with experience within the overall field of computer science would be deemed a competent professional for the purposes of a software development project. However, as software consists of a vast array of languages, frameworks and coding practices, the experience within the relevant sub-field of software development is particularly important. The individuals must be experienced within the languages and concepts used throughout the R&D to be classed as a competent professional. For example, a software developer fluent in Python, who has never coded using C, would not necessarily be deemed a competent professional due to the differences in the languages. Python is an object-oriented programming language, whereas C is a procedural language and as such, the differences can be significant and therefore, a project deemed uncertain by this individual, may not be deemed uncertain by a developer with experience using C.
Over recent years, Artificial Intelligence (AI) and Machine Learning (ML) have become two of the fastest emerging technologies in the world. Companies across all industries are identifying the benefits of utilising these technologies to perform tasks that would previously have been time and labour intensive. However, it is a common misconception that simply introducing and tweaking AI would constitute an R&D project, simply because this makes a task quicker to perform. Considering the BEIS Guidelines again, “the routine analysis, copying or adaptation of an existing product, process, service or material, will not be an advance in science or technology.” This highlights the requirement for development work to take place beyond adapting existing algorithms, or concepts to fit the needs of the company.
With AI and ML specifically, projects often encapsulate these in a way which requires training of specific data sets to enable them to be performant for the tasks a company is undertaking. As this is often bespoke to the company undertaking the project, this too can often be mistaken for an R&D project. However, within this example, we must consider the field of science or technology in which the project takes place. As we are considering the software industry, and more specifically the realms of AI and ML, we must consider whether the training of a Machine Learning algorithm would represent an advance in overall knowledge or capability in the field of software development. It is highly unlikely that performing tasks of this nature would qualify as R&D for tax purposes due to the availability of established methods already used to train machine learning algorithms.
Bespoke development projects are often confused with qualifying R&D as there is nothing on the market that can replicate the tasks required. This is a common misconception among claimants – the lack of established alternatives available on the market does not render a project as qualifying for R&D tax relief. For this to qualify, a project must also present scientific or technological uncertainties. Such uncertainties exist when the knowledge of whether something is scientifically possible or technologically feasible, or how to achieve it in practice is not readily available or deducible by a competent professional working in the field.
This again highlights the importance of the competent professional as well as their industry knowledge and experience, in order to establish whether or not something is scientifically possible or technologically feasible. A number of bespoke developments constitute adaptations of existing systems or platforms, which would fall under the category of business-as-usual challenges, and would in turn be deemed readily deducible by a competent professional. Paragraph 22 of the BEIS Guidelines states that, “the routine analysis, copying or adaptation of an existing process, material, device, product or service will not advance overall knowledge or capability, even though it may be completely new to the company or the company’s trade”. It’s important to note that, when introducing new technology to a company’s trade, it does not always constitute qualifying R&D where the adaptation of said technology has already been implemented, albeit in a slightly different way, within another industry.
Another common misconception surrounding software development projects is the ability to make the distinction between qualifying and non-qualifying activities within a wider project. It is critical that companies identify only those areas undertaken to directly resolve scientific or technological uncertainty as qualifying R&D. The boundaries of a project are key to establishing where qualifying R&D has taken place. It is unlikely that all activities within a commercial project will fall under the scope of R&D for tax purposes and therefore claimants must be able to define the boundaries of the overall project.
Whilst HMRC have adopted a strong approach to compliance within the R&D industry, there is credence to the rationale adopted in the rejection of claims, particularly in the software and technology sectors, where there is a lack of competent professional involvement. It is imperative, therefore, for such claims to be prepared with the competent professional, given their relevant knowledge, expertise and specific sector capability.
R&D related tax enquiries are on the increase, particularly where claims are based on software development projects. It’s therefore essential that claims are accurately prepared in line with the BEIS Guidelines and GfC3 to mitigate the risk of enquiry and potential tax penalties.
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