Research and Development: Definition and Appeals

CHAPTER 1 - INTRODUCTION

1.1 The Government recognises the important role which research and development (R&D) plays in a modern knowledge-driven economy. It is keen to see the UK improving its place among the top rank of world R&D performers. With this in view, on Budget Day last year, the Treasury and DTI issued a joint Consultation Document "Innovating for the Future: Investing in R&D".

1.2 In response to that consultation the Government is continuing to examine what can be done to support and encourage R&D in the UK.

1.3 This Technical Note carries forward the Chancellor's commitment, in his Pre-Budget Report published on 3 November 1998, to discuss further with business the definition of R&D for fiscal purposes. The discussion has two objectives

firstly, to clarify the scope of the existing tax reliefs for R&D
secondly, to lay the foundation for any new fiscal measures that may in future be introduced for R&D expenditure, or relating to R&D intensive companies.

1.4 Chapter 2 of this Technical Note summarises the existing tax reliefs for R&D, which are in terms of `scientific research'.

1.5 Chapter 3 discusses the definition of `scientific research' which applies for the purposes of these reliefs. The scope of this term is determined by the Secretary of State for Trade and Industry. Extracts from the current guidance on the meaning of `scientific research' in the Inland Revenue's published Capital Allowances Manual are reproduced at Annex 1.

1.6 A number of respondents to "Innovating for the Future" suggested that the guidance on the meaning of scientific research in the Inland Revenue's Capital Allowances Manual^* should be expanded and made clearer. In response to these representations, Chapter 3 introduces the draft new guidelines, prepared by the DTI and set out in Annex 2, for determining which activities fall within the definition of scientific research.

*See Annex 1

1.7 As well as covering the definition of scientific research, this Technical Note contains, in Chapter 4, a discussion of the related question how disagreements about applying the definition in particular cases can best be resolved.

1.8 Chapter 5 considers, as an alternative approach to determining the scope of R&D activity for tax purposes, the possibility of introducing a more detailed statutory definition. The form such a statutory definition might take is set out as a draft clause in Annex 3.

1.9 Chapter 6 brings together the issues raised in this Technical Note on which business may wish to comment further.

1.10 Annexes 4 and 5 give some further background on the OECD guidelines on R&D (the `Frascati Manual') and on SSAP 13 (Accounting for research and development).

CHAPTER 2 - EXISTING TAX RELIEFS FOR R&D

2.1 This Chapter summarises the existing tax reliefs for R&D, and how they are administered.

Statutory provisions

2.2 The existing provisions for R&D are in terms of `scientific research'. This is defined as "any activities in the fields of natural or applied science for the extension of knowledge"*. This is not intended to be an exhaustive definition of scientific research. It is in general terms which set out the parameters within which relief may be given. The precise application of the term "scientific research", and hence the scope of the relief, is left to be determined by the Secretary of State for Trade and Industry within those parameters.

*Section 508(3) ICTA 1988 and Section 139(1)(a) CAA 1990

2.3 There are a number of special tax reliefs for scientific research related to trading activity. These give

exemption from tax to scientific research associations (Section 508 ICTA 1988)
relief for revenue contributions to scientific research associations (Section 136(b) CAA 1990)
relief for revenue contributions for scientific research paid to a university, college or other similar research institution (Section 136(c) CAA 1990)
relief for both revenue and capital expenditure on scientific research (Sections 136(a) and 137 CAA 1990).

Administration of R&D reliefs

2.4 There is a common structure to these provisions. They do not follow the usual pattern for statutory tax reliefs, whereby the entitlement is set out in the statute and administered by the Inland Revenue subject to judicial oversight by the General and Special Commissioners and the Courts.

2.5 Responsibility for administration of the existing tax reliefs is split between the Inland Revenue and the Department of Trade and Industry. The final decision on the scope and application of these reliefs, including which activities qualify as `scientific research', rests with the Secretary of State for Trade and Industry.

2.6 In order to qualify for the tax exemption for scientific research associations, and the relief for revenue contributions to scientific research associations, universities, colleges and other similar research institutions, the body in question must first be approved by the Secretary of State for Trade and Industry. The decision whether the activities of a body fall within the parameters set by the statutory definition of scientific research and, if so, whether approval should be given are matters for the judgement of the Secretary of State. His decision is final. There is no right of appeal to the Commissioners and the Courts other than by judicial review.

2.7 The procedure is somewhat different for relief for revenue and capital expenditure on scientific research. The claim for relief is made by the taxpayer to the Inland Revenue, and dealt with as part of settling the claimant's tax affairs in the normal way. Where exceptionally there is a dispute which cannot be resolved by agreement between the inspector and the taxpayer, the Inland Revenue may refer the issue to the Secretary of State for Trade and Industry for decision. His decision is final. There is no right of appeal to the Commissioners and the Courts other than by judicial review.

CHAPTER 3 - THE MEANING OF `SCIENTIFIC RESEARCH'

3.1 Research and development (R&D) is an essential part of business for many firms especially those in rapidly changing markets populated by demanding customers. R&D frequently provides the means by which new markets may be created, or in more mature markets can facilitate product and service differentiation so that a company may effectively compete.

3.2 This Chapter considers the interpretation of `scientific research', in determining which activities qualify for the existing special tax reliefs for R&D. As explained in Chapter 2, the precise application of the statutory definition of scientific research* is determined by the Secretary of State for Trade and Industry within the parameters set by that basic definition and any further conditions of the particular statutory provision concerned. `Scientific research' as defined for tax purposes and R&D are considered to be largely one and the same.

*"any activities in the fields of natural or applied science for the extension of knowledge" - Section 508(3) ICTA 1988 and Section 139(1)(a) CAA 1990

3.3 A number of respondents to "Innovating for the Future" suggested that the guidance on the meaning of scientific research in the Inland Revenue's Capital Allowances Manual* should be expanded and made clearer. In response to these representations, the DTI has prepared new draft guidelines for use in deciding whether expenditure qualifies as scientific research for tax purposes. These are set out in Annex 2, and this Chapter includes various questions thereon. These guidelines do not alter the meaning of `scientific research', but explain and clarify the existing practice of the Inland Revenue and the DTI. They would also complement any implementation of the proposals in Chapter 5 for a new statutory definition of R&D by assisting taxpayers and inspectors in determining which activities qualify although their status would be then be reduced (see Chapter 4).

*See Annex 1

3.4 When the new guidelines are finalised, it is intended that they would be endorsed by the Secretary of State for Trade and Industry as setting out his views on the meaning of `scientific research'. They would accordingly be applied by him in deciding whether activities qualify as `scientific research' in any case referred to him under the existing appeal procedures and for the purposes of approving Scientific Research Associations, subject to any other qualifications required by the relevant provisions.

3.5 The new guidelines would also be included in the Inland Revenue's published Capital Allowances Manual. They will give taxpayers and their advisers greater certainty and clarity over what activities qualify as scientific research.

3.6 We would welcome comments on the draft guidelines in Annex 2.

3.7 The definition of scientific research in the draft guidelines is based on the meaning of "research and experimental development" as defined by the OECD in their 1993 publication "Proposed Standard Practice for Surveys of Research and Experimental Development", also known as the Frascati Manual (see Annex 4), except in one respect. The definition of scientific research for tax purposes is limited to activities in the fields of natural or applied science, that is to say science and technology. Frascati also covers activities such as research in social sciences and the humanities which fall outside those bounds and will continue to be excluded from any definition of R&D activity which applies for tax purposes.

3.8 Research and experimental development is defined in the Frascati Manual as "creative work undertaken on a systematic basis in order to increase the stock of knowledge .... and the use of this stock of knowledge to devise new applications...the basic criterion for distinguishing R&D from related activities is the presence in R&D of an appreciable element of novelty and the resolution of scientific and/or technological uncertainty". It is further divided into the various activities set out in Annex 2.

3.9 In common with the definition of research and experimental development in the Frascati Manual, expenditure on exploration and appraisal of mineral resources is excluded in the draft guidelines and would accordingly be excluded from any new reliefs that may in future be introduced for R&D expenditure. It is however intended that expenditure on oil exploration and appraisal, most of which at present qualifies for SRA, will continue to do so.

3.10 The Frascati definition of research and experimental development also forms the basis of the definitions used in SSAP13 (Accounting for research and development - see Annex 5) in which, again, R&D activity is distinguished from non-research activity by the presence or absence of an appreciable element of innovation.

3.11 Comments are invited on how successful the guidelines are in reproducing the essential ideas and boundary conditions in Frascati, in particular the dividing line between experimental development and product development. This requires the exclusion of, for example, routine pre-production work, and of routine product, process or service development, not involving a significantly innovative scientific or technological advance.

3.12 The application of general principles to the facts of specific cases has often proved difficult. In particular it is difficult to draw a precise boundary between experimental development and product development. This involves distinguishing cases where the degree of innovation in new product development amounts to scientific research from cases where existing products are altered and improved without an appreciable element of innovation.

3.13 The guidelines in Annex 2 exclude instances where the installation or improvement of new processes, systems and services does not entail a substantial amount of genuine R&D resulting in an extension of knowledge. They also exclude the simple installation of well proven equipment or technology into what might be considered by the company to be a new development, but which in practice does not represent a significant technical advance for the industry sector concerned.

3.14 We would welcome further comments on the criteria which might reasonably apply in determining the scope of `experimental development' as it applies to such `installation or improvement' work.

3.15 In common with Frascati, routine product, process or service development by itself would also not constitute R&D for tax purposes. That is to say, development work which forms part of a routine systematic programme of work to update an existing product, process or service by the application or introduction of well established techniques or equipment would not be regarded as R&D.

3.16 The definition of R&D for tax purposes does not extend to routine pre-production work and the capital investment in production equipment associated with it, since technical advances arising from R&D will have ceased at the point when testing of a prototype product has been completed or when the principles of a new production process have been established (both prototypes and pilot plant are discussed in Annex 2).

3.17 Can the distinction between R&D for the creation of a technical advance and routine updating development be further clarified? What criteria might be applied to ensure that routine product, process or service development work entailing the introduction of established principles or technologies to an existing product, process, or service is recognised as not qualifying for tax purposes?

3.18 In relation to the distinction between science and technology on the one hand, and the humanities and social sciences on the other, there are areas where this distinction may be difficult to draw. For example, in relation to virtual reality and multi-media, there are areas of research involving physiological aspects of the interaction between people and machines which would count as natural or applied science, whereas other areas of enquiry would fall outside this definition as more directly involving interactions between people or organisations.

3.19 We would welcome comments on where to draw the dividing line for excluding humanities and social sciences research from R&D.

CHAPTER 4 - APPEALS OVER CLAIMS TO SCIENTIFIC RESEARCH ALLOWANCES

4.1 A number of respondents to "Innovating for the Future" suggested that appeals over claims to scientific research allowances under the capital allowances legislation should be brought within the jurisdiction of the General and Special Commissioners and the Courts, rather than be subject to determination by the Secretary of State for Trade and Industry.

4.2 Transferring decisions on disputes about scientific research from the Secretary of State to the Commissioners and the Courts would involve procedural aspects of the appeals regime which require careful consideration. Even so, whilst there are arguments for retaining the present structure, it may now be appropriate to move closer to the normal tax appeals process.

The present rules for appeals over scientific research allowances

4.3 The present appeals procedure is set out in Section 139(3) CAA 1990. This states:

"If any question arises ..... as to whether, and if so to what extent, any activities constitute or constituted, or any asset is or was being used for, scientific research, the Board shall refer the question for decision to the Secretary of State and his decision shall be final."

4.4 So if exceptionally there is a dispute which the inspector cannot resolve by agreement with the taxpayer, the issue is referred to the Secretary of State for Trade and Industry for decision. His decision is final (subject to judicial review) and confidential. This means that there are no published precedents on which claimants may rely for guidance on what constitutes scientific research.

4.5 The definition of `scientific research' relevant for SRA purposes also applies in the context of approval of scientific research associations* and of any university, college or other similar research institution**. It is not proposed to transfer the administrative arrangements for scientific research associations and these other bodies away from the Secretary of State.

* Section 136(b) CAA 1990
**Section 136(c) CAA 1990

Extent of suggested changes

4.6 When a taxpayer and the Inland Revenue cannot agree on the correct amount of assessable profit or allowable relief, the normal route is for an appeal to be heard by the General or the Special Commissioners. More complex cases are often referred to the Special Commissioners. A Commissioners' decision on a point of law can be appealed by either party, to the High Court and Court of Appeal in England and Wales, to the Court of Appeal in Northern Ireland, and to the Court of Session in Scotland. The ultimate arbiter is the House of Lords.

4.7 This system of appeals applies to all disputed claims to capital allowances other than those involving the meaning of scientific research. The published decisions of the Special Commissioners and the judgements of the Courts provide useful guidance both to taxpayers and the Inland Revenue in subsequent cases involving the same matters of law.

4.8 Some respondents to "Innovating for the Future" suggested that the appeals procedure for SRA should be replaced by this normal right of appeal to the Commissioners and the Courts. They suggested that allowing SRA appeals to be determined by the Commissioners and the Courts would produce a body of case law which would establish clear guidelines for taxpayers and their advisers to follow.

Applying the definition of scientific research

4.9 The existing statutory definition does not contain detailed criteria as to what qualifies as scientific research. In cases where there is a dispute the Secretary of State for Trade and Industry has to apply his judgement within the existing outline definition in deciding whether the activities concerned qualify or not. This system provides a framework which leaves room for flexibility in accommodating scientific and technological developments. But a criticism of the existing system is that, until now, there has been little information publicly available on how the Secretary of State operates the broad definition given in the legislation.

4.10 We intend to address this problem by the publication of guidelines on the application of the existing definition. The draft guidelines in Annex 2 spell out what kinds of activities the Secretary of State would determine to fall within the basic definition of scientific research, and so establish how the statutory definition can be applied in practice by taxpayers and the Inland Revenue, subject to any other conditions imposed by the statutory provision concerned. Where a dispute over the meaning of scientific research is referred to the Secretary of State for Trade and Industry for a decision, the Secretary of State would apply these guidelines.

4.11 If a new appeals procedure were introduced, not involving the Secretary of State, it would be necessary to ensure that the appeal was also determined by reference to the same principles.

4.12 This would not follow if the new appeals procedure left cases to be determined solely on the basis of the existing statutory definition of scientific research as the wording is too general to establish these principles clearly. An independent appeals tribunal might therefore take a broader or narrower view of the meaning of scientific research than the Secretary of State. This would introduce an unacceptable degree of uncertainty over the entitlement of taxpayers and the cost to the Exchequer of the relief. It could take a considerable period before a sufficient body of case law was developed to provide taxpayers and inspectors with the same degree of certainty as offered by the proposed new guidelines.

4.13 In order to ensure that any new appeals system would apply existing principles in determining qualifying R&D activities, it would be necessary to introduce a new, more detailed, statutory definition of scientific research. This approach, which is explored in Chapter 5, would have the advantage that it would make it clearer, in primary legislation, which activities do or do not constitute R&D for tax purposes. It could also help make determinations whether activities so qualify more transparent. But it would reduce the value of the draft guidelines in Annex 2 since, while these would provide guidance to taxpayers and inspectors on which activities qualify, appeals would be decided by reference to the statutory definition only. The greater flexibility offered by the application of non-statutory guidelines within the existing definition, for instance by dealing with boundary problems using qualitative descriptions and examples, would be lost.

4.14 We would welcome comments on how well the publication of the proposed new guidelines addresses the lack of certainty felt about the existing system.

Expert knowledge

4.15 If the inspector and taxpayer are unable to reach agreement on whether an activity is scientific research, the resolution of the dispute will depend on an expert knowledge and understanding of the industry concerned. This requires detailed and specialised scientific and technological knowledge of the particular industry and activities in question.

4.16 Under the present procedures, the DTI is responsible for the provision of the necessary expertise. This is exercised when the application for approval is made by a scientific research association or, in the case of scientific research allowance, when the dispute is referred to the Secretary of State for decision. It was partly in recognition of the need for that expertise to be provided by the Department with ready access to appropriate knowledge and skills that the present arrangements were introduced, with administration split between the Inland Revenue and the DTI. However, the small number of SRA appeals has meant that DTI has not developed an extensive body of expertise in this field.

4.17 If a new appeals procedure independent of the DTI were introduced, it would be necessary to ensure that the appeals tribunal was provided with the necessary expertise. In the more straightforward case, the appeal could be handled by the Inland Revenue before the General or Special Commissioners like a normal tax appeal. But there will be more complex appeals where specialised expertise is required.

4.18 There are various ways in which this might be done

by referring all such appeals to the Special Commissioners who would be able to hear expert witnesses, including independent experts provided at the expense of the Exchequer
by referring all such appeals to the Special Commissioners and giving the Commissioners the power to co-opt an expert member when it hears such an appeal
by establishing a new tribunal for the purpose of hearing such appeals which was composed of, or could draw upon, the services of a panel of experts. The decision of this tribunal could be final.

4.19 There are drawbacks to all these appeal routes, including significant costs. It may be difficult to find independent experts in some fields. It is likely that there would be substantial administrative difficulties in arranging for the necessary experts/expertise to be provided.

4.20 Views are invited on which option in paragraph 4.18 is preferred and how the necessary expertise could best be provided.

Commercial confidentiality

4.21 The issue of confidentiality can be particularly important for claimants to SRA. Taxpayers often wish to ensure complete confidentiality over the nature of the activities for which relief is claimed. Under the present rules, this can be a serious obstacle to the acceptance of claims as the taxpayer may be unwilling to provide the information that the inspector requires in order to satisfy him or herself of the validity of the claim.

4.22 It may be difficult to provide judicial oversight while maintaining confidentiality. Proceedings before the General Commissioners are held in private, and although Special Commissioners' hearings are normally in public they will consider any request for a hearing to be held in private. But in spite of this, the taxpayer may be unwilling to disclose details of the activities to expert members or witnesses, particularly where, as could frequently be the case, the expert works in or has connections with the same field of work.

4.23 It may also be difficult to preserve commercial confidentiality in reports of Special Commissioners' hearings or where the case proceeded to the Courts. One solution might be for all hearings to be in private and for the factual detail in reports to be restricted in such a way as to protect the claimant's commercial interests. But this would diminish any precedent value for other claimants, which is one of the main grounds advanced for transferring jurisdiction from the Secretary of State for Trade and Industry to an independent tribunal.

4.24 The difficulty of protecting commercial confidentiality in this sensitive area was another reason for the introduction of the present arrangements giving the Secretary of State responsibility for appeals.

4.25 Views are invited on how the problem of protecting commercial confidentiality within the judicial system could be overcome and whether the practical compromises this would entail would significantly erode the justification for introducing judicial oversight.

4.26 Views are also sought on how more information on precedents could be provided under the present system of appeals to the Secretary of State without damaging commercial confidentiality.

4.27 More generally, we would welcome views on the various options for dealing with appeals on scientific research expenditure.

CHAPTER 5 - A POSSIBLE NEW STATUTORY DEFINITION OF R&D

5.1 An alternative approach to the problem of specifying more clearly the scope of R&D is to have a detailed statutory definition. The form such a definition might take is set out as a draft clause in Annex 3.

Oil exploration and appraisal

5.2 As noted in Chapter 3, most oil exploration and appraisal expenditure qualifies for SRA at present. Oil exploration and appraisal is not an R&D activity within the Frascati rules and would not be included in the draft clause in annex 3. Further consideration will be given to the best way of continuing with the existing 100% relief for most oil exploration and appraisal expenditure if it were decided to use the statutory definition of R&D for SRA purposes.

Coverage of definition

5.3 The draft clause seeks to express in statutory language the coverage of the Frascati definition of research and experimental development, but excluding research in the humanities and social sciences.

5.4 Comments are invited on how successful the draft clause is in reproducing the essential ideas and boundary conditions in the Frascati definition, in particular the dividing line between experimental development and product development. This requires the exclusion of, for example, routine pre-production work, and of routine product, process or service development, not involving a significantly innovative scientific or technological advance.

5.5 Comments are also invited on how successful the draft clause is in establishing the dividing line between scientific/technological R&D and research in the social sciences and humanities.

CHAPTER 6 - SUMMARY OF ISSUES ON WHICH BUSINESS MAY WISH TO COMMENT

We would welcome your views on the following issues raised in this note. They should be sent to:

Cheryl Scott
Business Tax Division
Inland Revenue
Room 305
Kingsway
LONDON
WC2B 6NR

by 12 February 1999

Chapter 3 - The meaning of `scientific research'

3.5 We would welcome comments on the draft guidelines in Annex 2.

3.10 Comments are invited on how successful the guidelines are in reproducing the essential ideas and boundary conditions in Frascati, in particular the dividing line between experimental development and product development. This requires the exclusion of, for example, routine pre-production work, and of routine product, process or service development, not involving a significantly innovative scientific or technological advance.

3.13 We would welcome further comments on the criteria which might reasonably apply in determining the scope of `experimental development' as it applies to such `installation or improvement' work.

3.16 Can the distinction between R&D for the creation of a technical advance and routine updating development be further clarified? What criteria might be applied to ensure that routine product, process or service development work entailing the introduction of established principles or technologies to an existing product, process, or service is recognised as not qualifying for tax purposes?

3.18 We would welcome comments on where to draw the dividing line for excluding humanities and social sciences research from R&D.

Chapter 4 - Appeals over claims to scientific research allowances

4.14 We would welcome comments on how well the publication of the proposed new guidelines addresses the lack of certainty felt about the existing system.

4.20 Views are invited on which option in paragraph 4.18 is preferred and how the necessary expertise could best be provided.

4.26 Views are also sought on how more information on precedents could be provided under the present system of appeals to the Secretary of State without damaging commercial confidentiality.

4.27 More generally, we would welcome views on the various options for dealing with appeals on scientific research expenditure.

Chapter 5 - A possible new statutory definition of `R&D'

5.5 Comments are also invited on how successful the draft clause is in establishing the dividing line between scientific/technological R&D and research in the social sciences and humanities.

Home

Next | Top

In this section