Manufacturers have been hit with increased costs across the board due to rising utility costs and supply chain disruptions, which has led to an increase in inventory and raw material costs. As businesses renew their focus on reducing manufacturing costs, are there any incentives that can support activities to minimise waste or reduce direct production costs?
Consumables for Research and Development (R&D) purposes are particularly relevant to manufacturers as consumables have a large impact on Manufacturing costs. However, when it comes to expenditure on consumables, many manufacturers aren’t aware of what can be claimed for within an R&D claim. Common examples of consumables in manufacturing that can be claimed include materials for the construction of prototypes, materials used in six sigma style process trials or materials used up in batch samples to reduce failures.
It’s also common when building a new product or working on product development that prototype design, batch samples and trials occur to test the product or subsystems within the product. For example, a semiconductor chip manufacturer will trial a new development on a wafer within the production line to see if the device can be produced at volume and with consistency across the wafer diameter. This test may produce many hundreds of individual electrical components, even if a small number are sent for testing this batch will form part of the R&D project. If the trial is directly linked to an eligible project for R&D tax purposes, it’s possible to claim for the production effort and consumable costs associated with this test. The same argument can also apply to large-scale prototypes where a pre-product item can be created for R&D testing purposes.
When it comes to identifying qualifying R&D expenditure on consumables, this is one area where the rules around making a valid claim are complicated. However, this aspect of the claim can make a substantial difference to the overall cash benefit received.
What exactly are consumables and how do you know if they’re eligible for R&D tax relief?
Consumables for R&D tax purposes are items that have been used up or otherwise could be deemed transformable during the R&D activities. Examples would be laboratory consumables or electrical solders used to produce a circuit board as part of the R&D project. However, this definition also extends to batch samples or distinct prototype units. The same applies for large-scale prototypes where a pre-production item will be created for R&D testing purposes. Therefore, within the manufacturing claim, the claimant must ensure that all of the trials and tests that can be claimed are identified, and the associated consumables costs are added into the claim calculation.
Within the manufacturing sector, consumable items can form a large part of an R&D claim when the components or chemicals used are expensive to obtain. Having a clear understanding of what can and can’t be claimed within a production environment or during new product development is critical to get the right benefit from your claim.
Fixed assets are generally not classed as R&D consumables as they have an ongoing value to the company. R&D tax relief is only available for expensed expenditure so any costs booked as fixed assets in the accounts cannot be claimed. These costs would fall under the capital allowances schemes such as annual investment allowances or research and development allowances. These schemes do not provide a cash element for non-tax paying businesses but can be useful for taxpayers as they will reduce the current year’s tax liability.
What happens if you sell the items produced within a manufacturing trial?
In 2015, the rules around R&D tax credits in relation to consumables were updated with a view to limiting benefits where a company is receiving a payment in relation to the output of the R&D activity. Unfortunately, this update made claims within the manufacturing and new product development areas more complex, and we still see many mistakes in claims covering this area.
Prior to this update, it used to be the case that a company could claim under the R&D tax credit scheme for the entire cost of R&D materials irrespective of whether the item was sold. Indeed, many smaller businesses would sell on prototypes to assist with cashflow management so having a sold prototype would be relatively common.
Under the new rules, if a company produces a trial batch with a few items within acceptable performance parameters and these items are passed onto sales, then the consumable costs associated with these items cannot be claimed. If the items are sold as scrap or at a significant loss, then it might be possible still include the consumable costs within the R&D claim. As you can see the rules are tricky to interpret.
In the instance where a new product development process creates a prototype, how do these rules apply in this case? The material cost of this prototype can still be claimed if the purpose of the unit is solely for R&D purposes. There must be no intention to sell or transfer ownership of this item to someone else. However, if an initial prototype unit has been produced for tests and it is identified much later on that this item could be upgraded and sold, then it might be possible to claim for the consumable expenditure. Again, the rules are complex and commercial arrangements of the business need to be taken into account when assessing whether the sold items exclusion applies.
Many businesses are still unaware of the consumables restrictions and make errors in their claims by ignoring this part of the legislation. But equally, we see many businesses shying away from claiming consumable costs as they fear an inquiry from HMRC.
Looking to claim consumable costs under the R&D tax credit scheme?
Firstly, we recommend consulting with an R&D specialist who understands how these rules apply to be clear about which costs are eligible under the R&D scheme. Next, setting up a process to create contemporaneous records around the intent to sell or transfer prototype items is critically important. This should be backed up by up-to-date project data. When preparing your claim, you will need to know what was spent, how this relates to the R&D project and how much of the expenditure is attributable to the R&D work. By keeping accurate records from the outset, making a claim for R&D tax relief is so much easier and less open to errors or missing potentially claimable items.
We also recommend companies budget the R&D claim into their development activities. If the trials and prototypes will attract relief, this might offset some of the costs incurred in development. Potentially under the SME R&D tax relief scheme by capturing these costs and submitting a robust R&D claim you could reduce the cost of a trial by 20%-30%. This will ensure that even with the rate of relief dropping for SMEs making a claim, you can still provide substantial savings and provide a boost to your innovation under the R&D scheme.
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