When claiming R&D tax credits through the UK Government’s research and development SME incentive scheme, businesses are able to surrender their losses for cash credit.
Is this the right call?
In the majority of instances, yes - but it’s a tad more complicated than that, as it ultimately depends on the company's current and projected financial standing.
Unprofitable businesses can surrender their losses through the SME R&D scheme to produce a payable tax credit. This creates additional cash flow that can prove invaluable to many early-stage SMEs.
However, it can often be better to carry your losses forward.
But what do all these terms mean? How and why can surrendering losses help businesses? What’s the best option for your SME?
Today, we’re exploring exactly that - breaking down all the vital know-how to help your business reach an informed decision.
What is loss surrender?
Surrendering your losses through the SME R&D scheme allows you to trade in your losses for a cash credit.
This cash credit is typically worth 14.5% of your enhanced expenditure (the total qualifying expenditure plus your R&D enhancement). In total, this means it’s worth 230% of your total qualifying expenditure.
Remember: R&D enhancement is the artificial increase of the total qualifying expenditure by a fixed percentage.
So, this means that surrendering losses yields a total cash credit worth 33.35% of qualifying expenditure. For example, a project with £200,000 worth of eligible expenditure could yield losses for a cash credit worth £66,700.
This cash credit is yours to spend how you wish, on anything from hiring new equipment to reinvesting in further research and development activity.
What about carrying losses forward?
Alternatively, you can carry your company losses forward as opposed to surrendering them. This allows you to offset your loss against future profits.
Put more simply, carrying your losses forward is the practice of using losses to reduce the amount of future profit your company makes.
Remember that these losses will have been enhanced by your SME scheme claim, meaning you’ll be able to offset a higher percentage of your profits.
The benefit of this is simple: the more profit you offset, the less Corporation Tax you’re due to pay.
Ultimately, carrying losses forward means trading enhanced expenditure for a tax reduction. This amounts to a reduction rate of 19p per £1.
Once you’ve incorporated your total R&D enhancement, your Corporation Tax reduction could be worth as much as 43.7% of your overall qualifying expenditure.
Compare this to surrendering losses, which is worth just 33.35% of total qualifying expenditure - a difference of over 10%.
Which option is right for your business?
Carrying your losses forward is worth an extra 10% to your business, so you’d be forgiven for assuming this was always the right option for your busines
But this isn’t the case.
Why? Because, in order to carry losses forward to offset against future profits, your company needs to, well, make a future profit!
So, if you’re projected to continue making losses throughout the next few years, it’s often a better option to surrender your losses for the immediate cash flow.
This is particularly true if you’re a loss-making company planning to conduct further research and development in the near future.
An immediate cash flow can be a tempting prospect even for companies projecting profits - it’s all about how big and how assured those profits will be.
One way to reach the right decision for your business is to calculate discounted cash flow. This approach enables you to accurately represent the fact that cash in hand today is more valuable than a cash increase further down the line (e.g. in a year’s time).
Why’s this important to do? Well, the logic dictates that cash in hand today could be wisely invested back into the business to reap quicker returns.
So, any cash you receive further down the line needs to provide equal value to the original potential return on investment at a minimum to justify carrying your losses forward.
Let’s look at an example.
Wise internal reinvestment could mean your R&D tax credit fund reaps a handsome 10% return on your business’s assets. This is known as the internal rate of return (IRR).
So, £100,000 with a 10% IRR today would be worth £110,000 in a year’s time.
Remember: surrendering your losses will entitle you to an immediate cash credit worth 14.5% of your enhanced expenditure.
Working to these numbers, a 10% IRR would make this 14.5% today worth:
- 95% in 1 year’s time
- 54% in 2 years’ time
- 29% in 3 years’ time
Based on these calculations, it’s clear that a business in this situation would be better off surrendering losses and reinvesting.
But what about companies with a higher IRR than 10%? Indeed, many pre-profit startups and SMEs will be aiming for a far higher internal rate of return.
Of course, the higher the potential growth rate, the higher the potential for return. A company with an achievable 50% growth rate would see their 14.5% cash credit worth 21.75% in a year, for example.
For this reason, a company with high growth potential in its near future is often best off surrendering losses.
There are exceptions where carrying losses forward may well be more beneficial - for example, in the case of a business that’s historically invested heavily but plans to switch to a profit-first model.
In instances where businesses are confident in making the move from loss-making to profit-generating within a tax year (and providing there’s plenty of money in the bank to fund overheads), it could be better to keep losses unsurrendered and offset against greater future profit.
Knowing when to surrender your losses - and how to file them in a claim - can be a complex skill to master, but could make a meaningful difference to your business’s bottom line.
To make sure you’re maximising your funding, Lumo is on hand to guide you through the process without the hassle. Get in touch with our team of R&D experts today to find out more.