The dreaded 2nd HMRC enquiry letter

As I covered in a previous article if HMRC decide to check your R&D claim, they will first write to you informing you they are opening an enquiry and they will also ask for some more information.

You might then feel a bit disheartened after sending in your response addressing all of the points raised when HMRC write to you again asking even more questions, some of which you have already answered, however this is actually a really positive sign as it means your R&D claim hasn't been rejected yet.

As the questions in the 2nd HMRC letter can be a bit difficult to answer for those not familiar with enquiries, I've written this article to hopefully help explain what it is HMRC actually want and how best to provide this information to them.

For those readers who aren't aware, this method of dealing with enquiries by HMRC is fairly new and whilst it had some positives it also has some drawbacks, especially for those who prepare their own R&D claims, with one of the main changes being that historically once the company sent in their response to the first HMRC letter, often the inspector dealing with the enquiry would request a call or meeting to discuss the claim in more detail and would then decide if the claim was valid, needed changing in some way, or should be dismissed.

In the case of self prepared R&D claims inspectors understood that the person they were speaking to was not a tax professional, so they worked with them to ensure that the correct outcome was achieved.

Malcolm Henderson who was an HMRC R&D tax inspector for many years said

"When we questioned the competent professional on the activities they thought qualified, we found on quite a few occasions that they were very good at telling us what they'd done, but not how they matched the DTI/BIS/BEIS Guidelines. We had to tease those out, successfully on most occasions"

More recently however, and due to HMRC using case workers to handle enquiries rather than experienced inspectors, they will now send a 2nd letter to the claiming company either dismissing their claim outright, or asking a series of generic questions, rather than having a call with the company to discuss their claim.

This approach seems a little unfair, as sure if HMRC are dealing with a tax consultant or accountant then asking questions relating to tax legislation and guidelines would seem reasonable, but to ask a company owner the same knowing if they don't answer correctly a potentially valid claim will be rejected to me feels wrong. Especially as HMRC themselves say that when you correspond with them you should always provide information "in laymen’s terms" and "provide all explanations in a form understandable to the non-expert"

So what additional information do HMRC ask for in their 2nd letter?

Well some of it might be specific based on your response to their first letter and commonly they will also ask a set of generic questions, regardless of if you have already answered some of them in your first response.

For each I'll give some comments on how best to answer and I'll also provide a sample answer based on the example project in my previous article.

For those who haven't read it, the example was an engineering company attempting to increase the power from a 1.6 litre engine from the 400bhp they knew was possible using current knowledge/technology to 450bhp.

For each project your company claimed R&D tax relief for, please provide:

Your response for each project should detail:?

What the existing product you are measuring each project against?

For this section HMRC are asking if there is an existing product which you are looking to improve, or what did you know was technically possible at the start of the project.

So for our example project the answer would be "We are measuring this project against the existing maximum power achievable from a 1.6L engine using readily deducible methods and technology to increase power, which at the start of the project was 400bhp."

What was the gap in technological knowledge or capability which necessitated the commencement of the R&D?

Now we have defined the projects starting point in the previous question, we need to detail the gap between that and what we were trying to achieve.

"The gap in technological knowledge and/or capability was that we knew by using existing technology and readily deducible methods we could increase the power of the engine to 400bhp, however no technology or information in the public domain existed which we could use, or adapt to reach our project goal of 450bhp."

What was the state of your platform before the R&D commenced, after the R&D activities completion and how does this compare to the rest of the market?

This question is to ensure that the advance you were seeking wasn't just to bring your company in line with others in your sector, but that it represents an advance across the entire market.

If for example a competitor had already launched technology capable to increasing a 1.6litre engine to 450bhp, which you were just going to copy, then this project wouldn't qualify for R&D tax relief, as even if successful no advance in engineering would be created. If however you realised that your competitors technology resulted in a 50% increase in engine emissions, if you attempted to develop technology to achieve the same power increase but with less than a 10% increase in engine emissions, then this would represent a suitable advance as you were looking to improve the existing technology, not just copy it.

"The state of our platform prior to the R&D commencing was that we had technology which could increase the maximum engine power to 400bhp, which was comparable to the rest of our market.

After our R&D project was successful we have now started to sell our technology, and at the time of writing no one else in our market has technology which can increase a 1.6 litre engines power to 450bhp"

Describe the advance or appreciable improvement in the overall field of technology sought or achieved, and its impact on the field as a whole

For this section you should provide HMRC with details of the advance in technology you were trying to create.

Avoid talking about how it will help advance your company only, or how it will advance your industry if you don't work in the same field of technology that the advance was being created in.

For example if your company is in the automotive sector, but your R&D project is software based you should describe the advance sought in computer science, not the advance you sought for the automotive industry.

Where you are simply looking to adopt currently available technology into your industry, this is known as a "change of use" and is disallowed for R&D tax relief purposes, as no advance to the actual technology occurs.

"The advance we were seeking was with regards to engineering, more specifically automotive engineering, and we were attempting to increase the maximum power achievable from 1.6litre engines, from 400bhp to 450bhp.

If we could achieve this then it would represent an advance in automotive engineering and would mean that small volume car manufacturers could stop using larger engines for their vehicles, as our new technology would offer the same performance as commonly used 2.5litre engines, resulting in lower build costs and also lower engine emissions for their vehicles"

All stages from planning to deployment

For this section it's best to provide a project timeline, with dates, for each of the various activities you undertook under the sections Pre R&D, Qualifying R&D and Post R&D. An example can be found in my previous article

Individuals’ involvement at each stage

This section should relate to the staff/subcontractor costs you are claiming for and provide details of who was involved with the project and what activities they undertook.

"Our main engineer, Bob Smith, was involved with all stages of this project and we also engaged a specialist engineering company, ABC Engineering Limited, to assist with the design and development of the various prototype parts required during the R&D stages of the project"

You could also combine the previous section and this one, so on your project timeline include the name of the people/companies involved with each activity.

Contemporaneous project documents that informed and support the R&D relief claim

If you have any project documentation which would help support your claim this should be provided, especially any documents which are dated as this helps HMRC establish that the R&D activities took place during the correct accounting period.

Please send a more detailed explanation of why there was no ‘information that was readily available in the public domain, nor is it readily deductible by a competent professional.’

For this section you should provide information about the research you undertook in an attempt to find a way to reach your project goals without R&D being required and why the known methods of development were not suitable for this project.

"During our research we did find information in the public domain with regards to how to increase an engines power and there are also known methods engineers such as ours are aware of which can be used to increase the power of an engine, these however only offer increased power to a point which in this case was 400bhp and our project goal was 450bhp, so no information in the public domain, or anything which could readily deduced would have allowed us to reach our project goal."

Uncertainty

The uncertainties must be more than challenges or complexities.

·??Please provide any research and analysis your competent professional undertook to establish that the uncertainties listed on your R&D report and supporting information were uncertainties and not complexities and challenges. Please can they explain how the uncertainties for all projects are of a scientific or technological nature as opposed to routine uncertainty. Refer to Para 13, 14, 29 & 30 BEIS (2004) guidelines when formulating your response

Bear in mind that just because your company does not know if something could be done, does not make it an uncertainty.

For the purposes of R&D tax relief there is a clear distinction between complicated non-qualifying projects and those which qualify as they have genuine uncertainty, so this section is designed to demonstrate to HMRC that your project wasn't just complicated and time consuming but that the required uncertainty existed.

The last sentence about your company not knowing if something could be done, is to ensure that the uncertainties you identified were industry wide and not just due to your own lack of knowledge or experience.

"At the start of our project we first undertook a great deal of research by searching online, reading printed technical articles and speaking with other competent professionals working in our field.

We then initially attempted to design our desired technology using the knowledge we had obtained, but found this would not be possible and at this stage we came to the conclusion that the project would not just be complicated, but would be genuine qualifying R&D as it was technically uncertain if the development we were attempting could actually be achieved."

As HMRC mention specific BEIS guidelines it's a good idea to address each of these in turn, as even though a lot of this information you may have already provided putting into context of how it applies to the guidelines will help HMRC see that your project meets the various criteria for qualifying R&D.

BEIS (2004) Para 13, “Scientific or technological uncertainty exists when 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 includes system uncertainty. Scientific or technological uncertainty will often arise from turning something that has already been established as scientifically feasible into a cost-effective, reliable and reproducible process, material, device, product or service”

"We were unable to find any information in the public domain, or any existing engineering methods which would allow us to meet our project goals, both our competent professional and other competent professionals working in the industry we discussed the project with were unable to readily deduce if our project goals would be achievable, so we believe this means that technological uncertainty existed. "

BEIS (2004) Para 14 “Uncertainties that can readily be resolved by a competent professional working in the field are not scientific or technological uncertainties”

"Neither our own competent professional, nor any of the others we spoke to, all of which are working in the field, could readily resolve the uncertainties.?If they had been able to the project would never have reached the R&D stage."

BEIS (2004) Para 29 “System uncertainty is scientific or technological uncertainty that results from the complexity of a system rather than uncertainty about how its individual components behave. For example, in electronic devices, the characteristics of individual components or chips are fixed, but there can still be uncertainty about the best way to combine those components to achieve an overall effect. However, assembling a number of components (or software sub-programs) to an established pattern, or following routine methods for doing so, involves little or no scientific or technological uncertainty.”

"For this project, our prototype was developed using some off the-shelf-components combined with those which we had to design specifically for this project and we also had to develop new engine management technology to control how all of the various components would work together in an attempt to achieve the advance being sought.?This was in no way an established pattern and did not follow any routine methods, as no one had ever attempted to do this before so no such method exists."

BEIS (2004) Para 30 “Similarly, work on combining standard technologies, devices, and/or processes can involve scientific or technological uncertainty even if the principles for their integration are well known. There will be scientific or technological uncertainty if a competent professional working in the field cannot readily deduce how the separate components or sub-systems should be combined to have the intended function”

"We were not just combining standard technologies, as those which already exist would not be fit for purpose.?We were combining some standard technologies with the new technologies we had to develop for this project and then try to develop a suitable way of controlling all the components to achieve our project goals."?

Knowledge Baseline

The baseline must be measured in the field of science and technology as a whole and not just within you own field.

Please provide details of the research conducted to establish your baseline for this project

• Describe the baseline in technology that the advance sought was being measured against

Baseline technology is the term used by HMRC to define the level of technology already available at the start of the R&D project, against which the advance being sought is measured.

HMRC would expect you to have conducted some research at the start of your project, and before undertaking qualifying R&D, to establish what the current baseline is in relation to the technology, not just the baseline for your industry, as only once you know what the technology baseline is can you be certain that what you are looking to develop will represent a genuine advance.

"As we work in the automotive engineering sector we keep up to date with the latest engineering developments by speaking to others in our field and also reading information both online and published for our industry and engineering in general.

These research methods allowed us to correctly identify the technology baseline for the project which our sought advance would be measured against"

Describe the advance or appreciable improvement in the overall field of technology sought or achieved, and its impact on the field as a whole.?

For this section you should expand a bit on your previous answer with regards to the advance you are seeking to create, ideally provide some details about other potential applications of your technology to show that it's a genuine advance for the whole field, with uses other than just the one you are focused on.

For example, if a company was developing technology for use in banks which could analyse billions of customer transactions faster than current technology can achieve to allow them to spot potential fraud quicker, they might describe how this technology could be adapted for use in the health sector to allow patient records to be analysed quicker and potential health issues to be identified sooner.

Or if the technology being developed only has a very narrow application you might provide some information with regards to how this technology will improve other types of projects.

For example, if a company was attempting to develop technology which would mean ground surveys could be undertaken a lot faster, they might describe how this could be used to reduce the time it takes to construct new buildings, which require an initial ground survey, giving examples of the time it takes using current technology vs their desired technology.

"Our industry as a whole is always seeking new engine technology capable of producing more power without needing to use bigger engines.

This is especially crucial at present as much lower emissions limits mean that simply using a bigger engine to give a vehicle more power is no longer feasible and this is a major issue for small volume car manufacturers as they rely heavily on readily available technology to ensure the vehicles they produce are not only as fuel efficient as possible, but that they also meet all relevant emissions standards.

So if we can create our desired technology this would not just represent an advance for ourselves, but also the wider field as it would allow car manufacturers to utilise our technology to improve the vehicles they are developing."

Software Costs

Please confirm if costs for software have been claimed, if yes please ensure you have provided us with?

• the rationale and methodology used to come to any apportionment
• supporting evidence of the total costs and the amount claimed
• confirmation that all the amounts included above have been incurred

If you have included any software costs as part of your R&D expenditure you should provide details of these, if you have apportioned them what calculation you used and any associated invoices.

Confirmation that all of the amounts have been incurred relates to the rule that in order for a cost to be included as part of a claims R&D expenditure that it has to have actually been paid, it can't just be accrued for in your accounts.

"Please find attached an invoice relating to the CAD software licence costs we have included as part of our R&D expenditure. As this software is used for both non-qualifying and qualifying R&D work, with a 80/20 split, we apportioned this cost at 20%.

We settled this invoice 7 days after it was received and please find a partial bank statement also attached to confirm this."

Consumable Costs????????

For consumable costs included in the claim for R&D tax relief please ensure you have provided us with

• the rationale and methodology used to come to any apportionment
• supporting evidence of the amount claimed (For compliance purposes we would need to see all invoices and evidence)

Same as with software HMRC need to see how you calculated your consumable item costs and they also need to see the associated invoices.

"The consumable item costs included for this project were invoiced separately by our subcontractor, ABC Engineering Limited, and please find attached 3 invoices which total the amount we have included as consumable costs for this project.

For the avoidance of doubt all of these invoices were settled prior to our claim being submitted to HMRC and none of these consumable items were used in the creation of a product which has, or will be, sold and were exclusively for use in a prototype system which we will use for internal testing purposes only."

I hope this article has provided some useful information with regards to answering the questions raised in HMRCs 2nd enquiry letter, and if anyone has any specific questions please either leave a comment below, or feel free to drop me a message.