R&D tax relief is a very valuable tax relief for innovative UK companies. Many companies are successfully claiming relief each year – latest government statistics show that 25,300 companies made R&D tax relief claims in 2015/16 – although many more are clearly still missing out. Of those 25,300 companies that claimed relief in 2015/16, over 93% (23,645) were SMEs.

The relief for SMEs is far more valuable than the relief for large companies so it is really important to correctly identify whether the company is an SME or not. A company will be an SME for R&D purposes if its headcount is below 500 (full time equivalent) and it meets one of two financial tests – either its turnover is not more than €100m or its balance sheet total is not more than €86m (yes, these amounts are specified in Euro, it is a modified EC definition that is used for the UK relief). There are added complications in that it is necessary to consider ‘related’ enterprises. In the jargon of the SME definition these related enterprises are referred to as being either ‘linked’ enterprises or ‘partner’ enterprises.

Enterprises are partner enterprises where one holds 25% or more of the capital or voting rights in the other and it is not a linked enterprise. It is possible for the 25% threshold to be exceeded and for the company still to be autonomous if the threshold is reached or exceeded by any of the following investors:

  • Public investment corporations;
  • Venture capital companies
  • Business angels with an investment in the enterprise not exceeding €1.25m
  • Universities and non-profit research centres.
  • Institutional investors, including regional development funds.
  • Autonomous local authorities with an annual budget of less than €10m and fewer than 5,000 inhabitants.

However, the investors listed above may not hold more than 50% of the capital or voting rights (i.e. they must not be linked, individually or jointly).

Two or more enterprises are linked when they have any of the following relationships:

  • One holds a majority of the shareholder or member voting rights in another.
  • One is entitled to appoint or remove a majority of the administrative, management or supervisory body of another.
  • A contract between them, or a provision in the memorandum or articles of association of one of them, enables one to exercise a dominant influence over the other.
  • One is able, by agreement, to exercise sole control over a majority of the shareholder or member voting rights in another.

An enterprise is autonomous if it has no linked or partner enterprise relationships.

One of the consequences of having linked or partner enterprises is that it is necessary to include data from those enterprises when considering the SME tests outlined above. For partner enterprises it is necessary to include the appropriate proportion of that enterprise’s headcount, turnover and balance sheet total. The appropriate proportion is the percentage of capital or voting rights held (which will be somewhere between 25% and 50%). For linked enterprises it is necessary to include 100% of the linked enterprise’s data. The important point to remember in practice is that, whenever there are linked or partner enterprises it will always be necessary to obtain information from those other enterprises about their headcount, turnover and balance sheet. It is not sufficient just to look at the individual claimant company’s data.

Period of grace

Most of the time, even where there are partner or linked enterprises, identifying whether or not the company is an SME is fairly straightforward but what about those times when the company is growing and begins to fail the tests (or indeed is shrinking and begins to meet the tests)? Those familiar with the UK’s R&D tax relief regime for SMEs will be aware that there are provisions in the EC definition covering the transition to or from SME status. These provisions are often referred to as the ‘period of grace provisions’ and can be found in Article 4(2) of the Annex to Commission Recommendation 2003/361/EC (the definition of an SME).

At the most basic level, the period of grace provisions say that a company will not cease to be (or start being) an SME until it has failed (or met) the SME definition for two successive periods.

Example 1

River Ltd has the following data.


31/12/14 31/12/15 31/12/16
Headcount 200 220 260
Turnover (€) 110m 115m 120m
Balance Sheet (€) 80m 87m 90m


In 2014 River Ltd failed the turnover test but met the balance sheet test and qualified as an SME. In 2015 the company’s balance sheet had grown such that it also failed that test. The company has only failed the SME definition for one year and the period of grace provisions mean that it remains an SME for R&D purposes.

In 2016 the company fails the definition for the second consecutive year and will be treated as a large company from that period.

The period of grace applies whether the company is ‘autonomous’ or has linked or partner enterprises.

The UK legislation – at CTA 2009, s 1120(2) (“Qualification 2”) – disapplies the period of grace provisions where four conditions are satisfied. The first point to stress is that Qualification 2 can never apply to an autonomous enterprise (i.e. one that does not have one or more linked or partner enterprises). The four conditions are as follows. In these conditions ‘C’ refers to the company whose status is being considered.

  • Condition A is that C is an SME, or would be an SME if any partner or linked enterprises were ignored.
  • Condition B is that an enterprise that is a partner or linked enterprise of C exceeds the headcount limit or both of the financial limits without taking account of C’s figures.
  • Condition C is that headcount, turnover and balance sheet data of C’s partner or linked enterprises have been taken into account in determining C’s status.
  • Condition D is that C satisfies the headcount limit and either one of the financial limits when its partner or linked enterprises are ignored.

Qualification 2 was primarily introduced to deal with the scenario of a large company acquiring an SME (in whole or part).

Example 2

Jungleland Ltd is an SME and its data is as follows.

Headcount 50
Turnover €15m
Balance Sheet €10m


On 1 June 2016 Rising Ltd acquired 51% of the share capital in Jungleland Ltd. Rising Ltd’s data is as follows.

Headcount 520
Turnover €80m
Balance Sheet €90m


All of the conditions listed above are met and the period of grace provisions in Article 4(2) are disapplied. Accordingly, Jungleland Ltd will become a large company in the period of acquisition.

Everyone is very familiar with this application of Qualification 2 but many are unaware that it can also apply in another scenario, where there is organic growth as opposed to an acquisition. This scenario also produces a rather bizarre outcome.

Example 3

Frankie Ltd has owned > 50% of the equity of Shenandoah Ltd for some time, they are Linked Enterprises. Shenandoah Ltd is the company we are interested in.


Frankie Ltd’s data is as follows

31/12/16 31/12/17
Headcount 400 510
Turnover €70m €80m
Balance Sheet €50m €60m


Shenandoah Ltd’s data is as follows

31/12/16 31/12/17
Headcount 50 50
Turnover €10m €12m
Balance Sheet €15m €18m


For the year ended 31/12/16, based upon the aggregated data, Shenandoah Ltd is an SME.

For the year ended 31/12/17, the aggregate data means the headcount test is failed. This is the first year that Shenandoah Ltd has failed the tests (based on the aggregate data) so it might be assumed that the period of grace would apply.

Looking at the conditions in CTA 2009, s 1120(2), however, for the year ended 31/12/17.

  • Condition A is satisfied – Shenandoah Ltd would be an SME without Frankie Ltd’s data.
  • Condition B is satisfied – Frankie Ltd exceeds the headcount limit without taking account of Shenandoah Ltd.
  • Condition C is satisfied – the data of Frankie Ltd has been taken into account.
  • Condition D is satisfied – Shenandoah Ltd satisfies all of the tests.

All the conditions are satisfied so the period of grace provisions are disapplied. As a result of the organic growth of Frankie Ltd, Shenandoah Ltd will become a large company in the year to 31/12/17.

That is bad enough but there is a rather bizarre twist to this scenario. Frankie Ltd will actually remain an SME for the period to 31/12/17. Despite being the larger of the two companies, and being the one that has (in this example) actually breached the headcount limit, Frankie Ltd is able to take advantage of the period of grace provisions that are denied to Shenandoah Ltd.

I have raised this issue with HMRC through the R&D Consultative Committee and have suggested that this might be a good example of something that should be tidied up as part of the current administrative review of the R&D reliefs. There was a fairly positive response to that suggestion but time will tell.

Watch this space.