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A sign of HMRC's increasing scrutiny of R&D expenditure - DNAe Group Holdings Ltd v HMRC

Posted on 15 November 2021

In the recent case of DNAe Group Holdings Ltd v HMRC, the First-tier Tribunal (FTT) heard the appellant’s appeal against HMRC's determination that they were not entitled to claim 125% research and development tax credits that were available to Small or Medium Sized Enterprise (SME).

Section 1119(1) of the Corporation Tax Act 2009 defines an SME as:

" (1) In this Part “small or medium-sized enterprise” means a micro, small or medium-sized enterprise as defined in Commission Recommendation (EC) No 2003/361, but subject to the qualifications in section 1120."

The case highlights that the intention behind making an investment is absolutely key in determining eligibility for certain reliefs.  It also acts as a reminder that HMRC are scrutinising claims in detail, and illustrates the lengths to which they will go to when considering whether or not a company qualifies for SME R&D tax relief.  It also comes at a time when HMRC is increasing the number of compliance officers to focus on R&D tax relief to ramp up efforts to combat perceived abuse of such relief.

The Case

DNAe Group Holdings Ltd (DNAe) was a research and development company focused on gene sequencing. The issue was HMRC's contention that DNAe was not an SME, because Edith Grove Ltd (EGL) who held more than 25% of the shares in DNAe could not be a considered a venture capital company within the meaning of paragraph 2(a) of Article 3 of the Annex to Commission Recommendation (EC) No 2003/361.

Under Article 2 of the Recommendation, an SME was defined by reference to its staff headcount and financial criteria. Where the enterprise was autonomous, only its headcount and financials would be taken into account. However, where an enterprise had Partner enterprises, the finances of the Partner enterprises were taken into account when determining whether the entity was in fact an SME. In the case of DNAe the issue of whether EGL was its Partner enterprise would be determinative with respect to whether they could claim the level of relief they were seeking.

Paragraph (2)(a) of Article 3 provides that any enterprise may still be regarded as autonomous even where there was an entity that held 25% or more capital or voting rights in the enterprise, so long as the shareholding entity was not "linked" and constituted one of the entities listed in paragraph 2, which included a venture capital company.

HMRC contended that EGL had been set up for the strategic purpose of investing in DNAe to benefit its own parent company and that this meant that it could not be regarded as a venture capital company.

The FTT considered previous cases dealing with the definition of venture capital companies, which concluded that it was matter of judicial notice. It also considered HMRC's guidance CIRD92100 which stated amongst other things what they expected a venture capital company to make:

"… We have seen examples of large groups that, through a group member, make strategic investments in new activities that have an obvious link with the overall business of the group. In these circumstances we would be unlikely to consider that the company was acting as a venture capital company if its aims were closely linked with the strategic aims of the group business."

The FTT went on to list the characteristics that a venture capital company would typically exhibit. This included making speculative new high-risk investments, maximising the return on investment by an exit strategy and focusing on the balance sheet value of the investee company rather than its day-to-day trading.

The FTT regarded the question of whether an investment was made for strategic purposes to be one of fact and degree. The FTT concluded that EGL was a venture capital company. The FTT rejected HMRC's assertion that EGL's primary purpose was to realise a strategic benefit for its parent company. The FTT concluded that EGL's actual objective in investing in DNAe was to make speculative high-risk investments and maximise its return on investment by an exit strategy and that any strategic benefit to EGL's parent company was ancillary. The FTT further concluded that HMRC had failed to clearly articulate what benefit EGL's parent company was supposed to gain from its investment in DNAe, and the appeal was therefore allowed.

Comment by Paul Noble

"Where claims for tax relief are made, detailed scrutiny from HMRC can be expected to ensure that the claims are valid and in cases such as this that the claimant company qualifies for SME R&D tax relief.  The case also serves as a reminder that the intentions of the parties need to be considered when looking at the holding structure of the company claiming relief and the value in having contemporaneous documentation to prove this.

HMRC's recruitment of additional compliance officers to work in this area serves as a warning that they think there are both misunderstandings and abuse of the current system.

These two elements of intention and availability of supporting documentation are key to the chance of success or otherwise in many tax disputes and their importance cannot be stressed enough.  Knowing how to navigate such disputes and weigh up the route to resolution either through Alternative Dispute Resolution (ADR) or litigation has never been as important."

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