What the Pre-Budget Report Really Said – Alex Chapman

The initial reaction to last week’s Pre-Budget Report (PBR) was that there was nothing in it for the games sector (unless you wanted to trade in your old boiler). However while there was no overt tax break announced for “culturally British” games, as the industry had been campaigning for, the Chancellor has provided a much needed tax benefit. Indeed the change to the tax system is one that benefits all developers – not just those that produce “culturally British” games.

That change is to the Research and Development Tax Credit System and means that all developers can now benefit from the scheme in a way that they couldn’t before.

Tucked away in note six to the PBR is a brief mention about intellectual property requirements: It means that developers no longer need to own the IP in the product of their research and development in order to qualify for an R&D Tax Credit.

What Does the Change Actually Mean?

Before the PBR amendment there were two main qualifying criteria for R&D Tax Credits (and still are for companies making claims in respect of accounting periods ending before 9 December 2009):

• 1: The R&D project “seeks to achieve an advance in overall knowledge or capability in a field of science or technology through the resolution of scientific or technological uncertainty”
• 2: The developer “must own any intellectual property that might arise from the project”

The first category has generally never been a problem for most games developers, because the work undertaken by them is inherently innovative and necessarily involves research and development. Her Majesty’s Revenue & Customs gives an example of R&D as being “an appreciable improvement to an existing process, material, device, product or service through scientific or technological changes” – which is what developers do on a daily basis. Therefore developers have generally always satisfied the first criteria.

However because most large scale games development in the UK is work-for-hire, a significant proportion of the R&D that many UK developers undertake does – or did not – obviously satisfy the second criteria.

An Opportunity Not to be Missed

Generally-speaking these developers will own their underlying development tools and technology and know how and will have a right to claim in respect of certain other IP that they have created. However that is not always the case especially for developers working on ports or conversions or using the publisher’s own underlying tools and technology.

Even where it is the case, in large scale projects funded by publishers, the developer is generally required to transfer the copyright in the rest of the game to the commissioning publisher. This therefore removed a significant proportion of the research and development spend from the tax credit claim or else created difficulties in persuading HMRC over the level of tax credit a developer should receive.

There are (and were) ways of squeezing more R&D spend into a claim (which I explain later) but they relied on the subtleties of tax law, intellectual property law and the intimate workings of games development contracts. This meant that some developers didn’t claim everything they were entitled to, or simply didn’t bother claiming at all – and those that did often saw their claims rejected because of these complexities.

So while the strict legal position is that developers were already entitled to claim for a great deal more that they have been, this announcement in the PBR will make it easier for developers to claim in respect to their entire R&D spend rather than just a proportion of it. Therefore the impact can be felt by all developers, and so the impact on the industry could be significant.

So How Does it Save you Money?

If, for example, you are a SME and spend GBP 100,000 on salaries for staff involved in pure R&D work, that GBP 100,000 becomes GBP 175,000 for the purpose of calculating your corporation tax liability.

The rate of corporation tax for many small companies is currently 21 per cent, so in this example, if the company is profit-making, this relief is worth an extra GBP 15,750 in tax it would otherwise have paid.

If you are a loss-making SME, using the same expenditure as above, you could opt to sacrifice the GBP 100,000 (not the GBP 175,000) from your corporation tax loss and get a cash tax credit instead from HMRC of 24.5 per cent – in this example GBP 24,500.

To a loss-making start-up this cash tax credit can be a lifeline, but it is a lifeline many companies fail to see, let alone grasp – but it should be noted that there is a requirement to have paid sufficient PAYE in the claim period to cover your cash tax credit.

In Summary

As is evident, many of the costs that qualify as R&D are typical costs for start-up SMEs. At the same time, there is a strong chance that many SMEs incur this standard expenditure on R&D, directly or indirectly.

However, SMEs often incur this expenditure without realising the opportunity that is available to recoup against it via R&D tax credits. Given the subjective nature of R&D, and the considerable scope within the HMRC definition, companies need to look closely at their activities to ensure they do not overlook a tax break that was created with a genuine motivation to encourage these businesses to continue to innovate.

But There’s More – Alex Chapman

It is worth stressing that developers should also consider carefully the claims for R&D Tax Credits prior to the new regime being effective – ie December 9, 2009.

There is no question in my mind that the tax change opens up the system for developers and removes a significant barrier to claims. However with an expert hand to guide them, developers could also find that they can claim much more than they might have thought under the ‘old rules’. This is because the definition of intellectual property under the old rules was sufficiently wide as to give developers much greater room to claim if they set out their claims appropriately.

Many developers consider the intellectual property requirement and the fact that under their development contracts the project is described as a “work made for hire” and therefore consider that it precludes them from claiming in respect of the R&D spend on anything other than the core underlying development tools or technology that they expressly own.

However This is Incorrect – Even Under the Old Rules

The new rules remove the issue going forward but it is worth knowing that there is a difference between what intellectual property would be assigned to a publisher as a “work made for hire” and what intellectual property would be created by a developer in the development of a game that would qualify as R&D spend.

However a “work made for hire” has a specific meaning that comes from US legislation – the United States Copyright Act (1976) – and importantly only relates to copyright works. Under section 102 of that Act it is expressly stated that copyright protection extends to (and therefore a “work made for hire” can only include) “original works of authorship fixed in any tangible medium of expression, now known or later developed, from which they can be perceived, reproduced, or otherwise communicated, either directly or with the aid of a machine or device.” That means it does not include anything in which copyright does not subsist.

However, intellectual property for the purpose of R&D tax credits includes “any industrial information or techniques likely to assist in the manufacture or processing of goods or materials”.

Industrial information includes development techniques, methodologies and processes. It is not protected by copyright and so is not necessarily transferred to the commissioner of a “work made for hire”. Additionally recent court cases have held that there is no copyright in the functionality or “feel” of software.

Therefore when considering the intellectual property that is retained by a developer under a contract expressing the project to be a “work made for hire” or otherwise assigning the copyright in the project, developers should note that they in fact retain far more than they might think and can therefore claim in respect of a greater R&D spend than they might think.

And That’s Not All

In addition developers should consider also that while they might not retain copyright in any art, environments and models under the old R&D tax credit rules it may still be possible to claim in respect of the R&D spend associated with their creation.

This is because the developer may have also be devising a new physics engine or lighting technology which will form part of its development tools and technology and which are typically carved out from any transfer of rights to a publisher. In order to research and develop that physics engine or lighting technology it is necessary to test it and the only way to do that is to have suitable art, environments and models. Accordingly there is a good case for including that spend.

A remaining consideration (and one that HMRC may now look more closely at) is that an R&D tax claim may be reduced or rejected to the extent that the R&D spend is considered to be “subsidised expenditure”. HMRC have taken a mixed approach on this issue and have at times argued that if a developer is paid to produce a game then the developer has been subsidised in respect of the R&D component also.

However this is, in my view an incorrect position. Firstly as anyone involved in games development knows, publishers are not in the business of subsidizing a developer’s R&D. The contracts clearly say that the developer must deliver on a time and date and if the developer decides to engage in risky R&D as part of that development that is up to it – no delivery no payment.

Therefore the developer has a choice – engage in R&D for the new physics engine or lighting technology or license it in. The R&D has much greater risk attached but it seeks to “achieve an advance in overall knowledge or capability in a field of science or technology through the resolution of scientific or technological uncertainty” and should therefore be rewarded with the R&D tax credit. That, at least is why the system exists.

In Conclusion

Of course each contract is different and each situation will turn on its facts (and this article isn’t a substitute for taking appropriate advice on your circumstances) but it should be apparent that the change to the R&D tax scheme could have a significant impact for all developers and it also allows us to bring into focus that, at a time when there is some angst over the support the government gives the industry we should all look to see if we are making the best out of what is already on offer.

With that in mind it pays to work closely with accountants and lawyers who understand the system and importantly understand games development contracts (and intellectual property for past accounting periods). The announcement in the PBR should substantially increase what can be considered R&D spend for many developers and should also make it considerably easier to claim. However an eye should be had on the small print and the principle of subsidised expenditure.

Article Authors:

Alex Chapman
Sheridans

Will Taylor
Lucraft Hodgson & Dawes