Subcontractor rules for R&D Tax Relief Claims (before 1 April 2024)

The rules on outsourcing R&D work to subcontractors can seem complex for companies looking to claim R&D tax relief on the project expenditure. 

Although HMRC has introduced more straightforward rules from 1 April 2024*, before this, many claimants found it difficult to establish which party could claim the expenditure as part of their R&D tax relief claim.

This blog aims to clarify the “old” rules surrounding subcontracted R&D projects, as these will still apply for accounting periods beginning prior to 1 April 2024. 

*This applies for accounting periods beginning on or after 1 April 2024

The SME scheme

For the SME Scheme, the company paying for subcontracted R&D work that is relevant R&D for the company has the right to claim the costs as qualifying R&D expenditure.  

If payment is being made to an unconnected subcontractor, they may include 65% of that cost in their claim. 

If the payment is made to a “connected” company, then they may include whichever is lower: 

1. the payment it makes to the subcontractor, and 
2. the relevant expenditure of the subcontractor (actual cost incurred by the connected company to provide that service). 

Determining whether R&D is being subcontracted involves examining the commercial arrangement between the parties, with important indicators such as the following playing crucial roles:  

• payment specifics 
• financial risk 
• autonomy in work 
• deliverables
• ownership of intellectual property (IP)

The RDEC scheme*

The RDEC scheme's rules differ from those of the SME scheme. Subcontracted R&D work to another company cannot be included in the claim. Only costs subcontracted to individuals, partnerships and qualifying bodies (typically a University) are allowed.   

However, in certain circumstances SMEs subcontracted for R&D work can make a claim under the RDEC scheme. This is where the work has been subcontracted to them by a “Large” company, a company not within the charge of UK Corporation Tax (such as an overseas entity), a Charity, a Government Agency or a Higher Education establishment. 

*From 1 April 2024 there is a new merged RDEC scheme. 

Work contracted out as part of a commercial contract

The new “contracted” rules have clarified who can claim for R&D costs where R&D is contracted out.  

Before this recent change, the difficulty claimants had in establishing which party had the valid claim has led to several claims being taken to a tax tribunal to challenge HMRC’s interpretation, with decisions yet to be published (as at April 2024).  

However, when followed strictly, the HMRC stance is as follows:

• Expenditure incurred by a company when carrying out activities contracted by another person/company is not a qualifying expenditure. This is intended to prevent both parties claiming for the same costs.
• HMRC states that any activities carried out in order to fulfil the terms of a contract are considered to have been contracted to the company.
• However, where the company carries out relevant R&D after the contract has been fulfilled, those post-contract activities will not have been contracted to the company.  

How does this work practically?

For instance, companies in the technology sector or construction industry will often be providing their services under a contract. However, this can often be a commercial contract where R&D is not specified by the customer, and it is only once the company begins work on the contract that they discover they need to do some R&D. 

Following HMRC’s strict interpretation of the rules, they are likely to deem the R&D project to be the customer's project, even though the customer may have no idea what the advance in science or technology was, the technical uncertainties that had to be overcome, or how this was done.  

Double claiming of relief

This was potentially where the double claiming of the relief was occurring, as often the customer company would make an R&D claim as well as the contractor that had actually performed the R&D activity, so both are making an R&D claim for the same project – most likely without either company knowing that.

Things to consider would be:

• autonomy over the project
• financial risk
• ownership of the intellectual property (IP)
• knowledge and direction/control of the activities
• terms of the contract.

Where most of these points lay with the contractor and not the customer, then the tax tribunal cases are believed to be challenging HMRC’s view that it is the customer's R&D and not the contractors that can claim the R&D expenditure.  

HMRC will typically challenge the contractual arrangement during an enquiry and ask to see contracts and any other communications that exist before making a decision.

The new “contracted” rules that apply for accounting periods beginning on or after 1 April 2024 have brought much-needed clarity to this complex area of R&D tax relief.

Always seek advice if you are unsure

If you are uncertain how subcontracted R&D work may impact your R&D tax relief claim, we strongly recommend speaking to an expert who can analyse the details and ensure your claim fully complies with whichever scheme you are claiming under.

The Radius team at Shorts is happy to assist in this area and will also provide a free review of an ongoing or historical claim.