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 clarify who can claim for R&D costs where R&D is contracted out.  

Before this recent change, claimants struggled to establish which party had the valid claim. This led to several claims being taken to a tax tribunal to challenge HMRC’s interpretation, which subsequently found in the taxpayer/claimants' favour.  

Before the Tribunal decisions and when followed strictly, the HMRC stance was 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 from claiming for the same costs.
• HMRC states that any activities carried out 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 have the Tribunal decisions affected this?

There are still some differences when you compare the updated HMRC guidance to the new “contracted” rules. These will still apply for any claim periods not covered by the new rules.

There are several factors to consider, such as;

• If the R&D is incidental to the supply of a product/service, then the company may claim and not the customer.
• If it is clear from the contract that the customer was aware that R&D was necessary to fulfill the order, then it is likely that the R&D has been contracted to the company, so unable to claim but the customer might be able to.
• If the company has a limited degree of autonomy, R&D is likely to have been contracted out.
• If the company has limited financial risk in undertaking the work, it is most likely that the R&D has been contracted out.
• If the company just retains the “know-how” and not the IP, then it is also likely that the R&D was contracted out to them.
• In all cases where it is deemed the R&D was contracted out to the company, they will not be able to claim. The only exceptions are if the customer is a foreign entity, or an entity not within the charge of UK Corporation tax, such as a University.    

Double claiming of relief

The double claiming of relief was likely to occur here. The customer company would often file an R&D claim and the contractor would file one for the same project, most likely without either company knowing. The post-Tribunal rules should clarify this so that only one entity claims for an R&D project. 

If HMRC were to enquire into a claim, they may ask to see contracts and any other communications that exist before making a decision.

Both the updated post Tribunal guidance and 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.