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Rules for R&D tax relief for subcontracted projects is evolving in the UK. Learn about SME, RDEC, and the new Merged Scheme effective April 2024.
In all industries, from IT to manufacturing, companies need to make commercial agreements to deliver innovation. It’s easier, faster and often more cost-effective to contract out elements of projects, or even the entire project, than to take on those tasks in-house without the needed expertise. However, working out who can claim R&D tax relief in a project with chains of contractors and subcontractors is not an easy task.
The new Merged Scheme for R&D tax credits, which comes into effect for all companies with an accounting period beginning on or after 1st April 2024, also comes with new rules around contracting. These updates are intended to clarify the scheme and avoid two separate companies claiming for the same activity.
For the avoidance of doubt, this article refers to the company that contracts or subcontracts another company as the “contracting party” and the company that is contracted or subcontracted as the “contractor”.
R&D tax relief is available to small and medium enterprises (SMEs) and large companies in different ways. SMEs claim through the SME R&D tax scheme, which generally offers higher rates of relief. However, large companies and SMEs unable to claim through the usual SME scheme must use the R&D Expenditure Credit, or RDEC, scheme.
In general, contractors cannot claim for their R&D costs, if it was contracted to it by another company. This avoids “double dipping”, where two companies claim for the same cost (the contracting party claiming for the subcontracted cost and the contractor claiming for the staff time).
Under the RDEC scheme, companies can only claim for specific instances of subcontracting:
Large companies that contract R&D out to SMEs or other large companies cannot claim for this expenditure. In these instances, the contractors (SMEs and other large companies) can claim for the R&D work they do, so long as it is contracted to them by a large company since the contracting party cannot claim for this work and becomes “irrelievable”. These companies must claim through the RDEC scheme for any contracted R&D projects, as the SME scheme cannot be used on subsidised expenditure.
SMEs can claim their subcontracted costs with no restrictions, so long as the R&D forms part of the contracting agreement. For example, a pharmaceutical company contracts a third party for testing. This clearly forms part of the R&D project, as the project cannot continue without this testing. The third-party contractor cannot claim for this work, as they have undertaken no risk and have already been remunerated for the R&D work.
However, it is not as clear which company can claim for the activity in some cases. For example, if the third-party contractor undertook its own R&D to develop a new testing procedure, in order to complete the testing for the pharmaceutical company, this may qualify. The new testing procedure was not agreed upon or known about before the contracting agreement, therefore the contracting party cannot claim for this work.
Each contracting agreement and subsequent R&D will be different, and the facts of each case should be considered separately. When determining which company can claim, you should consider who takes on the financial risk of the work, who retains the IP at the end of the work and what was agreed in the contracting agreement.
With the new Merged Scheme, HMRC specified further which company has the right to claim. These rules apply to claims for accounting periods starting on or after 1st April 2024 and supersede the rules of SME and RDEC schemes.
The biggest change is that large companies can claim for subcontracted costs under the Merged Scheme, opening large companies up to larger claims. With this change, SMEs that previously claimed for projects that were contracted to them by large companies can no longer include these projects in their claims.
The general principle is that the company deciding to initiate the R&D gets relief from that expenditure. Where the contracting party “intended or contemplated” R&D to be carried out by the contractor, it can claim for the contracted-out R&D.
However, for a contracting party to claim R&D tax relief, the R&D that is to be undertaken needs to be clearly conveyed. A statement of the advance in science or technology and what uncertainties need to be addressed, communicated to the contractor, would suffice. The contracting party may do so formally in contract, or in discussions, or in internal documents showing how the activity was required as part of the wider R&D.
If it is not reasonable to assume the contracting party “intended or contemplated” R&D at the point of contract and the contractor initiates R&D, then the contractor may claim.
HMRC’s guidance includes a specific example of this situation:
“Example 18
A company, B, is contracted to provide a product or service which is not R&D, such as constructing a building or developing a software product. From the contract, and the nature of the negotiations to agree it, it is clear to all parties that the customer, A, had no understanding or intention that any R&D should take place. If B undertakes R&D in delivering that product or service, it could claim relief even though it is undertaking R&D on an activity contracted out to it.”
In this case, the contractor undertook R&D to fulfil its obligations to the contracting party. The contracting party did not expect R&D to be involved. Therefore, the contractor may claim for this work.
This follows recent decisions at First-Tier Tax Tribunal, whereby contractors were permitted their claims, despite their R&D work being carried out within a larger, contracted project.
High-level wording in a contract is not enough to show that R&D was intended or contemplated. For example, a clause in a contract or an email that states, “Company A intends for R&D to be carried out by Company B. Company A intends to claim R&D tax relief on this work,” is not enough to prove that Company A actually intended for R&D to be done, as there is no description of the work.
Furthermore, a contract is not the only evidence of “intended or contemplated” R&D. Surrounding circumstances may be taken into account to assess the intent of the contracting agreement. Examples of surrounding circumstances include:
There are cases where the contractor can claim, even where the above conditions have not been met. For example, if the contracting party is not a UK taxpayer or an ineligible company, such as a charity, higher education institution, or UK Government department, they cannot claim R&D tax relief.
In these instances, the contractor can claim for that project, even without clear evidence of who intended the R&D. This is because there is no risk of “double dipping”.
The change in guidance brings complications for companies claiming in different accounting periods. What happens when one company in a contracting agreement follows the old guidance and the other follows the new one?
Fortunately, HMRC released specific guidance to help companies navigate this situation and ensure only one company claims R&D tax relief on any single expense. Ultimately, the rules favour companies who would’ve been able to make a claim under the SME or RDEC schemes but can no longer under the Merged Scheme.
Company A (an SME) contracts Company B (an unconnected SME) to do some work which forms part of its R&D project, but is not explicitly agreed as such under the Merged Scheme rules (i.e., there is no written agreement of what the R&D is). Company A’s accounting period runs from 1st January 2024 to 31st December 2024 (SME scheme) and Company B’s accounting period runs from 1st April 2024 to 31st March 2025 (Merged Scheme). Company A pays £100k to Company B and wants to claim 65% of this. Company B incurs £100k in costs to carry out R&D within this project and wants to claim the total.
In this case:
As the guidance favours those who can claim under the old rules, Company A can claim for this cost and, therefore, Company B cannot.
Company C (a large company) contracts Company D (an SME) and clearly communicated the intention to contract R&D. Company C’s accounting period runs from 1st March 2024 (RDEC Scheme) and Company D’s accounting period runs from 1st April 2024 (Merged Scheme).
In this case:
Company E (an SME) contracts Company F (an unconnected SME) to deliver a product which represents an advance in the field and involves R&D. Company E’s accounting period runs from 1st April 2024 (Merged Scheme) and Company F’s runs from 1st March 2024 (SME scheme).
In this case:
Claims must be made under one scheme or the other. For a company with an accounting period beginning before 1st April 2024, the claim is entirely under the SME scheme or the RDEC scheme, even if the accounting period crosses 1st April 2024. The Merged scheme rules cannot apply, even if they are more generous than the previous rules.
For example, a large company with an accounting period running from 1st March 2024 cannot claim any of its subcontracted costs, even though 11 of the 12 months of the fall after 1st April 2024.
Companies can shorten or lengthen their accounting period to match the rule change. Of course, companies should consider the other consequences of changing their period, but it may well be worth it to be able to claim eleven months of extra costs!
Effective from accounting periods starting on or after 1st April 2024, only activities physically performed in the UK by contractors can be claimed. This is part of the government’s efforts to benefit innovation within the UK.
In some very special circumstances, overseas costs may be claimed. Claiming for overseas contractor payments will only be possible if all the following conditions are met:
The guidance provides a non-exhaustive list with supporting examples of what could be considered ‘wholly unreasonable’ for a company to replicate the R&D activity in the UK. These include:
Essentially, if you cannot reasonably replicate the conditions for your R&D in the UK and thus can only complete your R&D overseas, this expenditure may still be included.
The guidance is explicit that the cost of the R&D activity and the availability of workers to carry out the R&D activity are not an exception to the general rule. This means that choosing overseas contractors because they are cheaper or more readily available will not be acceptable by HMRC as a reason for claiming that expenditure.
HMRC recommends claimants of overseas expenditure provide evidence of the selection process and compare the options of contractors, to substantiate any claim of this kind.
If the contractor is not connected to the claimant company, the cost is always reduced to 65% of the relevant R&D invoice value, to account for the mark-up of an invoice from a third party. This means that if 100% of an invoice is R&D, only 65% can be claimed. If only 50% is R&D, then 32.5% (or half of 65%) of it can be claimed.
However, the rules are complicated for connected parties, and a ‘look through test’ needs to be undertaken to determine the actual costs incurred. This means that you have to look at the work being undertaken by the connected party and only include eligible R&D expenditure at cost value (i.e., without markup). A contractor is connected to the claimant company if:
A company may elect, with the contractor, to be treated as connected by making a joint election (and therefore benefit from the full 100%). This can be done by writing to HMRC within two years from the end of the accounting period in which the contract was entered into.
It is important to note that any payments to a contractor who is also a director of the company cannot be included in an R&D tax relief claim.
Work needed for the R&D project to proceed is eligible R&D activity. Contractors may take on small elements of a project or the bulk of the R&D.
Not all subcontracted work is reinventing the wheel. Sometimes the work contracted will be relatively “standard” but is required within an R&D project. For example, testing is not in itself an uncertainty as it’s known how to proceed, but crucial to R&D.
With HMRC’s efforts to curb companies abusing the scheme, a cap was introduced on the payable tax credit that a company can receive. The measure limits the tax credit an SME can claim to £20,000 plus 300% of its total Pay as you Earn (PAYE) and National Insurance Contributions (NICs) for the period.
The exemptions are companies whose employees are creating or managing IP and who do not spend more than 15% of their R&D expenditure on connected contractors or externally provided workers (EPWs).
This impacts companies with low PAYE costs and high subcontracting costs may find their benefit capped.
At Myriad, our team has experience with all types of claims and all levels of complexity. If you’re looking to make sure your subcontracted costs can still be included under the new rules, or have questions about claiming connected costs, we’re here to help.
With an increase in HMRC scrutiny, especially around subcontracted elements, it might save you time and effort getting it right now instead of under a compliance check.
At Myriad, we're not just another tax incentives consultancy; we deliver high-quality services while eliminating your risk.
Our promise to you is simple: we stand firmly behind our advice. If a claim submitted by us is challenged, we'll defend it free of charge. If your claim is rejected, we won't charge you any fees. We'll cover any HMRC penalties and even compensate you for your time.
By leveraging our expertise, you can focus on what you do best – innovating and growing your business – while we ensure you receive the maximum R&D tax relief you're entitled to. We have experience at all levels of legal disputes with HMRC over R&D tax relief, from the first response following a letter through the letterbox to delivering ground-breaking decisions at First-Tier Tax Tribunal.
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