Contracted-out R&D: long sought after clarity from HMRC?

After our last article 'The R&D intensive SME regime', we are now looking at changes to research and development (R&D) tax reliefs announced in the Autumn Statement. We explore the intended changes to the definition of contracted-out R&D. HMRC identifies this as an area often prone to errors in R&D claims. 

The UK tax system provides tax reliefs to encourage businesses to invest in R&D. These investments aim to develop market-leading products, increase profitability and productivity, and boost economic growth. Successful R&D outcomes often depend on cross-disciplinary collaboration and knowledge sharing among businesses to bring in new ideas and views to ‘fill in the gaps’ of development work. This collaboration is often achieved by contracting out a portion of the R&D activities. 

Following consultation, changes to the contracted-out R&D provisions within the tax legislation are contained in the Finance Act (FA) 2024. These changes apply to accounting periods beginning on or after 1 April 2024. Although the legislation has now been enacted, HMRC is still finalising their guidance on this matter. Therefore, we might see further changes in the nuances of HMRC’s interpretation. To understand these changes, it’s important to first consider the pre-FA 2024 rules on what constitutes contracted-out activity for R&D tax relief purposes.

The pre-Finance Act 2024 position

HMRC’s current guidance attempts to define contracted-out R&D activity (which it refers to here as subcontracted R&D activity) as follows:

‘Where there is a contract between persons for activities to be carried out by one for the other, and those activities form the whole of an R&D project or are part of a wider R&D project, then R&D activities have been subcontracted.’

So far, so good, but the guidance recognises a variety of contractual arrangements that HMRC may or may not consider as contracted-out R&D. This ambiguity has led to a steady stream of cases either heard or queued for tribunal hearings.

To illustrate, if a company carries out its own R&D and merely receives a subsidy from another entity, this does not constitute contracting out – it’s subsidised expenditure. A consultant providing expert advice and charging for their time may not equate to contracting out R&D, depending on the circumstances. On the other hand, consider a situation where two companies are both undertaking R&D on the same subject and decide to pursue the R&D jointly. This is collaborative research, and each company would potentially be eligible for R&D relief on its share of the qualifying expenditure, rather than claiming for subcontracted R&D. This is a complex area where ambiguity, misinterpretation, and confusion are prevalent. 

The Finance Act 2024 position

The government has sought to develop a single definition of contracted-out R&D activity which will apply for claims made from accounting periods beginning on or after 1 April 2024. HMRC states that the over-riding principle is that the person making the decision to undertake R&D should be able to claim. This means that, when R&D activities are contracted out, the ability to claim will lie with the customer rather than the contractor, unless (broadly) the customer is not within the scope of UK tax. 

Key conditions within the definition include the following:

• a contract must exist between a customer (Company A) and the contractor. If no contract exists, then it’s not contracted-out R&D;
• if it’s ‘reasonable to assume’ that the customer ‘intended or contemplated’ that R&D would be undertaken to meet the obligations of the contract, and R&D activities do indeed take place, then the R&D is contracted out.

To provide more clarity for claimants, HMRC published draft guidance for consultation in February 2024. Alongside a long list of worked examples, the guidance states that it is necessary to look at the overall circumstances in full detail. This is to determine whether Company A’s primary objective is to have a project completed (eg construction of a building or development of software) or whether Company A’s primary objective is to conduct R&D. The relevant circumstances might include:

• intellectual property (IP) ownership;
• financial risk involved in undertaking the work;
• autonomy in how the activity is executed;
• the means by which the R&D is to be ultimately exploited;
• the decision-making process (for example, whether the motivation to undertake the R&D stems from the customer’s wider strategy, or an immediate tactical challenge identified by the contractor);
• the experience and seniority of the decision-takers; and
• the nature of the parties (for instance, whether it is evident that the contractor specialises in providing R&D services and the contract is typical of those R&D activities).

The guidance states that in many cases (eg the contracting out of routine activities that form part of the customer’s R&D project), it should be clear that only the customer can claim. It’s the responsibility of all claimants to assess all available information and to be able to justify their reasoning. The guidance also indicates that high-level wording in a contract specifying that R&D is required would not necessarily be sufficient to satisfy the ‘intended or contemplated’ test. Therefore, a customer cannot reserve the right to claim (and thereby deny the contractor this right) simply by adding a clause to the contract.

Long sought-after clarity?

Rewarding the company that makes the decision to undertake the R&D with the ability to make a claim is logical. However, this relies on them knowing that R&D needs to be undertaken. Due to the inherent specialist nature of the work in this area, the line between routine work and qualifying R&D may not be clear for either party.

Overall, HMRC’s guidance is helpful and there are plenty of examples that will help provide greater clarity for claimants. It also suggests that HMRC intends to adopt a more pragmatic approach than initially thought. Going forward, it will be necessary to look at contracts in detail and understand the wider circumstances of the R&D. Claimants should also consider the evidence they retain to support their conclusions.

In many situations, the new rules in relation to contracted-out R&D will necessitate discussion and agreement between all parties involved in a relevant contractual relationship. While this dialogue will potentially bring clarity, it also raises the possibility that terms may change to determine or reflect which party can make an R&D tax relief claim. Where one party benefits, the counterparty may be at a disadvantage.

The government has sought to develop a single definition in respect of contracted-out R&D activity, thereby resolving an area of uncertainty. It remains to be seen whether the complexity of the definition, combined with the evidential requirements, will allow this aim to be achieved.

To find out more about contracted-out R&D please contact Chris Alderman.