Subcontracted R&D: Long sought after clarity from HMRC, but will it be good for UK innovation?

Following the last article about 'The R&D intensive SME regime', this article looks at changes to the 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. 

One of the reasons for offering a targeted R&D tax relief in the UK tax system is to reduce the net cost of R&D investment and encourage more of it. In turn, the expectation is that if successful, these R&D activities will generate economic growth through increased business profitability and productivity. Achieving successful R&D outcomes often depends on how businesses can collaborate on development work as well as share knowledge and expertise. This model requires businesses to work with experts from other fields to bring in new ideas and views to ‘fill in the gaps’ of development work.

The UK R&D tax relief regime for small and medium sized enterprises (‘SMEs’) has historically offered some claimants the option to include outsourced R&D within their qualifying project costs. This option is also available, but to a lesser extent, under the R&D Expenditure Credit (RDEC) regime. In recent years, the definition of subcontracted activities has been the subject of disagreement between HMRC and taxpayers. Core to the different interpretations applied by HMRC and advisers/claimants has been the lack of a clear definition in the legislation.

Following a period of consultation, changes to the ‘subcontracted’ R&D provisions are included within draft legislation due to be enacted in early 2024. To understand the changes, let’s outline the existing rules and what is subcontracted activity for R&D purposes.

The current position

The rules for qualifying subcontracted R&D expenditure differ under the SME and RDEC scheme. For an SME company (company one), qualifying expenditure includes payments made to another person (company two) to carry out activities that are part of company one’s relevant R&D. For a large company, such expenditure on R&D contracted to other persons is generally not allowable except where, broadly, that person is an individual, qualifying body (typically a research institution) or partnership.

But what exactly is a subcontracting relationship? HMRC’s guidance attempts to define 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 there are a variety of contractual arrangements which HMRC may or may not regard as subcontracted R&D. It is this ambiguity that has led to a steady stream of cases either heard or queued for tribunal hearings.

To illustrate, where a company carries out its own R&D and simply receives a subsidy from another entity, this is not subcontracting - it is subsidised expenditure. A consultant providing expert advice and charging for their time does not amount to the subcontracting of R&D. Or consider where two companies are both undertaking R&D on the same subject, they may 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.

HMRC has often sought to challenge the eligibility of subcontracted R&D expenditure. It argues that in the absence of an explicit contract for R&D activities, the arrangement is a contract for the provision of goods or services and therefore not qualifying subcontracted R&D. This is a complex area where ambiguity, misinterpretation and confusion are common.

The future position

The government has sought to develop a single definition of subcontracted R&D activity which would apply for claims made in respect of accounting periods beginning on or after 1 April 2024. According to HMRC’s accompanying technical note, the new definition allows ‘the company making the decision to do the R&D and bearing the risk’ to make the claim.

Where a company with a valid R&D project contracts a third party to undertake some of the qualifying work, the company may claim for the relevant qualifying costs of that contract. The company contracted to do that work generally may not claim for R&D activities for delivering the project outcome for its client.

Conversely, if a company (‘contractor’) is contracted by another company (‘customer’), but the work does not form part of the customer’s R&D and was initiated by the contractor, the contractor may be able to claim relief. The contractor would have to meet the requirements of having valid R&D which was otherwise eligible for tax relief. This is an essential element.

Winners and losers

Rewarding the company that makes the decision to undertake the R&D with the ability to make a claim is logical, but it 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.

A possible solution may involve including contract provisions between the parties to determine entitlement to the R&D relief. It is important that any provision reflects the commercial substance of the transaction and is not just a standard clause.

For many claimants, this is a significant change that will necessitate discussion and agreement between all parties involved in the R&D relationship. While this dialogue will potentially bring clarity, it also raises the possibility that the terms of the contract may be challenged where one party is obtaining additional relief via an R&D tax relief claim. Where one party benefits, the counterparty may be disadvantaged.

The biggest winners will undoubtedly be RDEC claimants, who for the first time will be able to claim for activities subcontracted to other companies where the relevant conditions are met.

However, the new rules could prove challenging for those within an Original Equipment Manufacturer (‘OEM’) supply chain (i.e. companies that supply components used in the production of goods by other manufacturers). Such businesses often provide a blended mix of products and services without clearly defined contracts, and so may struggle to demonstrate that they bear the relevant R&D risks.

The government has sought to develop a single definition in respect of subcontracted R&D activity and achieve what would be a significant tax simplification. However, given the inherent complexity of this area, and the sheer scope and variety of contractual relationships, additional clarification may only be achieved through further rulings by courts and tribunals.

Look out for future articles in this series which will delve deeper and provide further analysis on additional Autumn Statement announcements.

For more information, please contact Chris Alderman.