(Sub)Contracted R&D: Is HMRC Getting It Right?

Subcontracted R&D has been a rather turbulent topic for the R&D tax relief world for years. It’s important to get it right: as we know, the scheme aims to generate value by incentivising uncertain projects that otherwise may not be taken on, stimulating economic activity, and increasing the knowledge and skill base here in the UK.  

Where this activity requires multiple parties, the question of which party (or, in some cases, parties) is the eligible claimant becomes crucial – for the scheme to return maximum value, it should incentivise the right people. Furthermore, if left unchecked, multiple claimants for the same project would be inevitable and could become rife, leading to HMRC investing several tax benefits for the same activity, even further undermining its return on investment. 

Being able to identify the ownership of the activity and, therefore, the eligible claimant is critical to a sustainable R&D tax relief scheme.   

The HMRC Position 

In the SME and RDEC R&D schemes (for accounting periods starting before 1 April 2024), projects can be classified into one of the following categories: 

1. Self-funded – pure R&D with a view to commercialising an outcome or deploying the resultant tech in-house.
2. Subsidised – where the costs of a project might be fully or partially funded by a third party (such as a funding body, or by any other person). 
3. Subcontracted – where the R&D undertaken by a company was directly contracted to them by another party.

There are caveats and nuances within the claim mechanism for each of these project types, but generally speaking, self-funded projects receive a greater rate of relief than subsidised or subcontracted projects.  

The recent turbulence around this topic has been a sometimes hard-fought battle over the classification of projects, with claimants classifying their projects as self-funded and HMRC arguing they have been subsidised or subcontracted in some manner.  

HMRC’s Corporate Intangibles Research and Development (CIRD) Manual provides guidance on the R&D tax relief legislation within the Finance Act. It provides expansions and sometimes contextual examples of the litigious text within the Finance Act playing out in real-world scenarios. In recent times, the CIRD guidance on subcontracted R&D was that “expenditure incurred by a company in carrying out activities contracted to it by another person is not qualifying expenditure,” with the main reason being the prevention of both parties to a contract claiming relief for the same activities.  

This has meant that, for example, when a builder is contracted to build a building and needs to research and develop an improved and innovative steel structure to do so, then the costs associated with this aren’t qualifying¹, as the builder was fulfilling a contract when incurring the costs. Or sometimes, where the activity wasn’t explicitly contracted, then HMRC might argue that the costs of the R&D were at least subsidised since the company was generating revenue when incurring the costs. 

Many have seen this approach as too generalist. HMRC even lost a First Tier Tribunal case on the topic of subsidised costs, where the judge ruled that the R&D costs and the revenue the claimant received were not inextricably linked, and therefore, the company could claim on the more generous scheme for self-funded projects. 

Despite this ruling, HMRC has continued to enforce rules on subcontracted and subsidised R&D in the same way. If an end customer is in play, then the R&D is either subsidised or subcontracted despite a lack of a direct link between contracted activity, R&D costs, and revenue. This contrary approach has created confusion and resulted in several more cases proceeding to the costly First Tier Tribunal stage over the topic. Several case results will be finalised over the next few months – with many a keen eye following!  

So, What’s Changing? 

Accounting periods beginning on or after 1 April 2024 will be subject to a new R&D tax relief scheme, either the merged scheme R&D expenditure credit (RDEC) or enhanced R&D intensive support (ERIS), depending on the level of R&D cost as a proportion of the total. These new schemes include overhauled rules for project funding status, which were explained in HMRC’s most comprehensive guidance on the subject yet, published on 9 February 2024.  

In essence, it seems HMRC is aiming to make classification easier. The subsidised category is no more, so there are only two project types: self-funded R&D or “contracted” R&D (which replaces the term “subcontracted,” for reasons they explain). The guidance – more than 6,000 words and 15 contextual examples — seems to place the burden of proof on the customer more than the contractor to prove that they have indeed agreed to contract out R&D activity. 

Under this new interpretation, the customer should articulate the nature of the R&D (including the advance in science or technology and the uncertainties that will be faced) before the project begins for them to be deemed the R&D activity owner. Indeed, the customer must have “intended and contemplated” that R&D would be required to meet the contract for them to own the R&D project. To use the earlier example, where the customer didn’t know the builder would need to do R&D to develop the steel structure, or if it wasn’t quantified and agreed upon in advance, then the R&D for the structure would likely be the builder’s R&D project.  

In addition to this main driver, there are myriad other factors that determine the rightful owner of the activity. These include:

• IP ownership
• Financial risk
• Autonomy in how the activity is executed
• And more, which are listed in the guidance

Each factor can be nuanced in its own way, meaning every case should be judged on all the facts surrounding it. It sounds complicated, but there are plenty of contextual examples within the guidance, and fundamentally, the intention to carry out the R&D activity is posed as the most important indicator.

HMRC is re-establishing the need for a connection between contracted deliverables and R&D activity and costs. This fundamental shift in attitude means that, in many cases, parties who were not eligible claimants under HMRC’s previous guidance will now be able to claim tax relief for the R&D they are undertaking. This will impact innumerable potential claims per year across all sectors, but the construction and software development industries, in particular, will likely be very welcoming of the news, having felt particularly tethered by the recent guidance. 

Conclusion 

The topic of subcontracted R&D has been hot recently, and the overarching outcome has been feelings of ambiguity and even discontent. At times, it’s felt like the “rightful” claimant was ineligible to claim, given the broad-brush approach of the CIRD guidance. Now, with the merged scheme RDEC and ERIS, it seems HMRC is looking to change that. The removal of the subsidised status and the alterations to project ownership seem designed to make things easier for the taxpayer and to encourage and incentivise the most effective party in a project, which can only be a positive.  

On the other hand, some in the industry highlight that the allowance of large companies to now claim for their contracted costs, preventing SMEs from claiming on activity contracted to them, redirects relief away from the SMEs that need it most and into the hands of larger entities.

It’ll be interesting to see the results of the pending First Tier Tribunal cases, and whether these have any bearing on future guidance. Many potential claimants, especially in construction and software, will be hoping the new guidance endures, seemingly providing them with a clear licence to claim, where up to now they’ve been unable to.  

Ultimately, we hope the desired effects of the new guidance manifest: increased certainty, reduced numbers of claims tied up in enquiry/tribunal, and critically, R&D tax relief hitting the right companies. 

What do you think?

Do you:

• Have a claim that is affected by the ambiguity of the older subcontracted rules?
• Have an HMRC enquiry in which you are defending this very point and need support?
• Want to know more about how the new requirements will affect the relief you can claim?

Feel free to contact me directly to discuss how Ryan can help, or simply fill in the form below and we will be in touch shortly.

¹ Caveats around the size of the customer company