Everything you need to know about the new rules affecting R&D Tax Relief for overseas subcontractors and externally provided workers.
New government restrictions mean that most payments for overseas contractors and externally provided workers (EPWs) no longer qualify for R&D Tax Relief.
Codified in the 2024 finance bill, these reforms affect accounting periods starting on or after 1 April 2024 and apply to both enhanced R&D intensive support (ERIS) and the merged scheme.
This change will have a major impact on the funding for startups and scaleups, which leverage overseas workers to access hard-to-find skills while controlling costs.
Thankfully (and sensibly), the legislation makes exemptions for certain overseas costs–Qualifying Overseas Expenditures (QOEs)–where it would be “wholly unreasonable” for you to conduct R&D in the UK.
We’ll get into the exceptions and the government’s definition of “wholly unreasonable” later. First, some additional clarity on what costs are affected.
Restrictions on contractor costs
For overseas contractors, the key is where your R&D took place. Generally, if it was outside the UK, you won’t be able to claim relief on payments to the overseas contractors and EPWs that delivered that work.
If you’ve made payments to contractors covering work that took place both in and outside of the UK, you’ll need to apportion the percentage of your costs attributable to UK R&D to your claim.
Your apportionment must be made on what HMRC calls “a reasonable basis”. This means using valid, quantifiable metrics like the number of days subcontractors spent working on UK R&D vs overseas R&D.
Restrictions on EPW costs
EPW costs qualify for relief if a worker is subject to PAYE and National Insurance contributions (NICs).
If a worker passes this straightforward “gateway” test, you can claim relief on all their EPW costs. So, not only the worker’s gross pay but also associated costs like agency fees and service changes.
As with subcontractors, if your EPW payments cover some workers who are subject to PAYE and NIC and others who aren’t, you’ll need to apportion those payments accordingly.
As an example, let’s say you paid an EPW provider £20,000 for the services of ten workers – £2,000 per worker – and seven of them were subject to PAYE and NIC. In that case, you could apportion 70% or £14,000 of that EPW payment to your R&D tax claim.
Remember, you can claim relief on up to 65% of your EPW costs if the provider is not a connected company. So, in the example above, you could claim relief on 65% of £14,000, which is £9,100.
Exceptions to these restrictions
Helpfully, some expenditures on overseas EPWs and contractors are exempt from these restrictions. These are called Qualifying Overseas Expenditures. ‘QOEs’ for short.
Your company can claim QOEs if all three of the following circumstances apply.
Circumstance 1: the necessary conditions aren’t present in the UK
The first circumstance is that the specific conditions you need to perform your R&D aren’t present in the UK.
For instance, let’s say you needed to test a new piece of machinery in arctic conditions. By definition, those conditions aren’t present in the UK.
More on what the government means by ‘conditions’ below.
Circumstance 2: the conditions are present where you conducting your R&D
The second circumstance is a natural corollary to the first. If the necessary conditions aren’t available in the UK, you need to perform your R&D where those conditions are present.
Using our example, you would need to go the far north or south – Alaska, Norway, Antarctica, etc – where arctic conditions are present.
Circumstance 3: It would be “wholly unreasonable” for you to replicate the conditions in the UK
The conditions you need for your R&D don’t exist in the UK. But could they be replicated here?
Take our arctic conditions example. It’s possible to emulate arctic-like conditions in a lab. But is it reasonable for your company to do so?
If not – if it’s, as government guidance says, wholly unreasonable – then the third circumstance is satisfied, and you’ll be able to claim relief on relevant and qualifying costs for overseas contractors and EPWs.
So, how does the government define “wholly unreasonable”? Sadly, there’s no blanket definition. It depends on your business – its size, resources and capabilities – and what kind of R&D you’re conducting.
In its guidance, which lists a number of useful examples, HMRC explains that time pressure is one of the main factors that would make it unreasonable to replicate the conditions necessary to your R&D in the UK.
For example, if you need to analyse samples collected in another country with a limited shelf life, It would be unreasonable to expect you the replicate the conditions you need to test those samples if they are going to become unusable by the team they reach the UK.
Helpfully, the government also clarifies what factors do not contribute to making R&D wholly unreasonable. But before we look at those, let’s explore what the government means by ‘conditions’.
What does the government mean by conditions?
The conditions the government is referring to are not purely environmental – sub-zero temperatures, tectonic activity, and so on.
The legislation lists a range of factors that are relevant to determining whether an overseas EPW or contractor cost qualifies for relief.
The list is not exhaustive, but the examples it does provide fit into two categories: geographical, environmental, or social, and legal and regulatory.
Geographical, environmental and social conditions
These conditions are “objective features of the physical world”, both natural and artificial. They include:
- The presence of specific animals and plant life not found in the UK
- Machinery or other artificial facilities you need for your R&D
- Medical factors, like the prevalence of diseases or availability of volunteers for drug trials
Legal or regulatory requirements
This encompasses:
- Guidance and accreditation from regulators
- Legislative requirements–for example, laws requiring that certain activities occur in specific locations
- Requirements and decisions of national and international regulatory bodies
Excluded conditions
As mentioned, the legislation excludes two factors from being ‘conditions’.
The factors are:
- The cost of R&D
- The availability of workers to perform the R&D
So, if the sole or primary reason you offshored your R&D was…
- It was cheaper
- You couldn’t find the right people in the UK
- A combination of the two…
…then, spending on overseas EPWs and contractors associated with that R&D will not qualify for relief.
But cost and skills can play a role
This doesn’t mean you can’t claim relief on any overseas EPW and contractor expenditures where cost and the availability of skills played some role in your decision-making.
After all, with enough money, you could overcome or replicate most of the government-sanctioned conditions listed above.
Cost is usually, if not always, a factor in a company’s decision-making. It just can’t be the main thing deciding whether or not you use overseas subcontractors and EPWs.
To explain, let’s take the example of biological samples. It may be possible for you to charter a plane and have the samples delivered to a UK lab before they expire. But that would be wholly unreasonable in most cases.
Why? Because, while cost is important here, private planes are very expensive, and the real issue here is time.
If, however, the samples lasted for months, then it may be reasonable for you to ship them to the UK. If you choose not to, it may be more a matter of cost. In which case, costs for overseas contractors and EPWs would not qualify as QOEs.
What about people that aren’t involved in R&D?
As mentioned, the availability of workers to perform the R&D cannot be the sole or primary reason for offshoring R&D projects if you want to claim relief on costs for contractors and EPWs involved in your development work.
However, this exclusion only applies to individuals who are conducting R&D. It does not apply to investors, academic advisors, and other individuals who add value to your R&D – by advising you on how to improve your research, for example – but actively conducting R&D on your behalf.
So, if the main reason you offshored your R&D was to be closer to people who aren’t involved in your R&D, and it would be unreasonable for you to replicate the conditions needed for your development work in the UK, you may be able to claim relief on overseas contractors and EPWs involved to that work.
Why has the government restricted relief on overseas R&D?
The previous government introduced these restrictions to “refocus reliefs towards innovation in the UK”. By doing this, it hoped to increase the scheme’s return on investment and maximise benefits from spillover effects, where the advantages of R&D and innovation are felt beyond the individual businesses responsible for them.
Announced in the 2021 Autumn Budget and Spending Review, these restrictions were initially due to apply to financial years beginning on or after 1 April 2023 but were postponed to coincide with the launch of the merged scheme.
The delay gave companies valuable time to come to grips with the legislation, collect evidence to prove their costs’ eligibility for relief and repatriate R&D where it made financial sense.
Get expert help claiming relief on your overseas investments
The legislation regarding overseas R&D expenditure leaves lots of room for confusion and error. Uncertainties surrounding this legislation will be compounded by complex new rules for claiming for subcontracted R&D.
That’s why, if you are planning to claim relief on contractors and EPWs based abroad, it’s highly advisable to seek expert help.
With 14 years of experience preparing compliant claims and over £450 million secured for our clients, our R&D Tax experts are perfectly placed to help you navigate these restrictions, securing relief on all of your eligible costs while proving your compliance to HMRC, minimising your chances of an enquiry.
For help understanding which of your EPW and contractor costs are eligible for relief, just get in touch. My colleagues and I are standing by to help.
