Your complete guide to the new rules on claiming R&D Tax Relief on subcontracted R&D.
The government has shaken up the regulations for claiming R&D Tax Relief on subcontracted development work.
For years, the rules around subcontracted R&D have caused a great deal of confusion. This has led many businesses to claim for ineligible contractor costs or forgo relief on qualifying investments because they were worried about non-compliance.
Thankfully, the government has decided to bring much-needed clarity to this element of the scheme by introducing new legislation that places the right to claim (in most instances) in the hands of the company that decided R&D was necessary.
The new guidance applies to accounting periods starting on or after 1 April 2024, coinciding with the arrival of the merged R&D expenditure credit (RDEC) scheme. This is separate from the new rules that prevent companies (in the main) from claiming relief on overseas subcontractor costs.
While, in many ways, the new regulations are a considerable upgrade on what we had previously, they do leave plenty of room for misunderstanding and misinterpretation – such is the nature of tax law.
If you need any help understanding the impact of these new regulations on your business or guidance restructuring your client or contractor relationships to validate your eligibility for relief, just get in touch.
What are the new rules around claiming R&D Tax Relief on contracted R&D?
The new guidance addresses relationships between:
- A customer – the company that outsourced work to a third-party
- A contractor – the company that performs the outsourced work
In the legislation, the term ‘subcontractor’ refers to work performed on behalf of a contractor.
For clarity:
- Company A (the customer) contracts work to Company B (the contractor)
- Company B (the contractor) then contracts some of Company A’s work to Company C (the subcontractor)
Obviously, in the real world, people use subcontractor to mean contractor. But for clarity, this blog will follow the terms used in the legislation.
Returning to the point. Fundamentally, the new regulations say that the right to claim R&D Tax Relief sits with the company that decided to undertake R&D. This is true of both the merged RDEC scheme and enhanced R&D intensive support (ERIS).
This change makes a lot of sense. The purpose of the R&D Tax Relief scheme is to encourage more research and development by making it less risky, less expensive, and more lucrative. It can only fulfil this purpose if it’s targeted at the businesses and business leaders who decide whether or not to perform R&D.
However, there are some cases where the contractor or subcontractor will be eligible instead. Ultimately, the right to claim rests on whether a piece of work qualifies as contracted out R&D.
What is ‘contracted out’ R&D?
If R&D is considered ‘contracted out’, then the customer who outsourced the R&D can claim relief. If not, the contractor may be eligible to claim instead.
Whether R&D is contracted out is determined by a three-step test. The first two steps are simple. However, the third is bound to induce a great deal of head-scratching.
Step 1: Is there a contract?
First off, there must be a contract between the customer and the contractor.
The contractor may be able to claim relief on that work if it is eligible for R&D Tax Relief and has conducted qualifying R&D.
This would not have been possible under the previous SME scheme, as it did not allow companies to claim relief on R&D that had been subsidised.
Also, and importantly, the R&D being claimed for must be covered by the scope of the contract.
This means that either the contract should relate specifically to the R&D, or the R&D should be specified within a contract covering a wider array of deliverables.
Step 2: Was R&D is undertaken
The contractor needs to have performed qualifying R&D on behalf of the customer, in line with their contract.
If there’s no R&D, the customer cannot claim relief on the contractor’s fees.
Step 3: Is it “reasonable to assume” that the customer “intended or contemplated” that R&D was needed?
This is where things get complicated.
Essentially, this final test asks whether the customer understood the science and technology behind their project well enough to see that someone – in this case, the contractor – needed to perform R&D to achieve their desired advance.
The customer’s understanding of R&D must be nuanced, robust and, crucially, informed by technical expertise that is relevant to the development work taking place. This expertise can be sourced in-house, from a competent professional, or via some external resource like a consultancy.
Neither simple speculation about the need for R&D nor uninformed acceptance that R&D may be required are sufficient to pass this test.
If you are the customer, the best way to prove to HMRC that you intended or contemplated the need for R&D is by writing it into the contract you have with your customer.
Internal documents showing that you saw the need for the contractor to perform R&D would also work as evidence.
It’s a good idea to share this evidence within your R&D Tax Relief claim. Otherwise, HMRC may open an enquiry to investigate whether your subcontractor costs are eligible for relief.
What happens when the customer isn't eligible for R&D Tax Relief?
There is an exception to the test above. That is, where the customer is not eligible for R&D Tax Relief.
If the customer isn’t eligible – if they’re a charity or an overseas foreign business, for example – the contractor will be able to claim relief on the R&D they conducted if they meet the three conditions listed below.
The government has created this exception to make sure that, wherever possible, qualifying R&D receives some relief.
Condition 1: The contractor is hired to perform R&D
Firstly, and fairly obviously, the contractor needs to have been contracted to perform R&D on behalf of another business.
Condition 2: The customer must be ineligible for R&D Tax Relief
Second, the customer must be ineligible for R&D Tax Relief.
This would be the case if the customer was any of the following:
- An overseas company
- A charity
- A higher education institute
- A government department
Condition 3: This expenditure is qualifying
Unlike step three in the test above, the third condition is very straightforward: the expenditure associated with the R&D they conducted on behalf of their customer must be eligible for relief.
Transition provisions
The updated regulations affect accounting periods starting on or after 1 April 2024.
This can create situations where customers and contractors are affected by different rules. For example, where a customer’s accounting period starts before this date and the contractor’s starts after it.
Thankfully, the government has anticipated this situation and introduced ‘transitional provisions’, which explain who can claim relief if companies are subject to different rules.
Provision 1
The customer’s situation
- Has an accounting period starts before 1 April 2024
- Has contractor costs that are eligible for R&D Tax Relief under the old SME R&D Tax Relief scheme
The contractor’s situation
- Has an accounting period that starts on or after 1 April 2024
- Has contractor costs that are eligible under the merged RDEC scheme as the customer’s R&D is not considered ‘contracted R&D’ under new regulations
The rightful claimant
- The customer is entitled to claim and will be able to claim for their contract costs under SME R&D Tax Relief
- The contractor cannot claim R&D Tax Relief on the work conducted on behalf of their customer, even though they would be able to under the new regulations
Provision 2
The second provision applies when a customer has contracted expenditure that:
- Took place in an accounting period starting before 1 April 2024
- Is not eligible for relief under the old rules, e.g. because they are a large business that has contracted R&D to an SME
- Would have been eligible for relief if it had occurred in an accounting period starting on or after 1 April 2024
The rightful claimant
In this case, the customer is treated as being ineligible for R&D Tax Relief for the purposes of determining whether a customer or contractor is eligible.
This means the contractor will be able to claim relief if it is eligible for R&D Tax Relief. This is true even if the contractor would not be able to claim relief under the new regulations.
Provision 3
The customer
- Has incurred contractor expenditure in an accounting period starting on or after 1 April 2024
- If they had been incurred in an accounting period starting before 1 April 2024, these costs would have been eligible for SME R&D Tax Relief
- The work associated with these costs does not meet the definition of contracted out R&D
The contractor
- Incurred the expenditure from the customer’s project in an accounting period starting before 1 April 2024
- Would be unable to claim R&D Tax Relief under the previous rules
The rightful claimant
- The customer is entitled to claim
- The customer’s R&D is considered contracted out even though it doesn’t meet the definition of contracted R&D laid out in the new requirements
Subcontracting chains
Often, companies contracted to perform R&D for a customer will subcontract that work to another company. This creates what the government calls ‘subcontracting chains’. You can think of them as supply chains but for intellectual property and technology rather than goods and services.
Regardless of how complex a subcontracting chain becomes, the process for working out who can claim R&D Tax Relief remains the same: apply the contracted out test. And, if necessary, the three conditions for contractor claimants.
If the customer meets the definition of contracted R&D, no company further down the chain can claim R&D Tax Relief on that work. Though, of course, they may be able to claim R&D Tax Relief on other work they’ve performed.
If the arrangement between the customer and contractor does not qualify as contracted R&D, then the contractor will have to apply the same test to its subcontractors, and so on, until the end of the chain.
This is more challenging the further down the chain you are, as you’ll need to make sure none of the companies closer to the ultimate customer are entitled to claim for your work before you can file for relief.
What about overseas contractors? - an example
The presence of overseas businesses in your subcontracting chain can make things appear more complex, especially now that payments to contractors based abroad are largely no longer eligible for relief.
To make things clearer, the official guidance gives an example involving three companies: Company A contracts R&D to a US-based Company B, who then subcontracts it to a UK entity (Company C).
Company A and B’s relationship meets the definition of contracted out R&D, so Company A is the rightful claimant, even though Company C is performing contracted R&D on behalf of an ineligible entity.
Let GrantTree’s experts guide you through these complex rules
The new regulations have completely shaken up the process of claiming R&D Tax Relief on contracted R&D.
Companies must get to grips with these new rules quickly if they want to continue claiming for outsourced R&D while maintaining compliance and avoiding HMRC’s compliance crackdown.
This is where my colleagues and I at GrantTree can help. Backed by 14 years of R&D Tax expertise, we can make sure your upcoming claim is compliant with all the latest legislative changes and that your future filings are protected by structuring your client or contractor relationships to demonstrate your eligibility.
To find out more about how GrantTree can help you, just get in touch.
