Know the difference between Externally Provided Workers and subcontractors


Externally Provided Workers and subcontractors: two sides of the same coin

When claiming R&D Tax Credits, there is a top line breakdown of which costs qualifyHowever, in the 4 criteria HMRC allows to be claimed (direct labour, external staff, subcontractors and R&D consumables – including software), two of these sound very similar but it is crucial to not be confused with each other – external staff (i.e. externally provided workers) and subcontractors. Let’s dig a little deeper into the difference and how much you can claim for each…

Externally Provided Workers/EPWs:

To cut through the HMRC jargon, an “Externally Provided Workers” (EPW for short) is someone who comes in and does day-to-day work like a normal employee, but is actually self-employed and always hired via a service provider. Nb: without the service provider they will be just a subcontractor, and subject to different claimable amounts.

The line between EPWs and subcontractors can be in a grey area, so make sure you are clear on how you classify each to make sure you are not over/under claiming!


For HMRC purposes, the “subcontractors” category is for situations where you have packaged up a sub-project or activity that is part of your overall R&D project, tendered it for a company to deliver it, and then paid them for the result in some way. For example, if you need a certain module developed, and you spec it out, and then hire an external firm to develop it, and they estimate it to be £10,000 worth of work, and they do the work and deliver it for you, that is what HMRC means by “subcontractors”.

When claiming, it is important to identify whether the subcontractor has already claimed Tax Credits for the R&D in question. If they have, then this R&D cannot be claimed for again, as HMRC would view this as double-dipping into the R&D claim benefit. It’s also worth noting that the subcontractors and Externally Provided Workers will only qualify if the work they do is “directly contributing” to the resolution of the technical uncertainty that the R&D project addresses.

Some subcontractor examples:

Example 1 – Company A commissions a digital agency (B) to carry out development of a new machine-learning system, which for the purposes of this example, has been deemed to be qualifying R&D. A has agreed to pay £50,000 for the work, B will be overseeing the development, and B will retain all rights to the IP. Working through the example, B will most likely have the financial burden as if the project exceeds the deadline, it will cost B more resource than they budgeted for. Because B is additionally in control of the project and B retains the IP, in this case the digital agency is more likely to be able to claim for the R&D than Company A.

Example 2 – Company A commissions an individual (B) to develop a new mutating algorithm that qualifies for R&D and has a 2 month delivery estimate. A agrees to pay B £1,000 per day to specifically develop this algorithm. A will oversee the development, and B will retain the rights to the algorithm. The financial burden will now be held by A as it will cost them a lot more than planned if the development takes longer than expected. Whilst B will retain the IP, A has control of the project and in this case it is more likely that A will be able to claim for the R&D under the Tax Credits scheme.

Whilst there is no science for determining whether a company can claim for a subcontractor, using the above examples to follow their logic to form a cohesive argument will go some way to identifying who may be able to claim.

When can you claim for Externally Provided Workers?

EPWs, on the other hand, are employees of the commissioned company and are provided to the claimant company for the duration of the R&D work. However, unlike the fairly flexible guidelines for claiming subcontractors, there are only certain situations where you can include Externally Provided Workers as a qualifying expense:

  1. The person provided must be an individual and cannot be a director or employee of the company claiming for R&D Tax Credits. It doesn’t matter, however, if they are a director of the company who are supplying the individual.
  2. The individual is under the direct control of the company who they are being provided to. This means the company who the individual is provided to will define the scope of the R&D, actively supervise, and ensure the work is completed to the determined specification.
  3. The individual’s services must be supplied to the company through a staff provider. This means that there need to be at least 3 parties involved in the contract (Company A, a staff provider, and an individual employee of the staff provider), however the addition of more intermediary companies will not affect the ability to claim for the individual.
  4. The individual must be under a contractual obligation to provide services personally to the claimant company under the agreement between the staff provider and the individual.

In addition to the above it is useful to consider contractual agreements between the staff provider and the company looking to claim for R&D. Clauses that outline that the company will be charged on a time and materials basis will point towards the possibility of an EPW relationship, whereas a fixed cost for the development work will tend to point to a subcontractor relationship.

Why does it matter whether they are a subcontractor or an Externally Provided Worker?

The importance of determining whether they are a subcontractor or an EPW rears its head when dealing with Large companies (for the purposes of R&D). Under the Large Company / RDEC scheme, subcontractors cannot be claimed whereas EPWs can be included. SME companies can claim for subcontractors and EPWs, but it is still important to categorise them correctly, because it can affect how much you can claim for them.

Can I claim the same amounts for both?

Subcontractors and EPWs are typically both able to claim 65% of their time spent on the R&D work (e.g. if they spend 90% of their time on R&D, then 65% of that can be included in the total R&D amounts). However, if the staff provider and the company are connected, they may be able to claim up to 100% of their time on the R&D work.

The nitty gritty: calculations

Apportioning Externally Provided Workers costs

EPWs should basically be treated just like internal staff, except their “total emoluments” cost is 65% of the amount paid to the umbrella company they are working under (or the amount paid to them as a sole trader if that is how they are receiving payments). The loss of 35% is meant to account for the external provider’s profit margin, and is fixed by HMRC.

Within that 65% envelope, you should assess what percentage of the EPW’s time was R&D. For example, an EPW programmer who spent 50% of their time on doing R&D and 50% on doing production support would be apportioned at 65% x 50% = 32.5% of the amount of money paid to them.

Apportioning Subcontractor costs

Subcontractors are easier to apportion, assuming that the contract has been split into clearly defined projects. HMRC’s regulations say clearly that a sub-project that is part of a larger project, where the larger project is qualifying R&D, will itself qualify for R&D relief even if it is “routine” work for the subcontractor. They give the example of a laboratory doing DNA sequencing as a routine activity, being subcontracted by a qualifying project. The routine activity of DNA sequencing would then qualify because it is part of a project that qualifies.

Like for Externally Provided Workers, the profit margin of the subcontractor is assumed to be 35%, and is therefore deducted from the cost envelope, but within the project cost there is no need for further subdivision (unless it is obviously apparent).

So, for example, if you subcontract company X to develop a module for you as part of a qualifying project and pay them £10,000, then £6,500 of that will qualify for relief.

If, on the other hand, the contract involved both building module X and doing some UI mockups for another project, and those costs comprised roughly 70% and 30% of the £10,000 respectively, then 70% of £6,500, i.e. £4,550, would qualify.

A warning on directors as subcontractors

It’s worth mentioning this fairly common arrangement for very small companies. Sometimes, we find that SMECo, with director John Smith, instead of paying John Smith a salary or even dividends, pays a company (e.g. John Smith Consulting Ltd) under an EPW-like arrangement, for work that John Smith is doing as a director of the company (which may include substantial amounts of R&D).

This arrangement is not quite right from HMRC’s perspective, but they often close their eyes to it when very small SMEs do it (we think that’s because the amounts of tax are small anyway, and they don’t want to spend their time hunting down tiny struggling businesses, which is ultimately not good for the economy). So you can use this arrangement while the company is very small. It’s not quite right, but it’s not wrong enough or big enough for HMRC to really care unless you explicitly draw their attention to it – for example, by filing an R&D claim and trying to claim that cost as EPW or subcontracted qualifying cost.

Our advice is that if you are using this sort of arrangement, then don’t claim for the director costs as R&D. Those directors should either be paid dividends, or be on salary, but as they are actively engaged in the operations of the company HMRC’s position would be that they are employees of the company and that the “consulting company” arrangement has been created purely to reduce tax, and not to reflect any sort of commercial reality – so they would advise against it.

So now you know all there is about the relationship between Externally Provided Workers and subcontractors. If you have any questions about how you should include them in your claim or about your funding options in general, please get in touch!

Pippa Clark

Author: Pippa Clark

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