Changes to the rules concerning contracted-out R&D

There have been major reforms to the rules surrounding claims for R&D tax relief in recent years, with the most significant changes being for accounting periods beginning on or after 1^st April 2024. For accounting periods beginning on or after 1^st April 2024, there is only one R&D scheme, regardless of whether a company is an SME or large company unless the claiming company is an R&D intensive SME in which case, the SME can claim under ERIS (enhanced R&D intensive support).

One of the most notable changes for R&D tax relief claims made in respect of accounting periods beginning on or after 1 April 2024 is in relation to the rules surrounding claims for contracted-out R&D with much-needed clarity provided as to who can claim and also extending the scope for large companies to claim for contracted out expenditure that could not previously be claimed for.

Previous Rules

Prior to 1^st April 2024, a large company claiming R&D tax relief under the RDEC (Research and Development Expenditure Credit) regime, could only claim for subcontracted R&D activity if it was subcontracting the qualifying R&D activity to a “qualifying body” such as a University, a charity, an individual or a partnership. This meant that large companies could not include the cost of paying an SME to carry out R&D activity as part of their claim for R&D tax relief.

This position can be contrasted with the position of SMEs who were not so restricted in terms of their ability to claim for contracted out R&D. SMEs, claiming under the SME R&D regime, were able to include 65% of the cost paid to unconnected subcontractors regardless of whether the subcontractor was another SME or somebody else.

SME-sized companies, carrying out qualifying R&D activity which had been subcontracted to them, could claim relief under the RDEC regime (provided the R&D activity was subcontracted to them by a large company and not another SME).

New Rules

From 1^st April 2024, there will only be one R&D regime for all companies regardless of whether a company is large or an SME (unless it is an R&D-intensive SME company). Therefore, the distinction in what contracted-out R&D costs can be claimed by the different sizes of companies is no longer relevant, with one set of rules regarding subcontracted R&D applying to all companies.

The new rules are that it is the company doing the R&D and deciding to contract out part of its R&D activity that can make the R&D claim for that contracted-out activity.

The key will be in proving who is making the decision to carry out the R&D activity and therefore who is eligible to make the R&D claim. The legislation states there must be a contract which is written, verbal or implied between the company doing the R&D activity and the company they are subcontracting the R&D activity to. In addition, the company doing the R&D activity and contracting it out has to demonstrate that it was intended or contemplated that R&D would be carried out to meet the obligation of the contract.

This goes beyond a general awareness that R&D will take place whereby the company contracting out the R&D activity must specify the required R&D activity to be undertaken, understand the R&D and articulate the nature of the R&D to the company it is contracting out to. This might be done in a contract, during discussions or in internal documents showing how the activity was required as part of the wider R&D activity.

The assessment of the R&D activity being intended or contemplated should be made having regard to the terms of the contract and any surrounding circumstances.

As the surrounding circumstances are also relevant when considering if the R&D activity was intended or contemplated, as well as the importance of the wording of any contracts, HMRC would also expect that commercial factors would align with the intention and form part of the surrounding circumstances. Therefore, the overall circumstances such as intellectual property (IP) ownership, financial risk and autonomy in how the activity is executed must be considered to determine whether the company’s primary objective was to perform R&D.

So What Does This Mean?

Large companies are now able to claim for R&D activity they contract out so there is a potentially greater benefit for them from doing R&D claims.

SMEs may lose some of the benefit of R&D claims they had historically. Previously, an SME may have undertaken R&D activity that was subcontracted to it by a large company. The large company couldn’t include the contracted-out cost in its R&D claim but the SME could include it in theirs under the RDEC regime. Under the new rules, if it is the large company which is doing the R&D and making the decision to contract out part of its R&D activity, it will now be the large company that can include the cost in its R&D claim.

The new rules are complex and must be looked at in the round having regard to the surrounding circumstances and the intention of the parties throughout the process. As with all changes in legislation, some companies will benefit and others won’t but the facts of each claim must be carefully considered to ensure the maximum benefit is available.