Subcontracted R&D: Out with the old, in with the new

In this article, Liam McHenry takes a look at the new rules for subcontracted research and development tax relief in the UK.

The new rules for subcontracted research and development (R&D) tax relief came into force for claimants with accounting periods beginning on or after 1 April 2024. More than a year later, HMRC is now starting to see corporation tax returns containing claims under the new rules and the two new schemes.

However, it remains to be seen how smoothly these reforms will land as it has been a very bumpy process to get to this point.

What were the original rules?

Under the historical SME scheme, the accepted interpretation was that the ‘owner’ of the R&D, that is, the party entitled to submit the claim, was determined by the substance of the engagement. This was never a binary test and required careful assessment in each case including who made the technical decisions, who bore the financial risk in the event of failure and who would exploit any resulting intellectual property.

In theory, this should have worked well, but in practice, there was often underlying ambiguity between the two parties to the contract. In addition, HMRC lacked any meaningful way to police the potential for double claims on subcontracted elements. This meant that relief for the same project was frequently claimed by both the developer and the customer. This was particularly prevalent in the construction sector when the main contractor would have had overall responsibility for the delivery of the design and build contract, yet complex subcontracted elements could frequently contain qualifying R&D activities.

What happened next?

At the same time as HMRC was coming under scrutiny for failing to act around the perceived abuse of R&D tax relief in the UK, they quietly changed their position on the treatment of subcontracted and subsidised R&D, such that their Corporate Intangibles Research and Development Manual was updated and other guidance was amended and/or deleted.

The new position was that if any of the qualifying R&D activity was undertaken during the process of completing a contract, then that was deemed to be subcontracted R&D, thereby shifting the claim from the SME regime to the R&D expenditure credit scheme (RDEC), regardless of whether or not the contract referred to any R&D work, or which party was taking the financial risk.

This policy shift followed a First-tier Tribunal (FTT) decision ruling against the taxpayer, the judgment from which included commentary on whether the claim breached the subcontracted and subsidised clauses in the underlying tax legislation. The case, Hadee Engineering Co Ltd & Others v The Commissioners for HM Revenue & Customs [2022] UKUT 00084, was arguably too narrow to justify a systemic policy overhaul, yet HMRC still went ahead and adopted a broad and general change.

A subsequent FTT case with well-presented arguments put forward by both parties ruled against HMRC’s interpretation on the subsidised element. Notably, HMRC did not opt to test their subcontracted policy in this case, and disappointingly, decided they would neither appeal that decision nor update their position. Instead, they continued to apply their revised policy going forward, despite their loss in this case.

This created a challenging environment for potential claimants. Experienced advisers informed clients that HMRC’s position had shifted, while HMRC maintained that no change had occurred. Despite Tribunal defeats on parts of their policy, HMRC persisted in applying their stricter interpretation of the legislation.

HMRC then published statistics for their revised estimate of error and fraud in the SME scheme. The figure proposed was enormous, with 24% of SME claims said to be inaccurate. Few would have been surprised to learn that the figure would be high, particularly with so many R&D tax relief advisors out there with little to no formal tax qualification, however this number caught the industry by surprise.

In my former role as Chartered Accountant Ireland’s representative on HMRC’s R&D sub-group forum, I had the opportunity to ask HMRC’s R&D Deputy Director how this figure had been calculated. Specifically, I queried what was being classed as an ‘error’, especially when HMRCs interpretation was being challenged on critical technical points such as subcontracted R&D activity.

HMRC confirmed that if a claimant made an SME-scheme R&D tax relief claim which was later disallowed under its subcontracted-activities interpretation, the entire claim would be recorded as an ‘error’, even if a claim was possible under the RDEC.

What was the outcome?

Fast forward a couple of years and HMRC has lost a further two FTT cases and reversed their change in policy. In response to a query regarding taxpayers who lost out due to adhering to HMRC’s short lived position, they stated that ‘it was only guidance’, and taxpayer’s had a choice. At this stage there is no indication of any redress system for those impacted.

Those widely reported error and fraud statistics were therefore inaccurate, however before this would become apparent, a consultation was launched on the future of the SME scheme and the new merged RDEC system was designed and rushed through as a solution to this.

So, what are the current rules?

The new rules now closely resemble the original position before HMRC’s change in interpretation and the last few years of uncertainty. Companies can potentially claim on R&D activity that was undertaken whilst completing a contract, however what is written inside that contract is more important than ever.

HMRC will want to see who instigated the R&D to determine who ‘owns’ it and is therefore eligible to claim. Broadly, this means that if a customer engages with a supplier to deliver a product, and within that contract it makes reference to the supplier needing to carry out development work, then the customer is effectively instigating the R&D.

Contrast that scenario with an example in which a customer engages a construction contractor to deliver a project. If the contract is silent on the need for any development work and any innovative activities undertaken are solely at the discretion of the contractor, then it would be anticipated that the supplier in this case would be able to claim.

In sectors with extensive supply chains, such as construction, these revised rules should reduce erroneous double claims on the same R&D activity and provide companies with greater certainty before filing.

Whilst this should prevent double claims on the same project, it will not necessarily prevent double claims on the same expenditure if both parties are working on different R&D projects. HMRC has considered this scenario and provided illustrative examples on GOV.UK. This means that it should not be necessary to try guess what an upstream or downstream party in the supply chain is doing in terms of their own potential R&D claim.

What should businesses do now to safeguard future claims?

With the new rules placing a renewed emphasis on contractual terms, it is critical that claimants are mindful of what agreements they are signing. There are a number of other factors which will be considered by HMRC, and they will also consider the substance of any agreements. However, if clauses in the contract set out in black and white that the R&D activity was not instigated by the company, then it will be very unlikely that a claim will be possible.

The key message is therefore that failure to review contracts used to engage with customers and suppliers will lead to obstacles when preparing and claiming R&D tax relief at a later date.

Ideally, companies should document R&D claims in real time. Retrospectively collating documentation from up to two years previously risks loss of critical information and the knowledge of key personnel.

If resources are limited, companies should prioritise the following two actions: (1) review HMRC’s updated subcontracted R&D guidance; and (2) submit any required Advance Claim Notification forms.

In this period of increasing complexity in making R&D claims, companies and advisors are eagerly awaiting updates from HMRC on what they have observed from the first wave of claims under the new rules.

This article highlights only one of the changes in the new merged RDEC. To accurately forecast the value of current R&D activity for future R&D tax relief claims, my advice is to engage early and in a meaningful way with a qualified advisor.

Liam McHenry is an independent tax advisor, specialising in tax incentives. He started his career at the Big 4, before moving on to lead the UK tax incentives team at the NI branch of a large multinational accounting firm.