A Strong Victory for Taxpayers Over ‘Subcontracted’ and ‘Subsidised’ R&D Rules for SMEs
On December 19, 2024, the First-tier Tribunal (FTT) ruled in favour of Stage One Creative Services Ltd (SOCS) in the case Stage One Creative Services Ltd v HMRC [2024] UKFTT 1059 (TC) offering a significant win for taxpayers interpreting the rules around subcontracted and subsidised R&D under the SME scheme for tax credits. This ruling comes shortly after the Collins Construction case and clarifies key aspects of R&D tax relief, especially concerning commercial contracts.
Case Background
SOCS, which specialises in providing engineering, construction, and automation solutions for live events, incurred R&D costs while working on these projects. However, HMRC rejected SOCS’s claims for enhanced R&D relief under the SME scheme for two main reasons:
- The R&D costs were classified as ‘subsidised expenditure’.
- The R&D activities were deemed to be ‘contracted out’ to SOCS under its customer contracts.
HMRC contended that any R&D expenditure incurred to fulfill contractual obligations with customers automatically fell under the categories of both “contracted out” and “subsidised.” SOCS disagreed and appealed the decision to the FTT, also challenging the Discovery Assessments raised by HMRC. SOCS argued that their claims were consistent with HMRC’s guidance before November 2021, which was in effect at the time.
The FTT ruled in favor of SOCS on both the core issues and the Discovery Assessments.
Key Issues Considered by the FTT
Was the expenditure ‘subsidised expenditure’?
This issue centered on whether the R&D costs were ‘subsidised’ within the meaning of Section 1138(1)(c) of the Corporation Tax Act 2009, which requires that expenditure be either directly or indirectly paid for by a third party. This point was previously addressed by the FTT in Quinn (London) Ltd v HMRC [2021] UKFTT 0437 (TC).
SOCS relied on the Quinn decision, which had been endorsed by the Upper Tribunal in HMRC v Perenco (UK) Ltd [2023] UKUT 169 (TCC). HMRC argued that Quinn’s interpretation was flawed and not applicable here, as it involved a different statutory regime.
Though the FTT agreed that it was not bound by Quinn or Perenco, it found both cases persuasive and, given the similarities in facts between SOCS and Quinn, adopted the same approach. The FTT ruled that R&D expenditure is not considered subsidised unless there is a “clear and direct link” between the third-party payment and the expenditure itself. Based on this, the FTT concluded SOCS’s R&D expenditure was not subsidised.
Was the expenditure ‘contracted out’?
The issue here was whether the R&D expenditure SOCS incurred was “contracted out” to them. Both parties agreed that SOCS’s R&D was undertaken to meet its contractual obligations to customers.
HMRC argued that any R&D expenditure incurred to fulfill customer contracts automatically qualifies as “contracted out.” In other words, only independent (or “freestanding”) R&D, not linked to a customer contract, would qualify for relief.
SOCS countered that while they had contractual obligations to deliver specific products, the contracts did not mandate particular R&D activities. They argued that they retained full control over how, if, and when to perform R&D, owned the intellectual property from this work, and assumed the financial risk for the R&D activities.
The FTT examined the meaning of “contracted out” within the legislative framework and its original intent, which is to avoid claiming relief twice for the same R&D. The FTT rejected HMRC’s view that all R&D linked to customer contracts is “contracted out” and supported SOCS’s position that the R&D was not contracted out. This conclusion was based on the fact that SOCS owned the intellectual property and had full discretion over its R&D efforts.
Thus, the FTT ruled that the R&D expenditure was not contracted out.
Discovery Assessments
The FTT also reviewed the validity of HMRC’s Discovery Assessments, which were issued based on the assumption that SOCS’s claims were incorrect.
The tribunal considered whether a hypothetical officer reviewing SOCS’s R&D reports could reasonably have detected that the assessments were insufficient, and whether SOCS’s tax returns had been filed in accordance with the “practice generally prevailing” (PGP) at the time, based on HMRC’s guidelines.
HMRC argued that the updates to the Corporate Intangibles Research and Development Manual (CIRD) in November 2021 did not significantly change their stance on the issues at hand. However, the FTT disagreed, noting that HMRC’s interpretation had indeed shifted, especially regarding whether R&D was subsidised or contracted out.
The FTT found that SOCS’s tax returns had been filed in accordance with the previous version of the CIRD, which recognised that SMEs could qualify for relief even if they retained intellectual property and controlled their R&D. As a result, the tribunal ruled that the Discovery Assessments were invalid.
Implications of the FTT’s Decision
This ruling is a significant win for taxpayers, building on previous victories in Quinn and Collins Construction. It reinforces that HMRC’s approach to defining “contracted out” and “subsidised” expenditure for R&D claims must align with prior guidance. We understand that HMRC does not plan to appeal either the Collins Construction or SOCS decisions, and new guidance will be issued in February 2025 to clarify the broader implications of these rulings.
For businesses with open R&D claims or pending inquiries for periods ending before November 2021, this ruling may have a significant impact if HMRC has incorrectly argued that R&D expenditure is either subsidised or contracted out in a manner inconsistent with the guidance in place at the time.
For many claimants with ongoing enquiries around subcontracted/subsidised expenditure, this has been a long and frustrating journey, but it is encouraging to see clarity beginning to emerge, with further guidance expected as early as February 2025.
HMRC has already begun contacting customers with open enquiries from the start of the calendar year to outline next steps and by initial accounts, appears to have provided a contact window that stretches out to June 2025. Nevertheless, there is movement.
We remain fully committed to supporting you throughout this process and beyond. If you would like to discuss how these decisions impact your current or future claims, please get in touch.
Learn how we’ve successfully helped our clients navigate HMRC enquiries, providing expert technical and financial support to secure approval for their R&D claim.
