Following a ruling by the First-tier Tribunal (FTT), which settles legal disputes on tax and other matters related to government, HMRC has been forced to clarify the guidance for SMEs claiming R&D tax relief on ‘contracted out’ and ‘subsidised expenditure’.
You can read more on the specific court case in our article, HMRC court case: Impact on your R&D claim. In a nutshell, it’s good news for innovative SMEs.
HMRC had attempted to deny relief to an SME scheme claimant, arguing that because their R&D activities had taken place as part of a commercial contract, the work should be considered as contracted out and subsidised, making it ineligible for relief.
The FTT disagreed, and HMRC decided not to appeal. Instead, they’ve updated the Corporate Intangibles Research and Development manual (CIRD) to provide greater clarity on what should and shouldn’t be defined as subcontracted R&D. In practice, this opens the door for relief claims where R&D has happened that was incidental to a commercial contract.
This will be of particular relief to any companies facing HMRC enquiries for this very reason, as there is now a much stronger basis for similar claims to be accepted.
Here, we explain how the clarified guidelines for subcontracted R&D expenditure affect SME scheme claims.
Guidelines for activities contracted to SMES
If a company outsources its R&D activities to a subcontractor, it’s generally only the customer (i.e., the company requesting the work) that’s eligible to claim for the expenditure. This rule is designed to prevent ‘double dipping’, where both the customer and the subcontractor claim for the same R&D expenditure.
There are, however, certain circumstances where the subcontractor can claim for R&D tax relief – even when fulfilling a commercial contract. For instance, if the subcontractor undertook R&D under its own initiative as a way of improving its ability to fulfil a contract, then they can likely make a claim.
The key here is that a ‘commercial contract’ doesn’t automatically mean that R&D has been subcontracted; it depends on if the client explicitly requested the R&D or if it’s likely that R&D would be needed for the work to be delivered. There are four factors can help to determine whether or not this was the case:
- Was the R&D incidental to the supply of the contracted work? If yes, the work isn’t considered contracted, and the subcontractor can likely make a claim.
- Was the subcontractor in charge of how they completed the work? If the subcontractor didn’t have much autonomy, and was directed by the customer on how to complete the project, the subcontractor wouldn’t be able to make a claim.
- Was there any meaningful financial risk for the subcontractor? If there was limited financial risk to undertaking the R&D (i.e., the commercial contract guaranteed payment no matter the outcome), it makes it more likely that the work would be classed as subcontracted.
- Does the subcontractor own the results of the R&D? If the customer kept all the rights to any intellectual property (IP) relating to the R&D work, it suggests that the R&D was part of the contract, so the subcontractor wouldn’t be able to make a claim.
Example 1:
If a company undertakes R&D incidentally during the supply of the contracted work, it is not considered contracted out.
Example 2:
When R&D is explicitly required to fulfil a contractual product specification, it is considered contracted.
Example 3:
If a company independently decides on R&D based on customer feedback and retains IP and financial risk, it is not considered as contracted.
Guidelines for activities contracted out by the SME
SMEs can hire another company to complete all or part of their R&D but to qualify for R&D tax relief, the SME needs to show that they had significant control and direction of the project. For example, if an SME hired a subcontractor for an R&D project and, as part of this project, the SME gave the subcontractor a design for a new device and asked them to build a prototype to match their specifications. This work would be eligible.
If, however, a contract simply is to provide general services, materials or expertise, and part of this work incidentally helps with R&D, but isn’t R&D itself, that’s just a regular service and therefore wouldn’t be considered subcontracted work.
Of course, it’s perfectly fine for two SMEs to carry out an R&D project together jointly. In this case, the SMEs just need to claim for their relevant share of qualifying expenditure.It’s also worth stressing (as it was an important part of the FTT ruling) that if an SME received a subsidy, which they then used for an R&D project, this wouldn’t be considered subcontracting, it would be classed as subsidised expenditure instead.
The importance of evidencing subcontracted R&D work for SME scheme claims
The important takeaway from HMRC’s clarified guidelines is that all companies must gather detailed evidence for their R&D activities. Key documents like contracts, meeting minutes, and correspondence can all be used to help determine the contracting nature of R&D projects.
How Leyton can help
If your SME is facing an HMRC enquiry relating to subcontracting, we can help with our R&D enquiry defence support service.Our experts have been working constructively with HMRC for years, not only in resolving R&D enquiries but also in helping to inform R&D relief legislation. Because of this, we can act as a trusted partner to help you substantiate your claim. We’ll audit your original claim and provide a robust defence for your eligible R&D activities. Working with your technical and financial leads, we’ll gather evidence and build a case to help clarify how your work qualifies for relief. We’ll also liaise directly with HMRC until the enquiry reaches closure.
Get in touch to find out more.
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