Contracted out R&D: everything you need to know

There are many potential commercial arrangements which could result in R&D being contracted between parties, so deciding whether you are undertaking R&D which has been contracted out to you, or whether you have contracted out some eligible R&D, is not simple. The introduction of the merged R&D scheme includes a new legislative definition of contracted out R&D, which has significant ramifications for R&D supply chains.

Understanding how these rules impact your company’s eligibility to claim is essential. We take you through the new legislation and HMRC’s published guidance, exploring the various implications of the changes and what to do next.

The treatment of contracted out R&D

The treatment of contracted out R&D – relating to whether R&D has been contracted between parties, who can make a claim for relief and for what R&D expenditure – is a particularly complex area. In recent years, a narrow interpretation of the SME relief rules led to significant uncertainty for SMEs when determining whether R&D has been contracted between parties.

An entirely new legislative definition of contracted R&D was introduced in 2024 to provide clarity. The definition applies to both the merged R&D scheme and the incentive for loss-making R&D intensive small and medium-sized enterprises (ERIS). Although a positive step in providing greater clarity on this point, applying the new definition to all R&D claims means that many more companies than before the change need to consider the impact when preparing R&D tax relief claims.

Subcontracting rules for accounting periods beginning on or after 1 April 2024

Changes to R&D tax legislation including the introduction of a merged scheme have been designed to align R&D tax relief to the company making the decision to carry out R&D and in turn bearing the risk. The aim is to encourage more R&D investment, meeting the overall policy intent. This resulted in a shake-up of the treatment of contracted out R&D including a new and more detailed legislative definition as laid out in the Finance Act 2024. This came into force for accounting periods beginning on or after 1 April 2024.

The subcontracted R&D rules incorporated into the merged scheme are modelled on the existing SME scheme, but are not entirely similar. Prior to drafting of the legislation, HMRC published a policy paper setting out the intention of the rules, and it has published guidance on its interpretation of the contracted out rules alongside the enacted legislation. This guidance provides specific examples to illustrate how complex technical points apply in practice. Although this approach helps to bring clarity, there are still elements that require close attention when considering interpretation and implementation.

Subcontracted R&D rules in summary

The new rules and accompanying guidance relate to whether a company is eligible to make a claim (so consideration of whether R&D has been contracted out to it and if so, by who) and whether a company can include R&D which has been outsourced to other entities (subcontracted R&D costs).

Before we dive deeper into the rules, it’s worth covering some terminology. In commercial relationships, a ‘customer’ typically refers to the entity buying goods or services. This could be a product which is the outcome of some R&D, or the service could be the R&D itself. This is an important distinction for the purposes of determining which party is eligible for relief on that R&D.   

This is because if a company is carrying out R&D in order to deliver some goods, or a service, to a customer who has little awareness or understanding of that R&D the intent of the legislation is that the company should have the right to claim R&D relief, not the customer. Conversely, if the customer is carrying out an R&D project and contracts a part of that work to the company, specifying the R&D to be carried out, the intent is that the customer should be the party receiving relief, not the contractor.  

This requirement to carefully consider the substance of the commercial arrangement and how it relates to the R&D carried out has introduced new more stringent requirements for evidencing the contractual relationships between the relevant parties. We’ll explore this later.

Contracted out R&D test

The new legislation introduced a three-step test to determine when R&D is to be considered contracted out. All three tests must be met for the rules to apply and they build on each other, such that the third test will be the most important and complex in practice.

Setting aside some ambiguous use of specific terminology, here is an overview:

1. Is there a contract to which the R&D relates? – the guidance confirms that both a specific contract for R&D activities, and a broader contract for goods or services to which the R&D relates would be included here. This is the simplest test as it is usually apparent if the R&D activities relate to delivering something to a customer.
2. Some R&D has been undertaken to meet the obligations of the contract – did the company do some R&D in meeting the obligations of that contract? This clause prevents a claim being made where R&D is contracted to a company, but subsequently is not actually carried out.
3. Contemplation of R&D – the most nuanced of the steps considers the understanding and intentions regarding the specific R&D activities when entering into the contract. The R&D carried out must link to the R&D which was contemplated; awareness or intention that some R&D will be required would not be sufficient to meet this threshold. HMRC’s interpretation of the wording ‘intended or contemplated’ suggests the nature of the R&D needs to be articulated in the contract negotiation phase, e.g. in scopes of work or meetings.

This third rule is a key provision in understanding where the boundary between a commercial contract for the provision of goods and services and a contract for R&D lies. It creates a narrower test than that which HMRC has historically applied to SME R&D tax relief cases.

The draft guidance provides helpful detail and examples on how companies might evidence meeting these tests (or not meeting them) in practice. There is plenty of detail in particular on the role of competent professionals in determining whether R&D has been contracted between parties.

R&D supply chains – who gets to claim when R&D has been contracted out

The new definition of contracted out R&D amounts to a significant change to the incentive. It is vitally important to understand your position in the supply chain and what that means for your eligibility to claim relief for your R&D expenditure.

The legislative definition of contracted out R&D covered in the previous section determines whether R&D has been contracted out between parties. The table below shows which entity claims under the new rules when R&D has been contracted out. Large companies, SMEs and R&D intensive SME contractors all receive relief on payments for contracted out R&D. That is a significant change for large companies compared to the position pre April 2024.

One of the main consequences of the new rules is that R&D subcontractors lose their right to claim regardless of whether the contractor is a large company or SME.  The exception to this is broadly where the contractor cannot claim relief, for example because they are a charity, university, individual, or overseas entity. More on this in the next section.

Each case will need to be considered quite carefully to understand the status of both the company and the relevant entities in its supply chain. ForrestBrown’s experts are here to help.

Can subcontractors claim for R&D tax relief for accounting periods beginning on or after 1 April 2024?

There are some scenarios where a subcontractor can claim R&D tax relief, when either the entity contracting out the R&D is an irrelievable client, or it is not contracting out the R&D in the course of a trade, profession or vocation within the charge to tax.

This exemption would apply to R&D carried out for non-tax paying entities such as charities, universities, scientific research organisations and government departments, as well as overseas entities which are not within the charge to UK tax.

If there is a chain of entities, every person contracting out the R&D must satisfy one of these conditions for the exemption to apply. So, if R&D is initiated by a UK company, but contracted on to its overseas subsidiary and then on again to another UK company, it would be treated in the same way as if it had been contracted from one UK company to another.

Contract Research Organisations (CROs)

Historically, some R&D carried out by CROs did not attract relief under either scheme; specifically when the activity was contracted out from a large company. This is because under the previous RDEC scheme, companies could not include the cost of subcontracted R&D with their claim. In addition, while the R&D carried out by CROs tends to be part of the contractor’s wider R&D project, it would not typically be relevant R&D in isolation for the CRO.

In the merged scheme, a large UK company should now typically be able to make a claim for the cost of a trial contracted out to a CRO as part of an R&D project (subject to overseas R&D restrictions). SMEs will continue to be eligible to include these contracted out R&D activities.

However, if the entity contracting out R&D activities to a CRO is ineligible for relief, the CRO will likely not be able to claim under the merged scheme via the exemption covered above. This is because the activities carried out are unlikely to constitute relevant R&D for the CRO when isolated from the wider R&D project to which they relate (as with the previous scheme).

New election for groups of companies

An election has been introduced for groups of companies, which maintains the previous position for large groups under RDEC. Previously, there were specific provisions in the RDEC scheme which set out that where R&D was contracted between members of a large group, it was treated as relevant R&D of the company actually carrying out the R&D.

In the merged scheme, the two group companies can elect to treat the contracting entity as an ineligible company. The effect of this is that the company carrying out the R&D can continue to claim relief. The companies need to put in place a joint election to this effect, in writing, which remains valid until the election is terminated by either company, or they cease to be part of the group.

Transitional arrangements

The new rules have the potential to apply to different businesses at different times, as they apply for a company’s first accounting period which begins on or after 1 April 2024. This means that one business might still be under the old rules at the same time as another is under the new rules. This creates scope for either both companies to claim relief, or neither of them, for the same R&D.

It has therefore been necessary for the legislation to include some transitional provisions. These are the three provisions:

• If a contractor is still able to claim for the work they do for you under the old RDEC incentive, you will not be able to claim.
• If a customer is still able to claim for the work they are paying you to do for them under the old SME scheme, you will not be able to claim.
• Where neither the customer or the contractor would otherwise be able to claim because one is under the new rules and the other is under the old rules, the legislation modifies the new rules such that generally the historical position is maintained for that interim period, to prevent a gap in relief.

In practice, this should mean that the earliest a company can lose its eligibility to claim will be the beginning of the first accounting period for which it must apply the new contracting out rules. For companies gaining eligibility to claim for R&D previously claimed by subcontractors, they will need to check when the new rules start to apply for their subcontractor.

Subcontracting rules for accounting periods beginning before 1 April 2024

Here is a brief overview of the rules on subcontracted R&D that applied for accounting periods beginning before 1 April 2024.

An SME carrying out R&D could usually claim 65% of the costs paid to a third party subcontractor for qualifying activities. Conversely, no relief was available under the SME scheme for R&D contracted out to a company. SMEs carrying out R&D as a subcontractor for a large company or non-tax paying entity could potentially claim under RDEC instead.  

Under the RDEC scheme, companies could claim relief for R&D contracted to them, unless the contracting entity was an SME. R&D contracted out to other parties could only be included in very limited circumstances, where the subcontractor was an individual, partnership of individuals, or a qualifying body.

Prior to 1 April 2024, subcontractors did not need to perform R&D in the UK.

As with the new rules, the activities carried out by the subcontractor did not need to R&D when looked at in isolation, but should form a component of the contractor’s R&D project. It is also worth noting that there were separate rules under each scheme for R&D contracted out to connected parties.

Contracted out R&D – practical considerations

It’s important to take the time to fully understand the impact of the changes both on commercial decisions and on R&D claims. We recommend going through these considerations

Has the R&D you have carried out been contracted to you?

The first thing you need to do is to determine your eligibility to claim. Consider the three tests for contracted out R&D, and what evidence you have available to support any decisions you reach (more on this below).

There may be a chain of entities and corresponding contractual relationships to consider.

Are you undertaking R&D for an irrelievable client?

If you are undertaking R&D which has been contracted to you, you may still be eligible for relief, if the entity you are working for cannot claim. Common examples include work for government bodies, overseas entities or research organisations.

In some cases, companies may contract with irrelievable clients via an intermediary on a pass through basis. If the intermediary is not undertaking contractual responsibility for the R&D activities, it is possible that it can be ignored even if it is a UK company.

Establish what costs you can include

If you are eligible to claim relief and have outsourced some R&D activities to another party, you may be eligible to claim the cost of the qualifying work within your R&D claim.

The same tests apply to these downstream contracts; including whether that R&D was intended or contemplating when entering into the contract. For any subcontracted R&D expenditure you include within your claim, you should be confident that you have sufficient records to support the amounts, nature and any apportionments applied.

Think about records

The legislative test considers whether it is reasonable to assume, having regard to the contract and surrounding circumstances, that the R&D was intended or contemplated. This means that if HMRC opens an enquiry into your claim, the case worker is likely to request copies of contractual documentation, as well as any other documentation which is relevant to the position taken in the claim. It is your responsibility to keep these records and ensure that they are available at the right time, which could be several years after the R&D project has taken place.

HMRC’s guidelines for compliance on R&D tax relief set out the records they expect companies to keep in support of R&D claims.

Be proactive

Commercial contracts, some of which may have been in place prior to the relevant period, will need to be reviewed to determine whether R&D has been contracted out. Once the correct legislative position has been established, it may be helpful to formalise this between the parties (either within the contractual documentation or separately), provided any updates reflect the substance of the arrangements.

It pays to be proactive and forward-looking when it comes to the link between your R&D claim and your wider commercial relationships. If you are part of a complex R&D supply chain, these rules could result in significant complexity as well as having a material impact on the value of your R&D claims. Ensuring that the R&D tax position is considered when entering into commercial arrangements where there is a possibility that R&D will be undertaken to fulfil contractual obligations will enable your business to make informed decisions and accurately forecast relief.

FB Consulting’s multi-disciplinary team includes legal and tax expertise which helps our clients to review their position and take positive steps when needed.

ForrestBrown insights

The subcontracted R&D rules represent a significant change that will affect many businesses, both large and SMEs.

• Large companies will need to urgently evaluate how the new rules apply to commercial structures and contracts, potentially for the first time. The impact of the new subcontracting rules is potentially enormous, in particular, if your clients are now eligible to claim instead of you or if there is scope to include substantial sums for subcontracted R&D activities. A review and analysis of commercial relationships and contractual documentation is recommended. Read our article on the contracted out rules and upstream and downstream commercial arrangements.
• SMEs need to stay up-to-date on the interpretation and implementation of this already complex and contentious area, especially in light of historic uncertainty in determining whether R&D has been contracted between parties. The new definition differs from the previous position, so SMEs will need to re-establish with confidence whether R&D has been contracted to them.
• Any businesses currently claiming under RDEC for R&D contracted to them are unlikely to be able to claim under the merged scheme because the cost of that R&D will form part of the R&D claim for the contracting company in most circumstances. This loss of relief could have a material impact on forecasts and budgeting for future R&D projects.
• Any situation where eligibility to claim relief is moving from one entity to another could trigger a commercial discussion between those parties. Understanding the correct legislative position provides the strongest foundation for these discussions.