Overseas R&D restrictions

Overseas R&D expenditure – the general rule

For accounting periods beginning on or after 1 April 2024, R&D expenditure on overseas third party costs is normally not eligible for R&D tax relief. These restrictions only impact expenditure on Externally Provided Workers (EPWs) and subcontracted R&D (both connected and unconnected). The rule applies to R&D claims made under the merged R&D scheme and Enhanced R&D intensive support (ERIS). There are however some limited exceptions to the general rule that we will explore in more detail.

EPWs and overseas R&D restrictions

When it comes to EPWs, the worker’s earnings need to be subject to Pay As You Earn (PAYE) and Class 1 National Insurance contributions (NICs) to be eligible.

The PAYE and NIC condition is a gateway test. Provided PAYE and NIC has been applied to the salary of the worker, the whole of the payment for the services of that worker can be considered eligible for relief (subject to any apportionment if they are not wholly engaged in R&D), not just the proportion on which PAYE and NIC has been applied.

Expenditure on unconnected EPWs is subject to a statutory restriction to 65% of the total payment attributable to R&D activities.

In its guidance, HMRC describes a company looking for specialist workers in the UK, but only being able to source six of ten roles to work on the UK site, with the remaining four working remotely from Mexico. These four do not meet the overseas R&D requirements, so the example suggests 60% of the total amount paid to the staff provider could be claimed (representing the UK workers). This does assume that wage levels are similar between Mexico and the UK, which might not reflect the practical realities of such an arrangement.

Exceptions to the general rule for EPWs are explored below.

Contracted out R&D and overseas R&D restrictions

Contracted out R&D activities must be carried out within the UK. R&D is undertaken in the UK to the extent that the activities physically take place in the UK, regardless of the nationality of the workers or where consumables, data or software are sourced from.

If contracted out R&D activities are not undertaken within the UK, they may be eligible if an exception applies.

See our complete guide to contracted out R&D.

Exceptions to overseas R&D restrictions

Overseas R&D expenditure is eligible if it relates to R&D where there are conditions present overseas which are not present in the UK and it would be ‘wholly unreasonable’ to replicate those conditions within the UK.

These could include geographical, environmental or social factors, or where legal or regulatory requirements mean that that activity needs to take place in specific territories.

In March 2024, updated draft guidance on new contracting out rules and overseas restrictions from HMRC provided 17 examples setting out how these exceptions may work in practice. Some of the more commercially applicable examples of overseas exceptions include:

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Example 1: scenario

A UK-based construction business sends a team of engineers overseas for 18 months to work on a specific construction project which includes developing new construction techniques on-site. Some of the team are employees of the UK company and the others are EPWs.  All need to be present on-site to support the R&D activity, which must be supervised by the local Ministry of Construction.

Example 1: how the rules apply

The overseas restrictions do not apply to staff costs so there is no restriction on the expenditure relating to the UK employees. The EPWs need to be on-site, the site is abroad and there are regulatory conditions which require the activity to take place there. So there are conditions in that country which cannot reasonably be replicated in the UK, meaning that the EPW costs will satisfy CTA09/S1138A, although the business should be prepared to state why they need to be on site.

Example 2: scenario

A company wishes to carry on destructive testing of its product, using a commercial testing lab (to which the work would be contracted).

Example 2: how the rules apply

If no suitable test facilities are available in the UK, the company must consider whether it would be wholly unreasonable to replicate the conditions required. For example, if there is a facility which could be readily adapted in the timeframe required. If not, the exception should apply.

If a UK test facility exists, but is not available on the required timescale and there are genuine time pressures for the testing to be carried out, HMRC considers that it would be wholly unreasonable to replicate conditions in the UK and therefore the cost of carrying out the activity overseas would be eligible.

Example 3: scenario

Raw materials required to undertake R&D are only available overseas, and the alternative to carrying out the work abroad would be to incur significant cost and carbon footprint of shipping the materials to the UK just to do the R&D testing.

Example 3: how the rules apply

Cost alone will not be an allowable exemption from the overseas restriction. However, if concerns around the environmental impact of transporting materials, or the need for a steady supply of material, were overriding factors, they might be relevant.

Whether the condition in CTA09/S1138A(2) is satisfied therefore depends on the wider facts.

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The examples set out in HMRC’s guidance are helpful, but given the broad range of potential scenarios where R&D may be undertaken outside of the UK, more complex cases will require careful consideration of the factors involved and the evidence required to support a claim for relief.

See more detail on these examples and others here.

Factors that are NOT relevant exclusions

For added clarity, the legislation confirms that the following are not considered relevant factors for exclusion from the overseas R&D restrictions:

• Cost.
• Availability of workforce.

There is also no de minimis, so the changes will impact any EPW or subcontractor spend, even if amounts are small, or contribute only a small proportion of overall R&D spend. Companies should be prepared to provide evidence to HMRC that any expenditure included under these categories is unaffected by the restrictions, even if it may seem obvious that the expenditure is UK-based. HMRC’s guidance confirms that their approach should be pragmatic and proportionate to the risk posed. For example, if a subcontractor is small and operates from a UK trading address, this is likely to be sufficient evidence to support that the activities were UK based.

It is also important to note that there is no exception for connected party costs, so the restrictions will apply to group employees if employed by an overseas subsidiary but supporting on UK R&D projects (usually eligible as connected party EPWs).

When did the new overseas restrictions come into place?

The new rules outlined above apply to a company’s first accounting period which begins on or after 1 April 2024. This means the restrictions apply earlier to some companies than others. For example, a company which draws up accounts to 31 March will apply the new rules to its accounting period ending 31 March 2025 (which began on 1 April 2024). One which draws up accounts to 31 December will apply them in its period ending 31 December 2025, which begins on 1 January 2025.

Accounting periods beginning before 1 April 2024

These changes were originally due to take effect in 2023 but were delayed for a year. If your accounting period began prior to 1 April 2024, there are therefore no overseas R&D restrictions to apply for that period. However, if a substantial proportion of your R&D expenditure relates to overseas activities (compared to UK employees), it is important to note that PAYE/NIC cap may restrict the amount of R&D relief available.

Why has the government made changes to overseas R&D rules?

Restrictions for expenditure on overseas R&D were first discussed in 2022, proposed as a way to refocus R&D tax relief on UK-based R&D activity and better encourage innovation within the UK. The government stated that it wished to maximise the benefit to the UK from the spill-over effect of R&D activity incentivised by the relief.

Some strong feedback followed these initial discussions which delayed any legislative changes. Although the legislation has now been enacted largely as originally proposed, this delay did mean that HMRC had a first draft of its supporting guidance to work from. Consultation on the initial draft took place at the start of 2023, giving HMRC time to reflect on feedback, much of which has been taken on board in producing more detailed updated guidance with a much broader range of practical examples. While the inclusion of practical examples is positive, it is expected that this complex area will continue to evolve as the rules take effect.

Making a claim for qualifying overseas expenditure – practical considerations

Before including any EPW or subcontracted R&D expenditure in an R&D claim, you will need to satisfy yourself that the costs are either UK based, or meet the criteria for eligibility in the overseas R&D rules (as well as all the other criteria for each category).

You will also need to consider the evidence that should be kept to support your R&D claim, should HMRC ask you to confirm eligibility at a later date. As well as evidence of the activities and expenditure, such as contracts and invoices, you may need to keep emails, meeting minutes and other records which evidence why the activity took place outside of the UK.

For EPWs, the additional information form asks for PAYE/NIC references from staff providers. Companies may encounter challenges when requesting this detailed information from third party staff providers.

Importance of evidence

If relying on an exception, this should be carefully documented, with evidence kept in the event of a compliance check, and consideration given to disclosing your position clearly to HMRC. It makes sense to retain meeting minutes or project plans to support the necessity for the work location.

Overall, this is an additional compliance burden, so companies will need to balance the cost to comply with the benefit of including these costs. Early consideration will be key.

Companies registered in Northern Ireland

The restrictions on overseas third party costs do not apply to companies registered in Northern Ireland. Instead, however, any credit claimed under ERIS will be considered de minimis state aid and will therefore be subject to a cap of €300,000.

The cap applies to de minimis aid received in any three-year period ending on the day in which the claim is made (ignoring any claims made for accounting periods beginning before 1 April 2024, but including any other forms of de minimis aid received by the company/group from the UK). Note the €300,000 limit applies to the additional relief received under ERIS insofar as it exceeds the net benefit of an equivalent claim made under the merged scheme.

This applies to claims made on or after 30 October 2024 by companies with a trade in goods, or a trade which involves the generation, transmission, distribution, supply, wholesale trade or cross-border exchange of electricity.

Any amounts in excess of the cap will be eligible for relief under the merged scheme, but the usual restrictions on relief for overseas spend on contracted out R&D and externally provided workers will apply. Businesses with no trade in goods or relevant activities in relation to the electricity market can opt out of these provisions. Doing so would mean that the limit on the amount of relief claimed in a three-year period will not apply. However, the overseas restrictions will instead apply.