HMRC’s new guidance on subsidised and contracted out R&D – next steps for SMEs

Following publication of HMRC’s new guidance on contracted out R&D and subsidised expenditure under the old SME regime (still relevant for 2023, 2024 and some 2025 accounting periods), here’s what SMEs need to do now.

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What the new HMRC guidance means for SMEs

HMRC has published its eagerly anticipated guidance on subsidised expenditure and contracted out R&D, following the loss of two First-tier (Tax) Tribunal cases at the end of 2024: Collins Construction and Stage One Creative Services (SOCS). The guidance affects the interpretation of the subsidised expenditure and contracted out R&D restrictions under the old SME scheme, which came to an end for accounting periods beginning on or after 1 April 2024.

Despite its limited application, the new guidance marks a long anticipated change of approach and an acceptance that the findings of both the recent cases must be respected. This is welcome news for those with open enquiries or cases in appeal, which have a similar fact pattern to Collins and SOCS.

It will also be relevant to those businesses that accepted HMRC’s position under its previous guidance and, as a consequence, either did not make an R&D claim or claimed under the less generous RDEC scheme. Businesses with affected accounting periods that are still within time to amend should consider reappraising their approach.

As with any update, the devil is invariably in the detail. So, what does the new guidance say? Who does it affect? And, crucially, what should businesses do about it?

Background context

Anyone who has claimed R&D tax relief in recent years will be familiar with the wholesale legislative reform that has taken place. The changes culminated in the introduction of the merged scheme on 1 April 2024, which replaced the previous SME and large company (RDEC) schemes. All companies – irrespective of size – now claim relief at the same rate (with a small exception for certain high-intensity R&D companies that have access to a higher rate).

Prior to the merging of the schemes, there had been considerable discussion around commercial chains:

• Where the R&D takes place within a project for a third party under commercial terms, and;
• Who would be eligible to claim any relevant R&D expenditure.

The key issues centred around the contracted-out R&D and subsidised expenditure provisions contained in the definitions of qualifying R&D expenditure found at sections 1052 and 1053 of the Corporation Tax Act 2009.

For a long time, the interpretation of these provisions was largely uncontroversial. In late 2019 this changed, with HMRC preferring a broader approach to the interpretation of each provision that would pull more cases within their ambit (with the result of removing some claims altogether or pushing others into RDEC). The disputes that followed were not helped by a lack of clarity and supporting definitions within the legislation itself.

It wasn’t long before the first case was tested in the First-tier (Tax) Tribunal. In 2021, in the first of three Tribunal cases to go in favour of the taxpayer, ForrestBrown successfully argued for its client Quinn (London) Ltd that Quinn’s expenditure on R&D was not subsidised by its clients, as HMRC had suggested.

It was hoped that this decision would herald a turning point in HMRC’s approach to subsidised expenditure. However, in the years that followed HMRC openly rejected it in favour of its own interpretation, despite the judgment being the only judicial authority on the point. That failure allowed ambiguity to persist and ensured that other cases found their way to Tribunal, notably Collins Construction and Stage One Creative Services (SOCS). These cases both dealt with the twin issues of subsidised expenditure and contracted out expenditure and were decided in late 2024 in favour of the taxpayers.

A matter of weeks later, HMRC confirmed that it would not seek to appeal either decision and that it would duly update its guidance on contracted out R&D and subsidised expenditure. On 27 February, that guidance was published as part of an update to its Corporate Intangibles Research and Development (CIRD) manual, paving the way for a new approach to interpreting contracted out and subsidised expenditure.

What does the new HMRC guidance say?

The guidance updates the CIRD manual at sections 81650 (subsidised expenditure) and 84250 (contracted out expenditure). On first reading, it reflects HMRC’s acceptance of the above decisions, with the broad application of the two restrictions now seemingly a thing of the past.

The approach on subsidised expenditure is perhaps the most straightforward, if perhaps a little confused in its current form. It  sensibly acknowledges that the subsidised expenditure and contracted out provisions are separate and should be considered as such. It then goes on to attach significant relevance to the contracted out status of any R&D activities for determining whether the expenditure on those activities is subsidised.

Niggles aside, the direction of the guidance is broadly clear. The important point is the acceptance that a commercial payment under the terms of a contract does not typically subsidise expenditure on the activities under that contract. For it to be otherwise, there needs to be a specific link between the payment by the principal and the R&D activities.

With contracted out R&D, the new guidance sees a return to a more nuanced approach. The guidance considers a number of indicators of R&D having been contracted out, such as financial risk, autonomy, know-how and IP, with the aim of aligning with Parliament’s intention to reward the relief to the party taking the risk to invest in R&D. This is a long way from HMRC’s previous guidance, where the mere existence of a contract was enough to trigger the contracted out R&D restriction.

Interestingly, the new guidance lists the relevant indicators in order of the weighting that HMRC consider should be applied. It is not immediately clear on what basis HMRC have determined the ordering in the list but the return of this more considered approach is welcome (and accurate).

Finally, the guidance also benefits from the addition of practical examples showing the application of the revised approach in practice. While practical examples in guidance are always welcome, they inevitably cannot catch all of the different fact patterns that companies will come across and so called “edge cases” will need to be considered carefully. We also don’t agree with the analysis in one of the examples, suggesting that there are likely to still be some areas of disagreement.

This final point is key. The new guidance doesn’t change the wording of the legislation, it is merely HMRC’s own interpretation of that legislation in light of the recent cases. The guidance should not be treated as definitive, and there may well still be cases where a taxpayer’s analysis and HMRC’s view diverge.

Who does the updated guidance affect?

The most immediate group to be affected by the updated guidance are those businesses already in dispute over a claim. There are cases that were informally stayed behind Collins and SOCS, where enquiries have closed, been appealed, and are now in the queue at the Tribunal waiting to be heard. They will now be seeking a resolution.

There are also those businesses with open enquiries that have similar fact patterns to Collins and SOCS that are waiting for confirmation of next steps from the caseworker. These could take many more weeks or months to resolve.

The other group that should pay keen attention to the new guidance are those that have taken a conservative approach to claiming R&D tax relief based on HMRC’s previous interpretation of the legislation, either not claiming at all or claiming under RDEC at a lower rate rather than under the SME scheme. For some, this may have been driven by a lack of resources to embark on a long-running dispute with HMRC, while others may not have wanted to take the risk. Whatever the driver, those businesses would have claimed less than they might otherwise have been entitled to.

What should businesses do next?

HMRC have acknowledged that they got the legal position wrong, so any company impacted by that error should look at their position.

For those within the appeal process or in enquiry with this issue in dispute, HMRC should now have no reason to delay reaching a conclusion. It is quite possible that HMRC will seek to continue arguing certain cases, particularly where the facts aren’t directly equivalent to those in SOCS and Collins. But the room to manoeuvre and the focus of any dispute should be dramatically narrowed which, in turn, should significantly improve the chances of resolving any continuing cases outside the courtroom.

For any SME which followed the previous guidance and either claimed under RDEC or omitted to claim at all as a result, there is an opportunity now to review those years still within time to amend and reappraise their approach.

While the above focuses on past accounting periods and the recovery of funds that a company should have been due, the status adopted in those claims is also potentially relevant under the new rules. For example, if an SME opted for RDEC as a conservative, less risky option when their R&D forms part of commercial work for a large company (whether technically contracted out or not), that SME may need to justify a shift of status under the new rules if it later claims that the R&D is not contracted out (which it will need to do in order to have a claim at all under the new rules). In other words, for some companies in this position, simply letting bygones be bygones may not be the best approach to protecting that company’s future position.

Going forward, the new rules will apply with the detailed guidance for those new rules sitting alongside. SMEs should continue to identify whether and where R&D has been contracted out – applying this new test. They should though, keep in mind two key points. First, SMEs working for large companies can no longer rely on accessing RDEC where R&D is contracted out (this connects to the point immediately above). This will all but eliminate claims for some SMEs.

The second is that, under the old SME regime, the assessment of contracted out relationships was inconsistent and HMRC felt that companies (and their advisers) were often too generous in their interpretation of the test when looking upstream and downstream; perhaps a little too willing to have their cake and eat it. The problem for HMRC was that, with poorly constructed legislative tests and limited guidance, taxpayers were left with a lot of justifiable room to manoeuvre, making enforcement challenging.

This has changed with the introduction of the new rules. The legislation incorporates key definitions which are then discussed in detail in the guidance. Companies will, as a result, be expected to get their position (both upstream and downstream) correct and to be able to evidence their position and how it was reached. Adopting a system for properly appraising upstream and downstream commercial relationships, in a pragmatic way, will be key.