Stage One Creative Services Ltd: Latest Tax Tribunal decision helps solidify the judicial view on ‘contracted out’ and ‘subsidised expenditure'

Key points

• HMRC lost on both the “contracted out” and “subsidised” expenditure points
• Although not bound by it, the judge agreed entirely with Quinn on subsidised expenditure
• On contracted out expenditure, the judge referred to Quinn and determined that a “broad interpretation” of the relevant legislation was not appropriate
• There was also a discovery issue before the Tribunal, which HMRC lost, although it was moot since there was no incorrect return given the decision on subsidised and subcontracted

Background

Stage One Creative Services (SOCS) involved appeals against a closure notice in respect of an enquiry into the Corporation Tax return for APE 31 December 2019. There was no dispute about the nature of the R&D activities themselves or the amounts, which were all agreed. There were also appeals against two discovery assessments for the 2017 and 2018 years.

There were three matters of law involved in the case. First, whether the company’s expenditure was “subsidised expenditure” within the meaning of section 1138 of the Corporation Tax Act 2009. Secondly, whether the activities had been “contracted out” to the company within the meaning of sections 1052 and 1053 of the 2009 Act. And thirdly, whether a discovery had been made or whether claims had been submitted under “prevailing general practice”.

Two witnesses appeared for HMRC, one to give evidence on the history of the statute and on HMRC’s view of the purpose, and the other to give evidence on the background to the assessments.

Three witnesses gave evidence for the company, one in respect of the contracts and the way in which the business was run, and two who gave evidence in respect of the discovery issue.

Hearing

Subsidy condition

SOCS relied heavily on Quinn, while HMRC fell back on Hadee. The judge clearly distinguished the two; Hadee was won by HMRC mainly on a lack of documentation, while there was “copious documentary evidence” in this case. Indeed, HMRC’s counsel conceded that “Hadee was ‘quite a difficult decision’ because the underlying documentation was absent.” On this basis the Tribunal found that Hadee did not assist them on the substantive issues.

HMRC’s skeleton argument contained “detailed submissions” setting out why Quinn was decided incorrectly, including; the meaning of “otherwise”; reference to the heading of section 1138 of the 2009 Act; the subject of a “clear link” in connection with the word “met”; and Judge Morgan’s thoughts on exploitation of the R&D for financial gain.

HMRC went on to say that any support for Judge Morgan’s analysis in Quinn on the basis of the findings in the Upper Tribunal case of Perenco, was “misplaced”. The Tribunal found that the Upper Tribunal’s comments on Quinn, despite being made in a case relating to a different statutory regime, were “highly persuasive”.

The Tribunal decided that the facts in SOCS bore numerous similarities to those in Quinn, and therefore not only found Quinn “persuasive”, but adopted the same approach. They agreed almost entirely with it, save for one minor exception that made no difference to the outcome. In doing so, the Tribunal found there was no error of law in Quinn, and that the expenditure in SOCS was not subsidised.

Contracted out condition

Once SOCS’ skeleton argument was lodged, it became apparent that a number of the projects claimed were freestanding, with no client. Since HMRC’s position was that the legislation for R&D tax relief was designed to apply specifically to freestanding R&D, these projects were clearly neither subcontracted nor subsidised.

For those projects undertaken for a client, the Judge found, in Para 198, “that the contractual obligation for SOCS was to deliver a specified project in return for an agreed price for that project subject to the sometimes very detailed terms and conditions set out in the contracts.” It was also found that the price may or may not cover the costs and that there was no evidence that any increases in price for the contracts were due to any R&D issues specifically.

Reference was also made by the Tribunal to paragraph 50 of Perenco, which endorsed both parties’ approach – that is to not just look at the words in the contract, but to “establish the parties’ obligations and duties and the statute is then applied to those facts viewed realistically.”

HMRC said that the legislation was intended to prevent competing claims for the same R&D activity, but on this issue, since the client would be unaware of any R&D being undertaken by the claimant, and since the IP belonged to the claimant, the Tribunal was unable to see how there could be competing claims. Paragraph 208 sums up the Tribunal’s view:

We have looked objectively at the meaning of ‘contracted out’ in the context of all of the legislative provisions and the purpose of that legislation. We find that it would mean that the SME relief would not be available in circumstances where R&D is carried out on behalf of someone else. Looking at the sample projects and, for the reasons given, we find that the obligations in term of the contracts did not encompass R&D. The R&D was a means to an end, enured to the benefit of SOCS, because the intellectual property was owned by it, and was an incidental part of delivery of the projects.

Discovery

HMRC argued that it could not have been reasonably expected to be aware that assessments became insufficient, and so it had made a discovery. HMRC also argued that there had been no change in practice in respect of subsidy and subcontract.

SOCS argued that HMRC had all the information it required to make a discovery in the claim documentation submitted with the return, which clearly showed, or could easily be inferred, that some R&D was freestanding and some was in respect of contracts for clients. They also argued that the claim had been submitted under “prevailing general practice”, in that it followed HMRC’s guidance at the time.

Decision

Subsidised expenditure condition

The expenditure was not subsidised within the meaning of section 1138 of the 2009 Act.

Contracted out condition

The R&D expenditure was not contracted out within the meaning of section 1052 of the 2009 Act.

Discovery

The Tribunal went through the various iterations of HMRC’s CIRD guidance, and references to subsidy and subcontract at the RDCC. They also considered representations made to HMRC at the time in respect of these issues, and the previous enquiry into SOCS’ R&D claim, in which HMRC made no mention of any issue concerning subsidy or subcontract.

The Tribunal found that there had in fact been a change of policy “on the ground”. As a result, the claims had been submitted in accordance with prevailing general practice.

Key takeaways

As always, facts are king. If you do not have them, any decision can be of little use. Hadee is a good example of this. Three separate Tribunal cases have found it of little use, while two have found the decision on detailed facts in Quinn persuasive.

As set out above, during the enquiry, HMRC agreed that there was no subcontracting issue, but later rescinded that agreement. This is something to bear in mind; HMRC will not feel bound by what an officer says. When considering whether to go to Tribunal, make sure you take into account any other issues you thought were agreed, and discuss them with HMRC’s Solicitor’s Office and Legal Services at an early stage.

SOCS is the fourth case to go to Tribunal on the subject of subsidised expenditure. The first, Hadee, suffered from a severe lack of documentation, and was therefore no help to the subsequent cases. Quinn was the first to go to Tribunal solely on the issue of subsidised expenditure, and the judgment was very detailed and meticulously considered the wealth of evidence. Both Collins and SOCS thoroughly supported and agreed with Quinn. The question now is whether HMRC will go against the thinking of all three judges, or whether it considers it time to draw a line underneath this issue.

The FTTs now have two cases to follow in respect of contracted out expenditure as well. Again, Hadee was of no help in those two cases, and again, the judges were clear on why the R&D expenditure was not contracted out. There are cases stayed behind these lead cases, and no doubt many more in the pipeline. It is hoped that HMRC will decide soon what they wish to do on this issue.

Final word

There will be many millions of pounds at stake on these two issues, in addition to the millions that have already been lost to companies who have either withdrawn or amended their claims because they do not have the resources and/or the will to pursue them.

Let’s hope that HMRC reviews its position and considers the effect of continued litigation on SMEs, as well as the effect on government policy in respect of R&D as a driver for growth in the UK. Clarity in this area – missing for almost five years – would be welcome.

• Since this blog was published, HMRC has confirmed that it will not seek to appeal either Stage One Creative Services or Collins. It has also indicated that it will update its guidance to reflect both judgments in 2025.