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Swimming upstream: why businesses can’t just go with the flow when it comes to new rules on contracting out R&D

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Illustration of odd red fish swimming in green shoal against current against beige background.

With the merging of the SME and RDEC schemes for R&D tax relief, new rules relating to contracting out R&D now apply. These new rules, which came into force for accounting periods beginning on or after 1 April 2024, may have significant implications for access to R&D tax relief, depending on how upstream and downstream commercial arrangements are categorised.

What’s changed?

Businesses benefitting from R&D tax relief have been pulled around by strong currents in recent months, whether as a result of rate changes, additional requirements when submitting a claim, or HMRC’s increased compliance focus.

The biggest impact, however, could be hidden below the water level. Wrapped up in the merger of the previous SME scheme and the Research and Development Expenditure Credit (RDEC), new rules on contracting R&D will have far-reaching effects across innovation ecosystems.

These changes are relevant where R&D activities take place within a commercial chain, with the rules seeking to define which entity can claim tax relief. It’s part of a wider issue concerning customer-led contracts that’s been making waves in the old SME scheme for some time – something ForrestBrown had first-hand experience of through our client, Quinn London Ltd and its involvement in a First-tier Tribunal case centred on another aspect of this, subsidised expenditure.

Despite this case (in which Quinn was successful), HMRC doubled down on its interpretation that R&D activities which relate in any way to a customer contract should be treated as contracted out. This impasse remained (with a number of disputes still ongoing) until plans for a new, merged scheme arose and provided the opportunity to take a fresh look at the legislation.

A new definition for contracting out R&D

The new definition that has emerged effectively places the right to claim R&D tax relief with the company making the decision to undertake R&D. This recouples the incentive with the policy objective of driving behaviour, namely the inherently risky decision to invest in innovation.

Put simply, if a company is carrying out R&D to deliver goods or a service to a customer, this should not affect its right to claim – unless the customer has defined the specific R&D activities which need to be carried out up front in the commercial arrangements.

If we turn from looking upstream to downstream commercial relationships, a company which is looking to include in its own R&D claim the cost of R&D activities undertaken by a subcontractor, will need to make sure of two things:

  • First, that the substance of what’s agreed between the two parties meets the requirements of the new test; and
  • Secondly, that the details of that arrangement are clearly evidenced. HMRC has made it very clear that evidence will be key and blanket provisions in contracts will not be sufficient.

The hope is that the revised approach and detailed specific guidance from HMRC will make it easier to navigate, notwithstanding some of the shortcomings of the new legislation.

The three-step test for contracting R&D

The merged scheme introduces a three-step test. All three steps need to be met for R&D to be considered contracted out.

  1. Is there a contract between companies to which R&D relates?
  2. Was qualifying R&D undertaken to meet the obligations of the contract?
  3. Finally, assuming the first two tests are met, was the relevant R&D intended or contemplated when entering into the contract?

How should businesses be responding?

While the three-step test seems straightforward on the surface, there is still scope for interpretation of contracts and their surrounding circumstances (which can also be taken into consideration). Businesses should be reviewing their commercial arrangements with supply chain partners carefully.

Large companies and contracted out R&D

The new rules will impact businesses differently depending on whether they were previously claiming under the SME or RDEC schemes. Large companies may have never had to think about R&D carried out by contractors. While last year’s increase in the RDEC rate benefited them, further gains from changes to the rules on contracting R&D could bring claims into the realm of material risk.

Conversely, large companies with other large company customers will need to check their positions carefully. Whereas historically each party would focus on their own R&D activities, going forward only one of these parties will be able to claim for a given set of R&D activities.

This added complexity and additional layer of analysis could also bring the methodology used into the spotlight. This all adds weight to the case for a review of the R&D claim process, and reforecasting of claim benefits.

SMEs and contracted out R&D

For SMEs, there is a similar need to reforecast, with an eye to the potential loss of relief to upstream customers. Reviewing contracts should also be a priority. It’s important to understand what R&D they can claim relief for and be confident this is backed up by contractual terms.

Bringing ‘VIM’ to your R&D claim review

VIM is an appropriate acronym for our recommended approach to reviewing R&D contracting – a task which companies should tackle with vigour and urgency.

  • Visibility is key. Whether upstream or downstream in the supply chain relationship, companies should understand where R&D is taking place and who is making the decision whether or not to carry it out.
  • Impact is also important to understand. Whether the changes will result in a smaller or larger claim is important to know when forecasting and setting budgets and for risk management purposes.
  • Methodology should also be reviewed to ensure it is fit for purpose, particularly for potentially larger claims. This is not only important for managing risk, but often overlooked are the practical requirements of completing this analysis for each accounting period. A clear and consistent methodology is essential to minimising this burden and is a key tool for engaging with HMRC customer compliance managers (CCMs).

The FB Consulting team can review your commercial arrangements and provide actionable insights into how the changes impact your business.

ForrestBrown’s view

ForrestBrown’s advice draws on technical expertise to get to the right answer, with insights from judgments or assessments used to support it.

We also take a practical approach which can be applied at scale for large companies and groups. Identifying and categorising upstream and downstream commercial arrangements shouldn’t be a recurring painful process each year.

Finally, it’s vital that this aligns with the overall tax strategy of the business.

Like swimming upstream, adapting to the new rules on contracting R&D can be difficult – but with the right technical approach it can leave your business in better shape than before to meet your next innovation challenge.

Review your R&D contracting processes

Get in touch to find out how FB Consulting can help your business review its R&D contracting arrangements.