Understanding the changes to contracted out R&D: what you need to know

The UK government has implemented significant revisions to the R&D Tax Relief scheme concerning subcontractor costs, effective for accounting periods beginning on or after 1 April 2024. These adjustments aim to refine eligibility criteria, ensuring the incentive supports businesses directly driving innovation. However, navigating these changes requires careful attention to detail to maintain compliance. This helpful guide provides an overview of the updated rules.

Shifting the Focus: Who Can Claim?

The core principle of the revised legislation grants the right to claim R&D Tax Relief to the company that commissions and ultimately directs the R&D activity. This ensures that the tax benefit accrues to the entity assuming the entrepreneurial risk and responsibility for the innovation.

Exceptions to this principle exist do exist though. For example, when the “customer” commissioning the R&D is ineligible for the relief (e.g., charities, overseas entities, or public bodies), the contractor performing the R&D may be eligible to claim, provided specific criteria are met.

A Three-Step Eligibility Test

Determining claim eligibility involves a three-step assessment:

Contractual Agreement: A formal contract must exist between the customer and the contractor explicitly covering the R&D work undertaken.
Qualifying R&D Activities: The contractor must have performed qualifying R&D activities as defined by the scheme. Mere routine application of existing technologies does not qualify.
Customer’s R&D Intent: The customer must have understood and intended that R&D would be necessary to achieve their project objectives. This intent should be demonstrable through contractual terms, project documentation, or other evidence.

If all three criteria are satisfied, the customer typically holds the right to claim the relief. If not, the contractor may be eligible, subject to meeting specific conditions outlined below.

Defining “Contracted Out” R&D

HMRC defines “contracted out” R&D as instances where a customer engages a contractor to perform R&D on their behalf. Generally, in these scenarios, the customer retains the right to claim the associated R&D Tax Relief.

However, a contractor may claim the relief in specific circumstances, even if performing “contracted out” R&D, if:

The contract explicitly specifies that the contractor is being engaged to conduct R&D.
The customer is ineligible for R&D Tax Relief (e.g., a charity or an overseas entity).
The contractor’s expenditure on the R&D activity qualifies under the scheme’s criteria.

Overseas Contractors and Subcontracting Chains

The updated rules introduce restrictions on claims related to R&D work performed by overseas contractors. Payments to contractors based outside the UK are generally no longer eligible for relief, with limited exceptions. These same principles apply to subcontracting chains. In situations where a contractor engages a further subcontractor to conduct R&D, each party must independently assess their eligibility based on the “contracted out” R&D test.

Transitional Provisions: Navigating the Changeover

For accounting periods spanning the 1 April 2024 implementation date, transitional rules apply. These provisions are designed to guide businesses through the transition between the old and new regulations. For instance:

If a customer’s accounting period commenced before 1 April 2024, they may still be eligible to claim under the previous rules for that period.
If a contractor’s accounting period begins on or after 1 April 2024, the new rules apply.

Careful consideration of these transitional provisions is crucial for accurate claim preparation.

Implications for Businesses

These legislative changes underscore the importance of meticulous contract drafting and comprehensive documentation of R&D activities. Businesses must ensure their contractual arrangements clearly define R&D responsibilities and that their internal records substantiate the nature and purpose of the R&D undertaken.

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For detailed guidance on the changes, visit the HMRC Corporate Intangibles Research and Development Manual.