With the raft of rule and rate changes that have impacted R&D tax relief in recent years, the fundamental shift in the rules surrounding contracting out R&D has perhaps been overlooked. With the right planning and forethought, the new rules have the potential for larger businesses to benefit from increased R&D tax relief.
With the introduction of the merged R&D scheme for accounting periods starting on or after 1 April 2024, guidance has changed when it comes to contracting out R&D. Pre-April 2024, companies claiming under RDEC were very limited when it came to the costs of outsourcing their R&D. This was only possible when the work was contracted to specific ‘qualifying bodies’ (such as universities and other not for profit organisations), to individuals, or to partnerships made up of individuals.
In contrast, the rules for SMEs were very different, take for example unconnected contractors, SMEs could claim for up to 65% of the qualifying contractor payments under the SME scheme.
Now under the merged R&D scheme, applying to accounting periods beginning on or after 1 April 2024, the company contracting out the R&D would be the entity eligible to claim R&D relief, rather than the contractor (in most cases). This principle allows the company who makes the decision to do the R&D and who bears the financial risk to claim the R&D tax relief. However, there may be circumstances where contractors are eligible to claim R&D tax relief.
For the customer to be eligible to claim relief for contracted out R&D costs it must meet a three-step test, these are:
To meet the third qualifying criteria, above, it is not enough for the company to show that there ‘could’ be R&D carried out as part of the contract, the company needs to show that it intends or contemplates for R&D work to be carried out. Neither is it sufficient to merely state that ‘company A Intends and contemplates R&D to take place as part of the contracted activities with company B’.
The nature of the R&D that is to be undertaken (such as a statement of the advance in science or technology and what uncertainties need to be addressed) would need to be articulated to show that it is intended or contemplated that R&D of a particular sort should be undertaken.
The main way the company could evidence that, is through its contract with the contractor or in negotiations and planning documents leading up to the contract. HMRC expects that several commercial factors may align to show that the customer intends for R&D to be carried out, this includes but is not limited to:
Another change is that a company can claim tax relief for qualifying R&D costs where it contracts out its R&D to a contractor, even if that R&D is then contracted out to another subcontractor. Previously this was only eligible for payments to unconnected subcontractors under the SME scheme..
The competent professional could have a vital role to play in establishing “intent or contemplation”. HMRC state that they may expect that the company will ask the competent professional to set and outline the terms of the contract from an R&D perspective. Like any R&D claim the competent professional must be a competent professional in the field of the R&D activity being claimed for.
Contractors can still claim R&D tax relief under the merged scheme, but only in exceptional circumstances, these are summarised below:
Special arrangements can be made where a group company contracts their R&D to another group company. Both companies can enter a “revocable election” for the company undertaking the R&D to claim the R&D relief.
The merged scheme may support larger business in claiming more of their R&D costs, but it is essential to start planning and record keeping ahead of time. Evidencing the claim may need new processes, documentation and enhanced contracts.
Companies need to remember that overseas R&D costs will not be qualifying R&D expenditure for accounting periods starting on or after 1 April 2024. So regardless of which party or entity claims the R&D tax relief, with limited exceptions, it must be carried out in the UK.
To ensure a compliant R&D claim under the merged scheme a company should prepare and retain contemporaneous documentation that can evidence the contractor conditions. HMRC explains that high level wording regarding R&D being required within the contract is not enough to show that the company intended or contemplated R&D taking place. It is key to have a competent professional involved in the process both in defining the scope of work to be contracted out and in the contract negotiations. A useful consideration is to include a collaboration clause in any contract so that you and your R&D advisor can get access to all the data you need to make the R&D claim.
In addition, it’s very important to review existing contracts to clarify exactly where the qualifying R&D tax sits for tax purposes.
