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Contracted out R&D

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.

Contracted out R&D under the previous RDEC and SME schemes 

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.  

Contracted out R&D under the merged 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 that makes the decision to undertake the R&D and 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:

  1. There must be a contract, i.e. either for a product or service that includes R&D, or for specific R&D activities. This may be written, verbal, or implied.
  2. R&D is undertaken as part of the activities within the contract; and
  3. It is reasonable to assume that the customer intended or contemplated that R&D would be undertaken to meet the obligations of the contract.

To establish who is eligible to make a tax relief claim for contracted-out R&D, use our eligibility checker .

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How to evidence “intended or contemplated” in contractor arrangements

To meet the third qualifying criterion 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 demonstrate that it intends or contemplates that R&D work will be carried out. It is also not 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 to be undertaken (such as a statement of the advance in science or technology and the uncertainties that need to be addressed) must be clearly articulated to show that R&D of a particular kind is intended or contemplated. The main way a company can evidence this 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 demonstrate that the customer intends for R&D to be carried out. These include, but are not limited to:
  • IP ownership
  • Financial risk in undertaking the work
  • Autonomy in how the activity is executed
  • Means by which the R&D is likely to be exploited
  • The decision-making process
  • The experience and seniority of decision-makers
  • The nature of the parties (for example, whether the contractor is a specialist in R&D activities)
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 subsequently subcontracted to another party. Previously, under the SME scheme, this was only eligible for payments to unconnected subcontractors.

The role of a competent professional in establishing “intent or contemplation”

The competent professional could have a vital role to play in establishing “intent or contemplation”. HMRC state that they may expect the company to 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 may be able to claim R&D tax relief under the merged scheme

Contractors can still claim R&D tax relief under the merged scheme, but only in exceptional circumstances. These are summarised below:
  1. If the R&D project is initiated by the contractor and not the customer, and does not relate to the customer’s R&D.
  2. If the customer is an overseas entity not paying UK corporation tax.
  3. If the contractor is contracted to provide a product or service that is not R&D, but undertakes R&D in delivering that product or service.
  4. If the customer fails to demonstrate that they intended or contemplated R&D to take place, and R&D activities were performed by the contractor.

Contracting between group companies

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.

How to plan for the merged R&D tax relief scheme 

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.

Reviewed by Akshay Thaman, IP and Policy Lead | 28 November 2024

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