On 27 February 2025 HMRC released new guidance that clarifies the treatment of subcontracted and subsidised R&D activity under the SME scheme. This guidance marks the culmination of 3 years of challenge through First-tier Tribunal (Tax), known as FTTs.
Before the introduction of the reformed reliefs; new RDEC and ERIS schemes, which apply to accounting periods starting on or after 1 April 2024, the SME regime required businesses to determine whether the R&D is the result of subcontracted activity or if it has been subsidised. Dependant on the determination, this can preclude the SME from claiming under the more generous SME tax relief or even at all.
Background to the CIRD guidance
In November 2021 HMRC updated their Corporate Intangibles Research and Development (CIRD) guidance; CIRD84250 – subcontracted activity and CIRD81650 – subsidised R&D for the SME scheme.
The update indicated that HMRC would regard any R&D expenditure carried out in order to fulfil a contract as not qualifying, based on contract profitability and, that any payment under a subcontract would be regarded as subsidising any expenditure carried out to fulfil the contract. In essence, HMRC’s view was that no SME claims were allowable on contracts where the fee for the contract covered the required expenditure profitably. This significant and harsh interpretation jeopardised many SME claims.
CIRD guidance in contrast to FTT decisions
This revised guidance was a distinct departure from their former guidance and, specifically for subsidisation, it ignored the judgment made by the FTT in the Quinn of London ‘Quinn’ case, where Quinn successfully defended their SME claim and won their subsidisation argument. The judge determined that, in the overall context of the SME scheme, the subsidy tax legislation did not apply since there was no clear link between the price paid by the customer and the expenditure on R&D.
It was in December 2021, at the Research & Development Communication Form (RDCF), that HMRC confirmed they would not be appealing the Quinn decision albeit they felt they should have argued the case on the basis that the activities had been contracted to Quinn. Whether this would have proved successful is simply unknown.
HMRC also advised that since FTT judgements are not binding and set no legal precedent, they would press ahead with their own views as reported in their CIRD manuals and would continue to challenge similar claims since the CIRD aptly reflected HMRC’s view of the application of the relevant tax legislation.
Further clarification sought through FTT appeals
It was clear that taxpayers would seek clarification and that further appeals to the FTT would be made. In late 2024, two highly anticipated FTT judgments were published and both cases challenged HMRC’s interpretation of; subsidised expenditure and; expenditure incurred in carrying out subcontracted activities. The Tribunal found in favour of the taxpayers; Collins Construction (Collins) and; Stage One Creative Services (SOCS) on both counts.
These FTT decisions were long awaited, but HMRC still had the opportunity of appeal to the Upper Tier (Tax) Tribunal but in December 2024, and after the requisite period for appeal had passed, HMRC announced that they would not appeal either decision and that they would amend their guidance to reflect the Tribunal decisions.
Impact of the FTT decisions and resulting guidance
The decisions in Collins and SOCS are welcomed but the incorrect application of tax legislation based on HMRC’s interpretation of subcontracting and subsidisation for over 3 years has resulted in huge ripple effects:
- SME claimants have withdrawn their claims
- SME’s have strictly applied HMRC’s 2021 guidance and claimed under the less favourable RDEC scheme
- HMRC have issued a large number of compliance checks challenging SMEs on the validity of their SME tax relief claim
- Claims have been rejected by HMRC, and moreover careless behaviour penalties have been applied to the SME R&D tax relief claimed
- Discovery assessments have been issued, resulting in earlier claims being scrutinised.
Next steps and remedial measures
To reflect this new guidance, HMRC have already contacted taxpayers who have open enquiries and anyone with ongoing appeals who have been impacted by the former guidance. However, there has been no commentary regarding historical cases and earlier determinations which adopted the former interpretation and it’s clear that this will have disadvantaged many taxpayers. So, with no suggestion of a review and, even if remotely possible, how would HMRC action this and to what end?
The new HMRC guidance for CIRD84250 and CIRD81650 show clear signs that they incorporate aspects of the FTT judgments for Quinn, Collins and SOCS but there is still a way to go.
Subcontracting – what the new guidance suggests
On the subcontracting point, CIRD84250 steps away from the harsh and punitive interpretation that any activities carried out to fulfil the terms of a contract are considered to have been contracted out. It advises that the terms of the contract are not the only factor to be considered, this is to avoid R&D contract clauses that imply contracted out R&D but other factors suggest otherwise.
HMRC affirm that there is no definitive test to demonstrate contracted R&D and that weighted factors will likely be considered. These are listed below in order of their likely emphasis:
- Whether the R&D is incidental to the supply of a product or service under the contract
- If there is a limited degree of autonomy
- If there is limited financial risk in undertaking the work
- The retention of IP, however less emphasis is placed on ‘know-how’
Subsidisation – what the new guidance suggests
For subsidised R&D, the new guidance aligns with the earlier judgements and HMRC have accepted that expenditure is only subsidised to the extent that any payment received meets that expenditure i.e. there must be a direct link between the price paid and the R&D. It also confirms that normal commercial contracts will not be considered a subsidy.
Recent years have provided a great deal of uncertainty for R&D tax relief and this once again only highlights its complex nature and application thereof.
Overall, we welcome the further clarity that this new guidance brings even though its application is only for a limited amount of time until the SME scheme sunsets and we make way for the reformed reliefs under new RDEC and ERIS schemes which applies to accounting periods starting on or after 1 April 2024. It’s clear that the concepts prevalent in the new scheme for contracted out R&D have influenced this new SME guidance, but the reforms and the removal of subsidisation rules, means that updated subsidy guidance will only be relevant to the old SME scheme.
