Contracted-out R&D: Can you claim now?

Research and development (R&D) tax credits can make a significant financial contribution to the cost of developing new technology. However, with the introduction of the merged R&D scheme for accounting periods starting on or after 1 April 2024, there are many changes to the rules to be aware of. Some changes are restrictive, but the new rules for contracted-out R&D may benefit larger businesses.

The old rules

Under the previous rules, companies claiming under RDEC (research and development expenditure credit) could only claim for the costs of outsourcing their R&D when the work was subcontracted to a limited number of ‘qualifying bodies’ (e.g., universities and other not-for-profit organisations) and individuals or partnerships. Small and medium-sized enterprises (SMEs), however, could claim 65% of the costs of qualifying subcontractor payments.

Merged scheme rules: contracted-out R&D

The rules for contracted-out R&D under the new merged regime have been modelled based on the old SME regime but with some important modifications. Under the merged R&D regime, all companies can claim qualifying payments for contracted-out R&D where these three conditions are met:

• There must be a contract (even if not specifically for R&D work).
• The contractor (or their subcontractor) actually undertakes the R&D work to meet the obligations under the contract.
• “It is reasonable to assume, having regard to the terms of the contract and any surrounding circumstances, that the person [principal/customer] intended or contemplated when entering into the contract that research and development of that sort would be undertaken in order to meet those obligations.”

To fulfil the third condition, the principal/customer must have “competent professionals” (i.e., someone with the technical knowledge to understand what scientific or technical uncertainty was required to fulfil the contract) who are involved in the contract negotiation and in a position to articulate the required R&D.

In addition, HMRC will consider the following factors when determining whether the principal can make an R&D claim for the contracted-out R&D:

• Will they own any intellectual property (IP) created?
• Do they bear the financial risk in undertaking the work?
• Do they oversee the R&D so that the contractor has limited autonomy?
• Do they have the ability to decide how the R&D is ultimately to be exploited?
• Does the contractor recognise that the decision to undertake the R&D flows from the customer’s wider strategy or an immediate tactical challenge?
• Is it evident that the contractor specialises in providing R&D services and that the contract is typical of those activities?

Merged scheme rules: R&D claims by contractors

Contractors can still make a claim for R&D relief in the following circumstances:

• Where the customer did not “intend or contemplate” contracting out R&D at the time of the contract (see above), or
• They are carrying out their in-house R&D that is unrelated to a customer contract or
• Where the customer is an “ineligible company” (e.g. a charity, an association, or a health service body) or
• The principal is not carrying on a taxable trade in the UK (e.g. Government body or overseas customer).

When a group company contracts out R&D to another company, both companies can enter an election for the company undertaking the R&D to claim the R&D relief.

The changes also mean that a company can claim relief for contracted-out costs. For example, it could contract out its R&D to a company, which in turn contracts out the R&D to another subcontractor. This was previously disallowed.

It is worth noting that overseas costs cease to qualify for R&D tax credits for accounting periods beginning on or after 1 April 2024, so regardless of which party claims the R&D, it must be carried out in the UK.

Planning for a ‘Yes, you can’

To enable a valid claim, contemporaneous evidence of how the above conditions are met should be prepared. It is not enough to have a blanket clause in all contracts stating that you, as principal, will be entitled to claim the R&D relief.

In addition, it is vital to have a competent professional involved in defining the scope of work to be undertaken by the contractor and in the contract negotiations. You may also wish to include a collaboration clause in the contract to ensure that you get access to all the data you need to make the R&D claim.

The new rules may be accommodating to large businesses, but a high level of advance planning and contemporaneous record keeping will be needed to support claims for contracted-out R&D. Therefore, putting good processes in place for all IT and development projects will help you access this valuable relief.

A review of existing contracts will also be necessary to determine whether the associated costs qualify for R&D tax relief.