R&D Tax Reliefs: New Contracting Out Rules and Overseas Restrictions

In the Autumn Statement, the government announced some important changes to the R&D tax credit schemes that will affect all claimants. The long-rumoured Merged Research and Development (R&D) Expenditure Credit Scheme (or, more simply, the Merged Scheme) will be effective from accounting periods starting on or after 1^st April 2024.

To give you a brief overview of what these changes entail and how they might impact your claims, we’ve included a video summary alongside this post. The video offers an overview of the adjustments, complementing the in-depth analysis we delve into below. To watch the video, click here or on the image below.

The Merged Scheme will replace the current Research and Development Expenditure (RDEC) scheme and the SME scheme; these popular schemes enable UK companies to claim back some of their Corporation Tax on qualifying R&D activity. The SME R&D intensive scheme that was launched in April 2023 will continue to be available for loss-making SMEs.

The government has published the Finance Bill 2023/24 covering the Merged Scheme and HMRC has recently provided more detail on the overseas restrictions and subcontracting rules and invited further consultation until 1^st March 2024.

This post outlines the key aspects of the draft guidance and some practical implications that will need to be considered in future R&D tax expenditure claims.

Overseas R&D Restrictions

For accounting periods beginning on or after 1 April 2024, expenditure on overseas subcontractors and externally provided workers (EPWs) for R&D activities will largely no longer qualify for R&D tax claims. Fortunately, this overseas restriction does not apply to staffing costs, consumables, software, data and cloud computing, or payments to clinical trial participants.

Whether the overseas restriction applies to subcontractor payments depends on the location of the subcontractor staff activities. If some activities take place in the UK and some do not, the subcontractor payment should be apportioned on a just and reasonable basis, so that only the UK-based activity is included.

For externally provided workers, the company or staff controller is required to operate PAYE and account for Class 1 NIC in respect of the worker.

The company must self-assess that its expenditure meets all the conditions for relief, including the overseas restrictions. The company must take care to understand and document where the R&D occurs in case of an HMRC compliance check. In some cases, it may be clear where the activities occur; in other cases, confirmation from the subcontractors or EPWs may be necessary.

Exceptions to the rule

It will still be possible to claim for overseas subcontractor payments and externally provided workers not subject to UK PAYE/NI, if all the following conditions are met.

• the conditions necessary for the R&D are not present in the UK;
• the conditions are present in the location where the R&D is undertaken, and
• it would be wholly unreasonable for a company to replicate them in the UK.

It is down to the company to consider whether all the conditions apply. HMRC may request evidence under a compliance check, so project documentation showing the options and justification should be retained.

The draft guidance provides a non-exhaustive list with supporting examples of what could be considered ‘wholly unreasonable’ for a company to replicate the R&D activity in the UK; these include:

• UK test facility is unavailable within the project timescale, and it would be unreasonable for the company to replicate a UK test facility.
• Medical circumstances such as the incidence of a disease or availability of participants to trial a drug or other medical treatment.
• Physical or geophysical circumstances (deep oceans or high altitudes; volcanic or seismic conditions; minerals and geology; fortuitous features such as deep mines suitable for locating particle detectors).
• The presence of machinery or facilities to which a company may require access
• Legal or regulatory requirements, such as that activities must take place in a particular country or according to recognised regulatory body.

Essentially, if you cannot reasonably replicate the conditions for your R&D in the UK and thus can only complete your R&D overseas, this expenditure may still be included.

What is not an exception to the rule

The draft guidance is explicit that the cost of the R&D activity and the availability of workers to carry out the R&D activity do not constitute an exception to the general rule. This means that choosing overseas subcontractors or EPWs because they are cheaper or more readily available will not be acceptable by HMRC as reasoning for claiming that expenditure. However, the guidance suggests that the rule is less strict when the cost of R&D activity or availability of workers is not the only consideration.

HMRC provide an example where the cost of R&D and time pressure prevent the R&D from being undertaken in the UK. The time pressure of waiting until a new facility is developed in the UK would be considered ‘wholly unreasonable’, allowing overseas subcontractor costs to be claimed. Another example is that raw materials are only available overseas, and the alternative would be to incur high costs and carbon footprint to ship the materials to the UK. The cost of the R&D can’t be considered as a valid factor for overseas expenditure; however, if environmental concerns and the need for a steady supply of material were overriding factors, they might be relevant.

Seeking to lower the cost of R&D and/or a limited availability of workers in the UK are not enough on their own to justify claiming for overseas expenditure. However, when combined with additional factors which meet the conditions discussed above, they can enhance the argument that overseas expenditure was required.

HMRC recommends claimants of overseas expenditure provide evidence of the selection process and compare the options of subcontractors, to substantiate any claim of this kind.

Contracting out R&D

As part of HMRC’s efforts to realign the guidance with the ethos of the scheme, the rules around contracted work are changing to further benefit the companies who take on the risk of R&D.

There have long been difficulties around knowing which company can lay claim to R&D activity where partnerships or contracting agreements have been put in place. These difficulties have led to “double-dipping” in some cases, whereby two companies claim for the same activity.

The draft guidance attempts to clarify what enterprise should claim tax relief when more than one party is involved in the R&D project. The general principle is that the company deciding to initiate the R&D gets relief from that expenditure.

Where the customer intended or contemplated R&D to be carried out by the subcontractor under contract, it’s the customer that can claim expenditure for contracted-out R&D. The draft guidance stipulates that for a customer to claim R&D tax relief, the nature of the R&D that is to be undertaken would need to be articulated to show that R&D is intended. A statement of the advance in science or technology and what uncertainties need to be addressed, communicated to the subcontractor, would suffice. The customer may do so formally in contract, or in discussions, or in internal documents showing how the activity was required as part of the wider R&D.

High-level wording in a contract is not enough to show that it was intended or contemplated; the company would need to substantiate what R&D work needed to be done, and the involvement of a competent professional in drafting contracts may be relevant to specifying results or milestones that require specific R&D.

However, if it is not reasonable to assume the customer “intended or contemplated” R&D at the point of contract, and the subcontractor initiates R&D, then the subcontractor may claim. This is not R&D contracted to the company under the new rules because the subcontractor had decided to initiate R&D. Example 18 in the HMRC guidance clarifies when a contracted company can claim tax relief.

Example 18

A company, B, is contracted to provide a product or service which is not R&D, such as constructing a building or developing a software product. From the contract, and the nature of the negotiations to agree it, it is clear to all parties that the customer, A, had no understanding or intention that any R&D should take place. If B undertakes R&D in delivering that product or service, it could claim relief even though it is undertaking R&D on an activity contracted out to it.

However, a contract is not the only evidence of “intended or contemplated” R&D. Surrounding circumstances may be taken into account to assess the intent of the contacted agreement; namely, whether the customer engaged the subcontractor to deliver a project or to deliver R&D. Examples of surrounding circumstances include:

• intellectual property (IP) ownership,
• financial risk in undertaking the work
• autonomy in how the activity is executed
• means by which the R&D is ultimately to be exploited
• the decision-making process (for example, whether the motivation to undertake the R&D flows from the customer’s wider strategy or an immediate tactical challenge recognised by the subcontractor)
• the experience and seniority of decision-takers

There are cases where the subcontractor can claim even where the conditions have not been met, for example, where the customer is not a UK taxpayer or an ineligible company such as a charity or higher education institution, or a UK Government department, so would not be able to claim itself.

What to consider for future claims

Companies should seek to understand the financial impacts to their R&D tax claim because of the overseas activity restrictions. For overseas activities, you should consider if any “wholly unreasonable” exclusions apply and record the decisions made with supporting evidence.

Concerning projects which are contracted out, either by or to your company, we would recommend a review of the supply chain to establish current arrangements with customers, subcontractors and externally provided workers. This review should include subcontractor discussions, contracts, and project documentation associated with the R&D activity. You should articulate the R&D activity requirements and results within contracts if required.

Get in touch

Whilst the above has hopefully sketched out the main details of the new merged scheme, we understand that this is still a complex area within the legislation.

For any additional advice or guidance, we recommend you get in touch with one of our experts. With experience in making claims since the scheme’s creation, we have weathered all the changes to the scheme and our team will be happy to help you navigate this particularly complex set of rules.