Contracted-out R&D costs

Executive Summary

The merged Research and Development Expenditure Credit (RDEC) scheme was introduced by HMRC as part of a broader reform to simplify and unify the UK’s R&D tax relief system. Effective from accounting periods commencing after 1 April 2024, the new scheme consolidates the previous SME and RDEC regimes into a single framework, aiming to reduce complexity and improve accessibility for businesses of all sizes. A key change under the merged scheme is that large companies can now claim relief for R&D activities that are contracted out to third parties, a benefit that was previously limited to SMEs, or to rare instances where large companies were contracting qualifying bodies to carry out R&D on their behalf. This adjustment reflects HMRC’s recognition of the evolving nature of innovation, where collaboration and outsourcing are increasingly common, and ensures that more businesses can benefit from tax incentives for genuine R&D investment.

Background

HMRC’s historic approach to contracted-out costs has been a contentious area in enquiries and tribunals. In several cases, the courts challenged HMRC’s narrow interpretation of what constituted subsidised or contracted-out R&D, often siding with claimants who demonstrated that the R&D was not explicitly funded or directed by their customers. HMRC had typically denied relief where contractors performed R&D under broader service contracts, arguing that any resultant R&D had been subcontracted and/or subsidised, even if the customer had no intention or awareness of the R&D being undertaken. The merged scheme introduces a clearer legislative definition of contracted-out R&D, focusing on the intent and contractual obligations at the time of engagement. This change is intended to reduce disputes and provide more certainty for claimants, especially large companies navigating complex supply chains.

The impact of this reform on large company claim sizes is likely to be substantial. By enabling claims for R&D contracted-out to third parties – regardless of whether those parties are qualifying bodies – many large businesses will now be able to include previously excluded costs in their R&D tax relief calculations. This is particularly beneficial for sectors such as construction, manufacturing, pharmaceuticals, and software development, where outsourcing is integral to innovation. Combined with the increased RDEC rate of 20%, the merged scheme could significantly enhance the value of claims for large companies, improving cash flow and incentivising further investment in UK-based R&D. However, companies must carefully assess their contractual arrangements and ensure they meet the new eligibility criteria, as HMRC continues to scrutinise claims closely under the updated framework.

Technical context

The legislative basis for the merged scheme was introduced in the Finance Act 2024, which amended the Corporation Tax Act 2009. The new rules for the RDEC scheme are specifically set out in Corporation Tax Act 2009, Part 13, Chapter 1A.

Recent First-tier Tribunal decisions, namely Quinn (London) Ltd v HMRC, Stage One Creative Services Ltd v HMRC, and Collins Construction Ltd v HMRC, have significantly shaped the interpretation of “subsidised” and “contracted-out” R&D expenditure under the Corporation Tax Act 2009. In each case, HMRC had denied SME R&D tax relief claims on the grounds that the R&D was either subsidised by client payments or contracted out under commercial agreements. However, the tribunals consistently ruled in favour of the taxpayers, finding that there was no clear and direct link between client payments and the R&D expenditure, and that the R&D was not specifically commissioned by the clients. These decisions clarified that where a company retains autonomy over its R&D activities, bears the financial risk, and is not explicitly contracted to perform R&D, the expenditure should not be considered subsidised or contracted out. The rulings provided much-needed clarity and reassurance to SMEs conducting R&D within broader commercial projects.

In response to recent tribunal outcomes and as part of the Finance Act 2024 updates, HMRC released updated and significantly more comprehensive guidance on what constitutes contracted-out R&D, which is closely aligned with the introduction of the merged RDEC scheme. This guidance supports the legislative changes that now allow large companies to claim for R&D activities they contract out, provided the contractual arrangements clearly demonstrate that the R&D was commissioned and directed by the claimant. While the guidance offers greater clarity and breadth than before, its detailed nature also means that HMRC is likely to scrutinise claims more rigorously. If a company attempts to claim for contracted-out R&D costs that do not align with the revised definitions (particularly where the contractual terms or project controls are ambiguous) HMRC may challenge their eligibility. The updated framework is designed to ensure that relief on contracted-out R&D is granted where the claimant can genuinely demonstrate that it intended and contemplated the need for R&D to be undertaken by the supplier and are able to define its scope.

Impact

The practical impact of the merged scheme and HMRC’s updated guidance will be particularly significant for large companies, who now have access to a wider pool of qualifying R&D costs. The removal of previous restrictions around contracted-out R&D means that businesses can now claim for work carried out by third parties, provided they meet the conditions set out in the new framework. This expansion reflects a more realistic view of how R&D is delivered in practice, especially in sectors where innovation is often outsourced or collaborative. However, the broadened scope also introduces a more nuanced set of requirements that claimants must navigate carefully.

Crucially, the onus is now firmly on the claimant to evidence their role as the initiator and controller of the R&D activity. HMRC’s revised guidance, while more detailed and helpful in defining eligibility, also sets a higher bar for compliance. Companies must be able to demonstrate that they directed the R&D and bore the associated risks. Where claims are made for contracted-out costs that do not clearly align with HMRC’s definitions, there is a strong likelihood that HMRC will challenge their eligibility. As such, businesses must approach the new regime with both strategic foresight and robust documentation to ensure their claims withstand scrutiny.

How we can help

For companies seeking to claim contracted-out R&D costs under the merged scheme, we can provide tailored support to help navigate the new requirements with confidence and help develop processes to enable more real time reporting and awareness of R&D. Our team can assess the eligibility of specific costs by reviewing the relevant contracts and surrounding circumstances to determine whether the claimant meets HMRC’s criteria that they intended or contemplated the R&D to be undertaken by the supplier.

We also advise on best practices for tracking and categorising costs in future periods, helping to streamline the identification and claiming process. Additionally, we can provide companies with web- based applications to assist in developing supporting documentation that can be issued alongside commercial contracts – clearly outlining the nature of the R&D relationship and reinforcing the claimant’s eligibility for relief. Importantly, simply inserting a clause stating who is entitled to the R&D credit is not sufficient to justify a claim. The proactive approach we adopt helps ensure that future claims are well-evidenced and aligned with HMRC’s expectations.

Author: Adam Gardner