Who claims the R&D relief when the work is done for someone else?

The rule

R&D relief is meant to reward the company that took on the scientific or technological risk. Where two companies are involved in the same work, the legislation asks which of them was involved and gives the relief to it alone.

It does that by defining when a person “contracts out” R&D. Three things all have to be true:

1. The person enters into a contract under which activities are to be undertaken for it — by the other party or by a sub-contractor.
2. The activities undertaken to meet the obligations owed under that contract include R&D.
3. It is reasonable to assume, having regard to the terms of the contract and any surrounding circumstances, that the person intended or contemplated when entering into the contract that R&D of that sort would be undertaken to meet those obligations.

Points 1 and 2 are usually obvious. Point 3 decides almost every real case.

If point 3 is met, the R&D is contracted out to you. Your customer claims the payment it made you as a contractor payment, and you cannot claim the costs you incurred doing it. If point 3 is not met, nothing has been contracted out, and you claim your own staff, materials and other costs in the ordinary way.

What “intended or contemplated” means

More than awareness. HMRC’s position is that it requires a specific appreciation of what R&D will be done — not a general sense that a job looks difficult, or that a supplier is the sort of business that does clever things.

Seven things bear on it:

• who owns the intellectual property in what is produced;
• who carries the financial risk of the work going badly;
• how much autonomy the contractor has over how the activity is executed;
• how the R&D is ultimately exploited;
• whose strategy the decision to do the work flowed from — the customer’s wider plan, or the contractor’s tactical problem in delivering;
• the experience and seniority of the people who took the decision;
• the nature of the parties, including whether the contractor specialises in R&D services and whether the contract is a typical one for it.

None of these decides the question on its own, and a contract clause saying the work is or is not R&D does not decide it either. What the parties actually understood, evidenced by the contract, the tender documents, the correspondence and the pricing, is what decides it.

Two patterns are worth holding onto because they recur:

A customer who cannot specify the R&D has not contracted it out. Where the customer knows a difficult problem exists but has no competent professional who can say what technical work is needed, HMRC accepts the contractor as the decision-maker. A manufacturer commissioning specialist tooling it does not have the expertise to design, a chemical company asking for an intermediate by a different process route it cannot specify, a developer commissioning a landmark building and caring only about the result — in each of those, the contractor claims.

A customer whose own competent professionals set the technical requirements has contracted it out. Where the customer’s technical people work in the relevant field, and their input shapes the contractual requirements, that is evidence the customer intended the R&D. The qualification matters: a software company’s engineers specifying lab and server-room requirements in a building contract are not evidence the software company contemplated construction R&D, because construction is not their field. A construction company’s engineers specifying net-zero design elements are.

When your customer changes its mind mid-contract

The test is applied when the contract is entered into, so a variation resets it. If a problem emerges on site that nobody anticipated, and you absorb the cost of solving it, you claim. If you and your customer then agree a variation that specifically provides for the additional R&D and prices it, your customer has intended that R&D and can claim it from the date of the variation. You claim the part you did before.

The same logic runs the other way. Even where your customer has properly contracted out R&D to you, work you do on your own account to solve your own delivery problem — improving your testing technology, say — is not what the customer contemplated, and is yours to claim. Where a payment relates only partly to contracted-out R&D it is apportioned on a just and reasonable basis, and you must strip out of your own claim any part of the work that was in fact done for the customer.

Work done before any contract exists is also yours. Scoping and feasibility work carried out to decide whether and how a job could be done can be claimed by the company doing it, and it does not matter whether a contract for the delivery phase is later agreed.

When the customer cannot claim, you can

The rule that the contractor claims nothing has one substantial exception. Where the customer is an ineligible company, or is not acting in the course of a trade, profession or vocation within the charge to UK tax, the contractor claims instead. Ineligible companies are charities, higher education institutions, scientific research organisations, health service bodies and any body the Treasury prescribes.

In practice this covers most of the cases where relief would otherwise be lost entirely:

• work for a UK government department or public body;
• work for a university, an NHS body or a charity;
• work for an overseas company that is not within the charge to UK corporation tax — a UK contract research organisation running trials for an overseas pharmaceutical group, for example, claims its own costs;
• work for a private individual who is not trading.

Prime contractors are worth a note here, because they are common in defence and aerospace. Where a prime sits between a government department and the company doing the work but provides only a procurement service — taking on neither the obligations to deliver nor contractual responsibility for the activities — the R&D is contracted out by the department directly to the company doing it, and that company claims.

Sub-contractors further down the chain

R&D contracted out by a customer is contracted out to the party who takes on the obligations and to any sub-contractor who takes contractual responsibility for the activities needed to meet them, including sub-contractors at more than one remove. So the exclusion follows the work down the chain from whoever originally intended it.

The consequence catches people out. In a three-party chain where the customer intended the R&D, only the customer claims — not the first-tier contractor, not the second. But where the chain begins with someone who did not intend the R&D, the first party down the line who did intend it is the claimant, and those below it cannot claim. A developer who commissions a building without contemplating any R&D, a contractor who works closely with a façade consultancy on a problem the developer never knew about, and the consultancy that solves it: the contractor claims, and the consultancy does not.

Groups

Two companies in the same group can jointly elect for the company contracting out the work to be treated as ineligible, so the company doing the work claims instead. It is made by written notice to HMRC before or at the same time as the claim that relies on it, is revocable by either company, and lapses if the companies stop being grouped. It also has a useful second effect: where the activity is R&D for the customer but would not be R&D for the contractor on its own, it is treated as R&D for the contractor.

This is the mechanism for a group with a central R&D company that does the work for trading subsidiaries, and it is worth deciding on deliberately rather than discovering after a claim has been prepared on the wrong footing.

Contracts that straddle 1 April 2024

Where the customer and the contractor have different accounting period start dates around 1 April 2024, one is on the old rules, and one on the new, and the two sets of rules do not mesh. Finance Act 2024 contains transitional provisions that go both ways.

Where both would otherwise qualify on the same expenditure, the customer is entitled and the contractor is not — unless the contractor would have qualified under the old rules disregarding the Finance Act 2024 changes.

Where a gap would otherwise open up, it is closed. A customer still on the old rules that cannot claim under them, but whose expenditure would have been contracted-out R&D under the new ones, is treated as an ineligible company so that its contractor can claim. And a customer on the new rules that did not intend or contemplate the R&D — so has not contracted it out — is deemed to have contracted it out, where its contractor is on the old rules and cannot claim because the work was contracted to it.

The practical point is that a claim cannot be assessed in isolation on either side of that boundary. Both companies’ accounting period start dates need to be established before either position is settled.

What the customer actually claims

Where you have contracted R&D out, you claim on what you paid the contractor, not on their underlying costs. For an unconnected contractor, 65% of the relevant portion of the payment qualifies — the relevant portion being the part attributable to R&D undertaken in the UK, plus overseas R&D that meets the overseas conditions. For a connected contractor, or where a joint election is made, you claim the lower of the payment and the contractor’s own relevant expenditure on the R&D. The mechanics are covered in What costs can I include in an R&D claim?.

The position for accounting periods beginning before 1 April 2024

The old rules asked a different question and produced different answers, and they still govern open years, amendments and enquiries.

Under the legacy SME scheme there was no “who intended it” test. A company simply could not claim expenditure incurred in carrying on activities contracted out to it by any person. HMRC weighed four factors — whether the R&D was incidental to the supply rather than required by the contract, how much autonomy the company had, who bore the financial risk, and who kept the intellectual property. A company that had contracted work out claimed 65% of the payment to an unconnected subcontractor, or the lower of the payment and the subcontractor’s relevant expenditure where connected.

That test was litigated, and HMRC lost. In Quinn (London) Ltd v HMRC [2021] UKFTT 437 (TC), and then in Collins Construction Ltd v HMRC [2024] UKFTT 951 (TC) and Stage One Creative Services Ltd v HMRC [2024] UKFTT 1059 (TC), the tribunal held that a contract to deliver a specified thing for an agreed price does not contract out the R&D that turns out to be needed to deliver it. In Collins the tribunal found the contracts did not require or contemplate R&D, that the need for it emerged during delivery, that the company kept the intellectual property and that there was no separate payment for it — so the work was not contracted out to it. Stage One reached the same conclusion on the same reasoning. HMRC did not appeal either decision, and amended its published guidance.

Under legacy RDEC, a large company generally could not claim for R&D it contracted to others at all, with narrow exceptions for payments to qualifying bodies, individuals and partnerships of individuals. Conversely, a large company could claim its own costs on R&D contracted to it where the customer was another large company or was not carrying on a chargeable trade — the ancestor of the irrelievable client rule.

The combined effect was that a large company contracting work to an SME often produced no relief for either party. That is the gap the merged scheme was designed to close, and it is why the reform is generally favourable to contractors’ customers and unfavourable to contractors.