R&D Tax Relief: The Merged Scheme – Subcontracted R&D

Sam Palmer
Research and Development
Sam Palmer Manager for Lovewell Blake

The introduction of the new merged R&D tax relief scheme from 1 April 2024 has attempted to clarify the rules surrounding subcontracting expenditure.

Sam Palmer Manager for Lovewell Blake

The new rules are intended to incentivise R&D by ensuring that the Company making the decision to pursue R&D can receive the tax relief for that expenditure. While some businesses may benefit, others will see their R&D claims significantly cut or become ineligible for the relief altogether.

The old rules

SME R&D tax relief scheme: Under the SME R&D tax relief scheme, payments to subcontractors attributable to relevant R&D undertaken on behalf of the company are a qualifying category of R&D expenditure.

R&D Expenditure Credit: By contrast, under the R&D Expenditure Credit (RDEC) scheme, subcontracted costs may only be included within a company’s qualifying R&D expenditure where the work is contracted to be undertaken by a qualifying body, an individual or a partnership (each member of which is an individual).

Subcontracting company: To prevent double claiming, if a company undertakes R&D that has been subcontracted to it by a third party, it is unable to make a claim under the SME scheme. Relief may, however, only be claimed under the RDEC scheme if the R&D has been subcontracted out to it from a large company or from a person otherwise than in the course of carrying on a chargeable trade.

The new rules

Subcontracted expenditure will be a qualifying category of R&D expenditure for all companies undertaking R&D.

Companies undertaking R&D that has been subcontracted to them from a third party will be unable to make a claim under the new rules, unless the contracting party is an ‘ineligible body’ or a person not within the charge to tax.

Simply put, if you (as a subcontractor) are being engaged to provide R&D, you cannot claim R&D tax relief, but if you are being engaged to provide a product or service, and there is no indication to the third party that R&D will be required, you may be able to make a claim.

How do I know whether the R&D has been contracted out?

HMRC have provided a new definition of ‘contracted out’ that aims to determine who was the ‘decision-maker’ for the R&D, and therefore define who is entitled to claim R&D tax relief.

            ‘A person “contracts out” research and development if:

  • the person enters into a contract under which activities are to be undertaken for it (whether by another party to the contract or by a subcontractor);
  • the activities undertaken in order to meet the obligations owed to the person under the contract include research and development; and
  • 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 research and development of that sort would be undertaken in order to meet those obligations.’

All three conditions must be met for work to be contracted out. Thus, if the nature of the R&D undertaken differed from that initially intended, the right to claim R&D would rest with the contractor, because the decision to carry out the work would have been undertaken of the contractor’s own initiative.

The concern was that large companies would use their size and bargaining power to claim all R&D was intended, but HMRC have clarified that ‘intended or contemplated’ is meant to be a high threshold, and will require the customer to understand and be able to able to explain the details of the R&D required. This would require a detailed technical understanding of the field, and not just that the work was ‘challenging’.​

What evidence will be required?

For companies subcontracting out work – you will need to be clear when entering into any contract that the contract and any pre-contract documentation, as well as the supporting circumstances under which the work is to be carried out reflect the fact that they intended for R&D to be undertaken. The supporting documentation may be internal or external, as long as the company can produce contemporaneous evidence to support their case if required by HMRC.

For subcontractors – similarly, if they believe they are undertaking any R&D of their own volition, they should ensure that the contract and pre-contract documentation is clear as to the scope of work and expectations of their customer.

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