Contracted-out R&D: Understanding the new definition

The merged R&D tax relief scheme introduces a new definition for contracted out R&D, which has significant implications for businesses engaging third parties to undertake research and development on their behalf.

What has changed?

Previously, the legislation did not define “subcontractor” or “contracted out” R&D, creating uncertainty and the potential for disputes. HMRC previously argued that R&D carried out under commercial contracts was ineligible, but tribunals disagreed.

In cases such as Quinn (London) Ltd and Collins Construction, the tribunals ruled that fulfilling a client contract does not automatically mean R&D is subcontracted or subsidised unless the client specifically required and funded the R&D. These decisions exposed the lack of clarity in the old rules and prompted the introduction of a statutory definition under the merged scheme.

The merged scheme addresses this by:

• Introducing a legislative definition of “contracted out R&D” and
• Removing the old R&D expenditure credit restrictions on subcontractor costs, while ensuring only one company in the supply chain can claim for a given piece of R&D

The new definition

The legislation now defines when R&D is considered “contracted out” if:

• It enters a contract for activities to be done on its behalf
• Those activities include R&D, and
• At the time of contracting, it was reasonable to assume that the company intended or contemplated that R&D of that sort would be done

Essentially, the new definition focuses on the intention at the time of contracting, not hindsight. A business should consider both the contract terms and surrounding circumstances to determine who initiated the R&D and for whose benefit it was carried out.

Examples

1. If a manufacturing firm hires a specialist engineering company to develop a prototype, and the manufacturing firm specifies the research objectives and owns the results, the manufacturing firm can claim the tax relief for the contracted-out R&D costs
2. Conversely, if a software agency is contracted to deliver a bespoke IT solution but the agency itself sets the direction, innovates, and bears the financial risk, the agency (not the client) would be able to claim for the R&D work performed

Key actions: To align with the new definition, businesses should carefully review their contracts to ensure roles, responsibilities, and risks are clearly set out and documented. This will help establish who is entitled to claim and provide the necessary evidence should HMRC request further information. By understanding the new definition and structuring agreements accordingly, companies can maximise their R&D tax relief claims and avoid costly misunderstandings.

To download the full merged R&D tax relief scheme document, please click here. 

If you wish to discuss this in further detail, please contact one of our Business Tax experts here.