Contracted-out R&D: what the merged scheme means for defence SMEs

Defence innovation rarely happens within a single business. A new capability may involve a prime contractor, systems integrator, specialist engineering SMEs, software developers, testing facilities and several tiers of suppliers.

Many of those businesses will have claimed R&D tax relief under the previous SME scheme. However, for accounting periods beginning on or after 1 April 2024, most SMEs now claim under the merged R&D expenditure credit scheme, commonly referred to as merged RDEC.

One of the most significant changes concerns contracted-out R&D. The fact that an SME carries out the technical work and incurs the cost no longer necessarily means that it is the company entitled to claim.

Who decided that the R&D was needed?

Under the merged scheme, the central question is whether the customer contracted out R&D to the SME or whether the SME decided for itself that R&D was needed to deliver the required product or service.

Where a customer commissions a defined piece of R&D, the customer will generally be entitled to claim and the contractor will not. This might arise where a prime contractor has identified a technological uncertainty and engages an SME to undertake a specified part of the development programme.

The position can be different where the customer buys a product, component or service without intending or contemplating the particular sort of R&D undertaken to deliver it. The assessment looks at the contract and surrounding circumstances when the agreement was entered into.

Leaving the technical approach to the SME does not, by itself, establish entitlement. A customer can commission R&D without specifying every detail of how it should be performed. Equally, general awareness that some R&D might be needed is not enough to establish that it has been contracted out.

A demanding specification alone does not necessarily establish that R&D has been contracted out. A customer may define weight, security, resilience or performance requirements without possessing the specialist knowledge to identify the R&D needed to meet them.

HMRC's guidance recognises this distinction. Its examples include a customer commissioning specialist prototype tooling while the supplier determines and bears the risk of the necessary development. Subject to the remaining conditions, the supplier may claim in that situation.

Look beyond the immediate contract

Defence SMEs often operate several tiers below the ultimate customer. A supplier may contract with a systems integrator, which is itself delivering to a prime contractor or government body.

The immediate contract is therefore important, but it may not tell the whole story. Businesses should consider:

• what the wider programme is seeking to achieve;
• whether the customer intended or contemplated the relevant R&D;
• what technical work the SME was specifically engaged to undertake;
• who determined the development approach; and
• who carried the financial and technical risk if the work was unsuccessful.

Financial risk, technical autonomy and intellectual property ownership can help establish the position, but no single factor determines who can claim. The circumstances need to be considered together.

Contracts, statements of work and tender documents will be relevant, but the discussions and circumstances surrounding the agreement also matter. Technical scoping records, pricing arrangements and project governance can help demonstrate what each party intended.

Government contracts need particular care. An SME undertaking R&D directly for a UK government department that is not carrying on a chargeable trade may still qualify, even where that department commissioned the work. The position can change where a prime contractor sits between them. However, an SME may still qualify under a genuine pass-through arrangement where the prime provides only a procurement route and does not undertake contractual responsibility for the R&D.

There may also be separate R&D projects within the same commercial arrangement. For example, an SME might undertake work forming part of its customer's R&D programme while separately developing its own reusable technology, process or platform. Those projects should be considered individually rather than assigning the entire contract automatically to one party.

Do not carry forward the old claim treatment

Under the previous SME scheme, SMEs could often claim for qualifying work undertaken on behalf of customers, subject to the relevant subsidised and subcontracted R&D rules. That earlier treatment should not simply be carried forward into a merged-scheme claim.

Sam Swansborough, R&D Tax Director at James Cowper Kreston, comments:

“Defence SMEs are often solving the most difficult technical problems in a wider programme. Under the merged scheme, however, carrying out the R&D does not by itself establish entitlement to the relief.

Businesses that have claimed under the previous SME scheme should revisit their customer-funded projects. The contract, the customer’s intentions and the SME’s own role in identifying and controlling the R&D will all be important.”

Review contracts before forecasting the benefit

The best time to consider the position is when the contract and delivery model are being agreed, while the commercial and technical teams can explain clearly what each party is responsible for.

An early review can help an SME establish which projects it may be entitled to claim, identify any separate internally initiated R&D and retain the right supporting evidence. It also reduces the risk of including an expected R&D credit in budgets or project pricing before entitlement has been established.

The new rules do not prevent defence SMEs from claiming for customer-related work. They do, however, require a more careful assessment of where the R&D originated and which business intended or contemplated that it should be undertaken.

To discuss how the contracted-out R&D rules may apply to your defence projects, contact Sam Swansborough or your usual James Cowper Kreston adviser.