Contractual terms will be crucial to claiming UK tax relief on contracted-out R&D

The terms of the contract in which the R&D is contracted out by a business and undertaken by another party will be important to that business claiming tax relief for the costs of the contracted out R&D.

Broadening the R&D tax regime to enable access to tax relief for the costs of contracted out R&D is a welcome development. It is common for businesses involved in complex R&D projects to contract part of the R&D activity to another party that has the expertise and equipment to undertake the R&D more efficiently. Under the previous regime, tax relief for contracted-out R&D costs was very limited and usually only available to small and medium sized (SMEs) businesses under the now abolished SME relief scheme.

According to UK tax authority HMRC, tax relief for contracted out R&D has been introduced to ensure that R&D tax reliefs effectively incentivise and generate increased R&D activity across the UK economy - recognising that the company making the decision to undertake the R&D should be eligible for tax relief on the associated R&D costs.

Amongst other conditions, under the new rules, tax relief will only be available for contracted out R&D where the definition of “contracted out” is met. There are three conditions for R&D to be “contracted out”: there must be a contract between the business claiming relief and another party for activities to be undertaken; the activities must include R&D; and when entering into the contract, it is reasonable to assume having regard to the terms of the contract and any surrounding circumstances the business intended or contemplated that R&D would be undertaken.

Given that the definition of “contracted out” focuses on the existence and nature of the contract under which a business contracts out R&D activity, the contractual terms will often be key to determining whether the business can claim tax relief.

HMRC confirmed in its draft guidance published earlier this year that the “language of the contract” is a source of evidence in assessing whether R&D was intended or contemplated. The draft guidance also confirms that a contractual declaration made in good faith regarding which party intends to make an R&D claim based on the agreed facts will be “persuasive in terms of interpreting the rules where these declarations reflect the economic reality.”

An intention or contemplation to undertake R&D needs to be evident at the time when the contract is entered into. This highlights the importance of ensuring that the terms of the contract clearly reflect the business’s understanding that R&D activity is to be undertaken and that it intends to claim tax relief for the contracted out R&D. On entering into a contract, if a business is unsure whether R&D activity will be undertaken, it should consider including wording to reserve the right to claim tax relief for contracted out R&D and to vary the contract if R&D ultimately needs to be undertaken.

There is no legal definition of the meaning of intention or contemplation. HMRC considers that the business claiming tax relief for contracted out R&D must be able to understand and articulate the nature of the R&D and that this will necessitate the business having or drawing on the capability of a competent professional.

The fact that HMRC states the need for competent professionals to be involved in an R&D project, reinforces the accepted view that R&D tax reliefs should only be available for genuine specialised R&D. Although not mandated, it may be sensible for the contract to provide details about the competent professionals involved in the project.

Beyond the contractual terms, when determining whether R&D has been contracted out, and specifically whether a person intended or contemplated that R&D would be undertaken, the new rules also mandate that it is necessary to consider the surrounding circumstances. HMRC has said that it would expect “a number of commercial factors” to form part of the surrounding circumstances. The draft guidance provides several examples, including (but not limited to): ownership of patents; which party bears the financial risk of undertaking the R&D; which party directs how the R&D is undertaken; and the nature of the parties. HMRC accepts that these circumstances will not necessarily all be equally relevant or helpful in every case, and that looking at the reality of the situation and what happens in practice will be key to determining the position.

Tax relief cannot be claimed on the same R&D twice. Therefore, where R&D activity is being contracted out it is important to understand at the outset who is eligible to claim relief. It is positive that HMRC has provided such detailed guidance on contracted out R&D. However, there are still areas of uncertainty, particularly where it may be unclear due to the complex nature of the R&D project and the lack of clarity in the contract which party should be entitled to claim. HMRC has acknowledged that the inclusion of formal language in a contract doesn’t mean that R&D has been contracted out, whilst the lack of formal language doesn’t mean that it hasn’t. Areas of uncertainty are exacerbated by HMRC’s guidance not having been finalised despite it now being several months since the new rules were introduced. It is hoped that the finalised guidance will provide further clarity.

Tax relief for contracted out R&D will not be available where the R&D is undertaken outside the UK. There is an exemption for R&D contracted out overseas where there are conditions necessary for the R&D to be undertaken overseas, that are not present in the UK and where it would be wholly unreasonable to try and replicate those conditions in the UK. Examples of necessary conditions include: geography, environment, social, or regulatory or other legal requirements that the R&D must take place outside the UK. The availability of workers or relative cost of the R&D cannot be necessary conditions for the R&D to be undertaken overseas. HMRC’s draft guidance confirms that whether or not a condition is necessary will be a matter for the business claiming R&D tax relief to determine. When seeking to claim tax relief for R&D contracted out overseas, a business will be expected to produce a detailed plan, evidencing and justifying the decision-making process.

HMRC’s detailed guidance on the overseas restriction again highlights the complexities of the R&D tax relief scheme and the prevalence of subjective criteria in determining the eligibility for relief. Businesses should ensure that they maintain full and detailed records of the R&D project planning and decision-making process to evidence intention to undertake R&D and justify any decision to contract out R&D overseas.

The UK’s new R&D tax relief scheme enables eligible companies to claim a 20% tax credit for qualifying R&D costs. The new scheme is a merger of the two previous R&D tax relief schemes - one for SMEs and another predominantly for larger companies, known as the Research and Development Expenditure Credit (RDEC) scheme.  The mechanics of the tax credit under the new scheme are based on the previous RDEC. Broadly, an “above the line” tax credit is brought into account as a trade receipt, increasing taxable profits (or conversely reducing losses). A credit of 20% of the qualifying R&D expenditure is then credited to the company.

Additional tax relief is available for certain loss-making research-intensive SMEs, which can claim an additional tax deduction of 186% on qualifying R&D expenditure.  An alternative repayable cash credit at a rate of 14.5% of surrenderable losses may also be available. Broadly, an SME will be research intensive, where 30% of its total expenditure is on qualifying R&D.  The enhanced tax relief for research intensive SMEs has been available since April 2023, although the research intensity threshold was reduced from 40% from 1 April 2024.

The introduction of the merged scheme follows a wide-ranging government review into the UK’s R&D tax relief system, that was launched in Spring 2021, with the objective of modernising the system to ensure that R&D tax reliefs effectively incentivise UK innovation, whilst combatting opportunities for abuse.