Given all of the recent changes to the R&D tax relief regime, it was welcome news to businesses that R&D tax wasn't at the forefront of the recent Spring Budget. But, since then, new HMRC guidance has been issued on the available R&D tax regimes, together with a revision to the already comprehensive contracted out and overseas restrictions guidance.
Be in no doubt, there's plenty for businesses to consider and plan for now in respect of their R&D claims.
New merged R&D tax relief scheme
Despite some calls for the previously announced merged scheme to be deferred, it's confirmed that it will be introduced for accounting periods beginning on or after 1 April 2024. All businesses will therefore need to consider the implications of the merged scheme sooner rather than later, as for some, the changes could be effective as early as April 2024.
The merged scheme will broadly follow the current R&D expenditure credit (RDEC) regime and will offer a 20% above-the-line taxable credit, resulting in net cash benefit of 15-16.2% for all businesses, depending on whether a payable credit is claimed.
Enhanced support for R&D intensive SMEs
The alternative enhanced R&D intensive support (ERIS) scheme will run alongside the merged scheme and apply to loss-making small and medium-sized enterprises (SMEs) only. It offers a more generous payable credit of up to 27% for every qualifying R&D £1, subject to meeting the qualifying ‘R&D intensive’ conditions.
A company would be considered ‘R&D intensive’ where its R&D expenditure accounted for at least 40% of its total expenditure (plus the expenditure of connected companies) for the period, with the intensity threshold reducing to 30% for accounting periods commencing on or after 1 April 2024.
The restriction for subsidies received by the claimant under the existing SME regime has been removed under the ERIS, and neither does it apply to the new merged scheme.
New rules on contracted out R&D – who can claim relief?
One of the most significant changes under the merged scheme, compared with the existing RDEC regime, relates to the treatment of contracted out R&D activity involving two or more parties. These rules will also apply to the ERIS. The point of interest is who is entitled to claim relief: the customer or the contractor?
The new rules confirm that where one UK company 'contracts out' R&D to another UK company – and both are within the scope of UK corporation tax – the customer can make the R&D claim for the activity.
What is ‘contracted out R&D’?
While the existing legislation refers to the treatment of “expenditure on sub-contracted R&D”, sub-contracted R&D was not specifically defined. However the new rules, along with the recently issued updated guidance, go much further in defining what is meant by “contracted out R&D”.
R&D is considered to be contracted out where it is “reasonable to assume” that the customer intended or contemplated R&D would be undertaken. HMRC has stated that ‘contemplated’ does not indicate a minor or fleeting consideration. It's not enough to have a belief or knowledge that R&D may be required and there must be more than a mere awareness that R&D will take place. The customer must go beyond merely listing project challenges and constraints: they must specify the required R&D, understand the R&D and articulate the nature of the R&D.
If the customer doesn't meet this test – ie, they don't adequately understand and specify the R&D needed – then the contractor is unlikely to be considered as undertaking 'contracted out R&D' for the customer. The contractor may instead be undertaking 'in-house R&D', albeit with a view to fulfilling a contract. The contractor could potentially claim for the R&D in such a scenario, not the customer. The effect is broadly to reward the initiator or key risk-taker with regard to the innovative activities and thereby to incentivise companies to undertake further R&D.
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Assessing the terms of the contract
When considering whether R&D is 'contracted out', it's important to consider the primary objective of the customer based on the contract and surrounding circumstances, and whether this relates to completing a project or for R&D to be performed.
HMRC lists the following considerations to determine the surrounding circumstances and who has entitlement to claim:
- IP ownership – as ownership of IP by a company supports that company being the decision maker
- Financial risk in undertaking the work – which is typically borne by the decision maker
- Autonomy in how the activity is executed – if a company has less autonomy, it is less likely to be the decision maker
- Means by which the R&D is ultimately exploited – typically, the company who exploits the R&D will be the decision maker
- The decision making process – whether this was the customer’s strategy or a tactical challenge recognised by the contractor
- The experience and seniority of decision makers and the nature of the parties – ie, if the supplier specialises in providing R&D services and the contract is typical of those R&D activities, this supports the supplier being more likely to be the claimant
There are cases where the contractor can claim regardless of the extent to which the customer had knowledge of the necessary R&D. For example, if the customer is not a UK taxpayer – such as a non-UK company or a government body – and would therefore not be able to make a claim itself. There are also multiple nuances to the new rules, including transitional rules to deal with potential double claims, and special rules allowing group companies to have some say over which company is able to make a claim.
Overseas restrictions
To encourage innovation in the UK, the Government is also applying restrictions on certain expenditure incurred on activities undertaken outside of the UK. For accounting periods commencing on or after 1 April 2024, qualifying expenditure on sub-contracted R&D activities will be restricted to activities undertaken in the UK. In addition, qualifying expenditure on externally provided workers (EPWs) will be limited to EPWs whose earnings are subject to Pay As You Earn (PAYE) and Class 1 National Insurance contributions (NICs).
When is overseas expenditure claimable?
The overseas restrictions don't apply to the company’s own staffing costs, for example, where employees of a UK company are required to work overseas on R&D. Nor does it apply to consumables, software, data and cloud computing costs, or payments to clinical trial participants (regardless of where these are sourced from).
In relation to sub-contracted and EPWs expenditure, the overseas restriction doesn't apply if the following circumstances are met:
- There must be conditions necessary for the R&D that are not present in the UK
- Those conditions must be present in the location where the R&D is undertaken
- It would be wholly unreasonable to replicate the conditions in the UK
Examples of conditions that may be present overseas but not in the UK include geographical, environmental, legal and regulatory conditions. However, importantly, the conditions which relate to either cost or availability of workers to carry out the research and development activity will not qualify for the exemption. The HMRC guidance (see 6.2-6.4) is helpful in interpreting the terms 'necessary', 'not present in the UK', and 'wholly unreasonable' but, as ever, the examples and guidance don't cover all scenarios, as it will depend on specific fact pattern. This is a complex area and there are sure to be several borderline cases where a variety of factors affect a company’s decision to undertake R&D overseas.
Companies should document their decision-making processes if considering a claim for overseas expenditure. Helpful evidence would be project planning documentation, commercial documentation, or informal communications among staff or companies involved in the project.
Reissued guidance
The HMRC guidance regarding contracted out R&D and overseas expenditure was reissued in March 2024 following a consultation into the initial draft guidance. Notably, the Chartered Institute of Taxation (CIOT) published its response to the initial draft guidance and expressed some disappointment with it. This centred around the guidance not appearing entirely consistent with the legislation, and the lack of detail or clarity on the information required to support a claim.
The reissued guidance has gone some way to address these points but it will still inevitably provide uncertainty over how the new rules should be applied in the extensive range of commercial scenarios.
The guidance on contracted out R&D was updated specifically to incorporate our firm's suggestion that HMRC should take into account clauses in contracts which note the parties’ understanding and intention regarding who is entitled to make an R&D claim.
A focus on compliance
Despite all of the recent and upcoming legislative changes, it's clear that compliance remains at the top of HMRC’s agenda, having recently announcing that over 20% of R&D claims are currently subject to compliance checks. This follows HMRC’s estimate that the level of error and fraud in 2022-23 stands at £1.1 billion, from the £10.2 billion of support claimed.
With the additional Information form now a requirement for all companies submitting a R&D claim, and new guidelines for compliance published by HMRC last October, it’s clear that there's a focus on documentation and minimising error and fraud within the R&D tax regime.
As part of its focus on compliance, HMRC previously announced a claim notification requirement for first-time claimants and companies whose last claim was made more than three years before the last date of the claim notification period (broadly, this date is six months after the period of account of the claim). The claim notification requirement came into effect for accounting periods beginning on or after 1 April 2023. So, for example, the notification deadline for a year ended 31 March 2024, will be 30 September 2024, and is fast approaching.
HMRC’s increase in compliance activity comes against a backdrop of dissatisfaction with HMRC’s enquiry process, with the handling of enquiries led by HMRC’s Individual and Small Business Compliance (ISBC) being a source of particular concern. Recent reports by both the Committee of Public Accounts and the National Audit Office (NAO) have criticised the way in which HMRC has failed to deal with abuse of the R&D regime. They encourage HMRC to go back and re-open claims where it believes there are instances of ‘egregious fraud’.
At the Spring Budget, the Government announced an intention to introduce an expert advisory panel to support the administration of R&D tax reliefs by providing insights across sectors such as technology and life sciences. An open consultation also discusses the Government’s potential options to implement its intention to raise the standards in the tax advice market. For example, introducing the mandatory membership of a recognised professional body to address issues with substandard tax advice from non-affiliated tax practitioners is listed as one potential option. Further change in HMRC approach should therefore be expected.
How to prepare for the R&D changes
With the fast-changing R&D landscape, businesses need to consider what the changes mean for them and plan ahead to manage risk, ensuring claims remain robust while managing projected cashflows from future R&D tax claims. This could include:
For further insight and guidance throughout the claim process, contact Ian Rowland.
