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Incentivising risk – Tax relief on contracted R&D

Author: Tom Mason

With many R&D projects now being carried out by both the controlling business and contracted support, it’s important that your clients understand their rights and obligations when claiming tax relief for contracted R&D work.

If you work with clients on R&D tax claims and, for example, they:

  • Outsource chemical development to a third-party laboratory
  • Contract a service to test a new product
  • Engage a manufacturer to develop new materials

You will need to consider the regulations around claims for contracted R&D and the allowable costs for each claim.

In line with the latest guidance released by the Government in March 2024, the new regulations refer to ‘contracted’ R&D as activities undertaken by a ‘contractor’ on behalf of a ‘customer’, replacing the term ‘subcontracted’ under previous legislation.

How is contracted R&D classed under the merged scheme?

One of the key changes announced as part of efforts to clarify the R&D tax relief scheme and reduce unintended non-compliance is the simplification of the rules around contracted R&D.

You may have already discussed with clients that, under the latest rules, contracted R&D costs are eligible for R&D tax relief.

For the first time, R&D tax regulations explicitly give the right to claim to the customer, the party which bears the financial risk for the project.

The merged scheme also effectively puts an end to the concept of ‘subsidised’ R&D from a contractor/customer perspective – as well as removing relief restrictions on subsidised R&D expenditure.

How is the contracting party identified?

This is the core of the issue which many accountants face when establishing if their clients are eligible to claim R&D tax relief for payments to contractors.

In some instances, it will be clear which party has contracted out their R&D activities (i.e. the customer), but some commercial relationships have a tendency to obscure these definitions.

We will typically account for the following considerations when identifying the contracting party:

  • Intention – Any R&D carried out must be explicitly intended within the contract or agreement, or else the contracted party may argue that they have carried out the R&D themselves.
  • Risk ­– The uncertainty of R&D makes investing it in an inherent risk, particularly financially, so the party which finances the project is typically considered to be the contracting party.
  • Property – The intellectual property for the R&D project usually belongs to the contracting party.

Making reasonable assumptions

One of the key clarifications made by new legislation is the circumstances under which contracting parties have the right to claim for R&D activity carried out by a contractor.

There must be:

  • A written or verbal contractual agreement
  • R&D undertaken

However, most crucially, there must now also be a “reasonable assumption” that the customer “intended or contemplated” that R&D would be required to fulfil the terms of the contract.

The purpose of this clause is to make it clear that R&D has been purposefully contracted out and has not been carried out incidentally by the contractor.

In its latest guidance, the Government takes a holistic view which might come across as a surprise to your clients.

It states that clauses requiring a ‘reasonable assumption’ that R&D was intended under the contract are not necessarily satisfied by contracts alone, nor do contracts which do satisfy these clauses need to explicitly state that R&D is needed.

The best way for you and your clients to demonstrate intentionality is to ensure that the ‘contracted’ nature of the R&D activity is made clear at every stage and that evidence of this communication is kept, readily available.

Ownership and intention are particularly significant under the merged scheme, as these factors help to determine the contracting party in more complex commercial relationships, ensuring that the party bearing the risk is able to maximise the incentive they receive to innovate.

For tailored advice on claiming for contracted R&D on behalf of your clients, contact our team of R&D tax experts.