For accounting periods starting on or after April 1, 2024, there are new rules that dictate which company can claim the Research & Development (R&D) expenditure on contracted-out R&D. In this article, we summarise the main changes and points to be aware of, which so far have been published as Draft guidance (link at the end of this article).
Since contracts are established well in advance of filing R&D claims, familiarising yourself with the changes is critical. Doing so will help you mitigate any potential negative impacts and maximise any R&D claims you may be able to make in the future.
The key principle
The changes are applicable for ALL R&D claims whether made by large companies or Small and Medium Enterprises (SMEs). The key principle behind the changes is to ensure that the company deciding to undertake R&D receives the R&D incentives. The aim, of directing tax relief to the decision maker, is to better incentivise companies to undertake more R&D, by reducing the costs involved. The overall goal being to address market failure, which happens because the broader economic value of R&D, exceeds its immediate benefit to the individual company making the investment.
Thus the new legislation ensures that the costs of Contracting-out R&D by a Customer to a Contractor can attract relief for the Customer. Where the Customer is not Contracting-out R&D i.e. because the contract is for a product or service which is not R&D, the Contractor can claim the R&D relief, if it carries out qualifying R&D to deliver the contract.
This principle represents a change from the previous rules for Small and Medium Enterprise (SME) claims, where the SME claimant could normally include a portion of its contracted-out R&D in its claims. It also means that there is no longer a prohibition on SMEs claiming for funded or subsidised R&D activity – see more below.
Under the new rules, which company has the right to make the R&D claim will depend on the nature and intention of a contract. This means that companies need to be clear on the new rules at the point of entering into a contract. It also makes it essential that written contracts are put in place.
Which company has the right to claim the R&D incentive?
The new rules give the right to claim Contracted-out R&D to the Customer, i.e. the company issuing the contract, provided that:
- It is reasonable to assume that the Customer intended or ‘contemplated’ that R&D would be done.
The draft Guidelines clarify that ‘contemplated’ means that the Customer has more than just a mere awareness that R&D will take place. The Customer must:
- Have a substantial intention that R&D will be undertaken.
- Have a specific appreciation of what R&D will be done.
- Have the ability to understand and specify the R&D.
The Customer’s R&D intention might be reflected in a contract just for the R&D, or a part of the R&D, or a wider commercial contract that includes the R&D.
If the Customer did not ‘contemplate’ that R&D would take place i.e. because the Contractor is delivering a product or service which is not R&D, then the Contractor has the right to claim the R&D incentive on any work it undertakes to deliver the contract.
What demonstrates that R&D has been Contracted-out?
The legislation states three conditions that must ALL be met for R&D to be considered contracted out:
- There must be a contract in place.
- In meeting the obligations of the contract, R&D must be undertaken.
- It is “reasonable to assume” that the Customer “intended or contemplated” that R&D would be undertaken as part of the contract obligations.
It goes on to say that the intention or contemplation of R&D must be specified somewhere. This can be in the contract, in discussions leading to the contract or in the Customer’s internal documents and records. The R&D specification does not necessarily have to be shared with the Contractor.
For example, in some cases a Contractor may be undertaking simple tests that for it, are not R&D, but the tests may be R&D within the Customer’s larger R&D project.
How to you show the intention for R&D to be undertaken?
To prove the intention or contemplation of R&D the Customer must be able to demonstrate:
- Capability in understanding and articulating the nature of the R&D – to do this the Customer will need to either have in-house technical capability or a source of technical capability drawn from elsewhere.
- An understanding of the nature of the R&D that is to be undertaken– this means being able to state what the advance in science or technology is; and what the associated uncertainties are, that necessitate R&D. This goes beyond listing project challenges and constraints, to being able to specify specific R&D actions.
Thus, it follows that the Customer will need to have evidence to support any claim that it has the right to make an R&D claim, otherwise the right to make the R&D claim may pass to its third party contractor.
In some cases it will be beneficial for the Customer and any potential Contractor to discuss where any R&D claim should lie, before a Contracted-out arrangement is entered into.
Follow this link to read the draft guidelines: https://www.gov.uk/government/consultations/draft-guidance-research-and-development-rd-tax-reliefs-new-contracting-out-rules-and-overseas-restrictions/research-and-development-tax-reliefs-new-contracting-out-rules-and-overseas-restrictions-draft-guidance
If you would like help with understanding any of the changes to UK R&D tax incentives or need help in making your R&D claims get in touch.
Author: Linda Eziquiel, Regional Director, RandDTax