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Research and development tax relief, HMRC data requirements, promoters of tax avoidance and sentencing for tax fraud Contents

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Chapter 5: Subcontracting Arrangements

131.A company embarking on an R&D project may outsource to another company part of the R&D activity—for example, where the other company has particular specialist experience.205 The existing schemes contain specific rules that set out who can claim relief for R&D that is subcontracted to another person. This is because, as Mace told us, the: “treatment of subcontracted R&D in a merged R&D relief scheme is critical for preventing ‘double counting’ in a supply chain, where one entity performs R&D but then contracts out those activities to another entity, and they are both able to claim the cost as qualifying.”206 However, the existing SME and RDEC schemes differ in how they deal with subcontracted R&D—which we summarise in the next section. The treatment of subcontracted R&D generally generated the most concern from our witnesses.207

132.A company intending to carry out R&D activity may also seek funding from a third party for its work, including grant funding or another form of subsidy. The existing SME and RDEC schemes also treat subsidised expenditure differently.

Treatment of subcontracted R&D and subsidised expenditure under the existing R&D relief schemes

133.Under the existing SME scheme, where one company (the customer) outsources R&D to another company (the provider), it is the customer (and not the provider) who claims R&D tax.208 Conversely, under RDEC, only the provider is generally entitled to claim R&D relief.209 If one company in a subcontracting arrangement is a large company, and the other an SME, then the question of who can claim R&D relief—and on what basis—is, in effect, determined by the scheme that applies to the customer. For example, where a large company subcontracts R&D to an SME, the SME would claim R&D relief under RDEC.210

134.Under the current SME scheme, where a company’s expenditure on R&D is ‘subsidised’ (in that it is met by someone else)211, that company cannot claim relief in relation to that subsided expenditure. No such restriction, however, applies to RDEC. It is the case, however, that an SME prevented from claiming under the SME scheme because of a subsidy should be able to claim R&D relief under RDEC.212

Different interpretations of subcontracted R&D and subsidised expenditure?

135.Last year’s Finance Bill Sub-Committee report, Research and Development tax relief and Expenditure Credit, 213 found a difference in view between HMRC and most advisers on how the SME scheme rules relating to subcontracted R&D and ‘subsidised expenditure’ applied in practice, and that this was creating uncertainty for businesses and advisers.

136.In this year’s inquiry, our witnesses explained that the difference in view mainly concerned contracts under which the customer outsourced work to the provider under contract and the provider subsequently found that, to do that work, it needed to carry out R&D.214 We were told that HMRC’s current view was that: “any activities carried out in order to fulfil the terms of a contract are deemed to be subcontracted”.215 Ayming told us that if a civil engineering firm were hired to build a stadium for a football club and, after starting work, found a problem that it needed to undertake R&D to resolve: “it would not be the civil engineers making the claim but … a premiership football club.”216

137.In addition, we were told that HMRC’s view of when expenditure is subsidised could also prevent a company claiming R&D relief for activity they are paid to do under a contract. Mace explained: “if a company secures a contract up front with a customer to undertake a project, any activity that takes place thereafter will be deemed as fulfilling the terms of a contract. HMRC would therefore treat any R&D expenditure on a commercial project as subsidised by the customer”.217 Ela8 summarised: “subsidised R&D continues to be a difficult area for companies and advisers alike”.218

138.The previous Finance Bill Sub-Committee’s report into R&D tax relief, 219 asked HMRC to consider what steps it could take to resolve uncertainty around the meaning of ‘subsidised expenditure’. However, in its evidence for the current inquiry, CIOT told us that HMRC was: “permitting a situation of uncertainty to continue” in relation to this issue.220

139.We recommend that in 2024 HMRC work closely with members of its Research and Development Communication Forum in order to clarify the treatment of both ‘contracted out R&D’ and subsidised expenditure.

Who should claim relief for subcontracted R&D and subsidised expenditure?

140.In its consultation on a single scheme, the Government said that the new scheme would contain only one rule for subcontracted R&D and asked for views on: “which set of rules would best support companies”—the SME scheme rules, RDEC or a different approach.221 Given the significant differences in the treatment of subcontracted R&D and subsidised expenditure between the two existing schemes, ICAEW said: “some people will win and some people will lose … it will be impossible to find a solution that suits everyone affected”.222 Indeed, some witnesses favoured the RDEC model and others the approach of the SME scheme.223 Justin Arnesen of Evelyn Partners told us that this issue, which he described as: “ultimately who was eligible to claim” between customer and provider, was a: “major point of debate”.224

141.When it published draft legislation in July 2023, the Government said that it had decided to adopt the SME approach, with the customer being entitled to claim R&D relief (subject to an exception where the customer was outside the UK).225 Mr Henty told us that: “there is a strong economic case for giving R&D relief to the decision-making body, the company that has the project to resolve a scientific or technological uncertainty”.226 CIOT told us that this was a: “significant change for large companies”.227

142.To illustrate this, Table1 below summarises who can claim R&D relief under each of the existing SME and RDEC schemes where R&D has been subcontracted. Table 2 summarises the effect of adopting the SME model for the merged scheme, highlighting the changes from the current schemes.

Table 1: Subcontracting: who can claim under the existing schemes

	Customer	R&D Claim	Provider	R&D Claim
1	Large company	None	Large company	RDEC
2	Large company	None	SME	RDEC
3	SME	SME relief	SME	None
4	SME	SME relief	Large company	None

Source: Written evidence from ForrestBrown (DFH0016)

Table 2: Subcontracting: who will be able to claim under the merged scheme

	Customer	R&D Claim	Provider	R&D claim
1	Large company	Merged Scheme	Large company	None
2	Large company	Merged Scheme	SME	None
3	SME	Merged Scheme	SME	None
4	SME	Merged Scheme	Large company	None

The text highlighted in bold in Table 2 shows the differences for large companies under the merged scheme.

Source: Written Evidence from ForrestBrown (DFH0016)

143.FSB supported the Government’s decision to adopt the SME scheme’s approach to subcontracting in the merged scheme, given that, for SMEs: “the practicalities … mean [that R&D] will need to be outsourced from time to time”.228 IoD also saw this as: “the right approach”.229 NCUB was similarly in favour and told us that this was: “the most common approach internationally.”230

144.BIA saw the SME approach as working: “perfectly from a life sciences point of view”. However, while it recognised that it: “was very hard to fix” all the issues, it had some reservations about this being a blanket rule, given issues around fragmented R&D.231

145.Many of the witnesses who, conversely, sought a replication of the RDEC approach to subcontracting, highlighted the uncertainty surrounding the interpretation of the rules on subcontracted R&D and subsidised expenditure under the current SME scheme232. Mr Craig said that, in adopting the SME model, the Government had: “picked up one of the most problematic, and currently most controversial, aspects of the SME scheme”.233 Even though ATT thought the SME model was both: “reasonable” and “sensible”, it nevertheless felt that: “one drawback is that consideration as to whether R&D has been contracted into a claimant company or subsidised by customers will continue to be important.”234 According to ForrestBrown: “Adopting the SME approach to contracting out could cause major disruption for large companies if the recent uncertainty regarding the interpretation of ‘contracted out’ continues”,235 and ela8 told us that the proposed restriction for subsidised R&D should be removed as it is: “not appropriate within the merged scheme”.236

146.Ayming’s view was that the merged scheme should: “parallel the current RDEC scheme … as this would bring the benefit [through R&D relief] of providing relief to the company actually undertaking the R&D … as well as ensuring the company claiming had the competence to prepare the claim accurately.”237 Mace and Morgan Sindall Group (Morgan Sindall), each of which currently claims R&D relief under RDEC, agreed238—Mace told us that RDEC credit: “provides vital support and investment in construction … allowing the sector to take financial risks on innovation and modern methods of construction”, and that, if the merged scheme followed the SME model: “a significant proportion of R&D tax credits are set to be directed away from construction companies”239—which, Morgan Sindall pointed out, would be: “with only a few months’ notice”.240

147.Mr Davies explained that another issue with the SME model was that many companies will be unaware that: “R&D is taking place as part of an arrangement they have with someone else. They suddenly become eligible claimant organisations but will have no understanding of R&D … so you will end up with the ironic situation of R&D taking place but nobody being able to access relief.”241

148.Mr Arnesen of argued that: “the entity that should be claiming is the entity that has the technical know-how in that particular area, as opposed to a funder who is ultimately paying for an activity but does not necessarily understand the scientific baseline”.242

149.Some witnesses who favoured the RDEC approach to subcontracting questioned whether the Government properly understood how subcontracting worked in different industries. For Skanska UK plc (Skanska), issues around subcontracting and subsidised expenditure were the main issues relating to the merged scheme. Gillian Thomson told us that:

“when the Government talked about merging the scheme there was talk about a lot of it falling with the large scheme, so it was not something that we [in]tended to consult on at that point. When the draft legislation came out … we found it was a complete change …. We do not feel the Government have looked at what they really mean by ‘subcontracted’.”243

She also said that Skanska believed that: “the subsidy part should be taken out altogether … . There should not be a penalty for us for being able to claim the R&D part purely because we are getting some income towards the project as a whole rather than the R&D specifically”.244 ICAS was also concerned that the Government had not taken: “sufficient account of the range of commercial arrangements and allocation of economic risk” relating to R&D activity.245

150.Mr Henty told us that there had been: “a lot of discussion” since the publication of the draft legislation in July.246 Referring to those discussions, HMRC said that the: “main topics of conversation have been around subcontracting and subsidised expenditure rules”.247

151.CIOT and BIA both told us that, in those discussions, the Government had proposed two different solutions to deal with subcontracting.248 The first was to define ‘subcontracted R&D’ by: “distinguishing in the legislation an R&D contract (only the customer can claim) from a non-R&D contract (the subcontractor may be able to claim).”249 The second was a system of notification by the customer: “whereby a party initiating a contract notifies the subcontractor, ahead of payment, that the subcontractor cannot claim R&D relief.”250

152.ICAEW and Ayming preferred the notification system option, while recognising that: “there are practical steps to get over to make that work.”251 On the other hand, Ellen Milner said that CIOT’s preference was for the first approach as it felt that a notification system would mean that parties: “potentially start to get wrapped up in contract negotiations”.252 In any event, it felt that: “the outcome of the Government’s deliberation following these discussions and the proposed way forward should be the subject of further consultation.”253

The Government’s preferred approach: defining subcontracted R&D

153.In its summary of consultation responses, the Government said it would like: “further discussions to understand how a potential merged scheme could distinguish between ‘normal’ (non-R&D) contracts and ‘subcontracted out R&D’ so that those undertaking qualifying R&D are enabled to claim relief, whilst avoiding double claims.” The Government also said that it was still considering whether the merged scheme should contain a restriction on relief for subsidised expenditure.

154.HMRC told us that in its discussions with stakeholders over summer 2023, it had been: “working with industry to get the detail right” in relation to how the new scheme dealt with subcontracting arrangements.254 The draft Finance Bill clauses did not distinguish between the two types of subcontracting arrangements identified by the Government—non-R&D and subcontracted R&D—which CIOT described as a: “huge omission”.255 However, HMRC told us that it would be informally consulting on any further draft legislation on this aspect of the scheme before finalising the next Finance Bill.256 Although the Government did not say what it meant by this distinction, Ms Thomson told us that there were two main types of subcontracting: the first, where: “there is the subcontracting of an R&D project”—for example, outsourcing a drug trial—and the second where R&D is: “embedded in a wider commercial project”, as is usually the case under a construction contract.257

155.At Autumn Statement 2023, after our non-government witnesses had given evidence, the Government confirmed that it intended to pursue the option of defining a ‘subcontract’ for R&D purposes in the legislation. Where a contract met that definition, the customer would be the person entitled to claim R&D relief (as per the SME model). For other contracts, it would be the provider that could claim relief—so that: “if a company is contracted to provide a product or service which is not R&D … [but undertakes] R&D in delivering that product or service, they would be able to claim relief even though they are undertaking R&D on an activity contracted to them”.258

156.The Government also announced that, because of how it planned to treat subcontracted R&D: “the rules relating to subsidised expenditure in the existing SME scheme are no longer relevant”, meaning that: “if a company receives a grant that covers part of the cost of its R&D, or if the cost of the R&D is otherwise met by another person, then (subject to the contracting out rules … ) this will not reduce the amount of support available under the merged scheme”. The Government also announced that it would be making equivalent changes to the R&D intensive scheme (which, as discussed in Chapter 3 above, is based on the existing SME scheme259) in the interests of: “consistency across the regime” once the merged scheme was in place.260

157.Mr Henty told us that these rules were designed: “to ensure that we pick up all the R&D and do it at the level of the decision-making body that is trying to resolve a scientific uncertainty” and that, both in principle and from an economic perspective: “it is better to have the rules that we are proposing”. He said the Government was not in favour of a notification system as it would mean that R&D relief was granted on the basis of: “bargaining power … [rather than] following the substance”. He accepted that there would need to be: “a lot of guidance and clarity from HMRC so that people know exactly what needs to be done” when working out whether their contractual arrangements were caught by the legislation of not, and that HMRC’s: “focus over the next few months will be to make sure that that is right.”261

158.It is clear that changing the rules on subcontracted R&D would always result in winners and losers. The Government should have been more transparent in July about its reasons for its chosen approach so that those businesses at risk of losing out could at least understand the policy rationale for this.

159.We consider that there should have been a wider, and more formal, consultation on the treatment of subcontracting arrangements at an earlier stage. It is particularly disappointing that the new Finance Bill provisions on subcontracting were not themselves subject to formal consultation before being laid before Parliament.

160.Given the range of commercial arrangements relating to R&D activity, we consider that defining ‘subcontracted R&D’ to exclude what the Government calls a ‘normal’ contract may be very challenging, if not impossible. We therefore agree that it is vital that detailed guidance on the meaning of ‘subcontracted R&D’ is made available as soon as possible. We are concerned, however, that there is insufficient time for such guidance to be developed prior to the legislation coming into force from April 2024.

161.We welcome the Government’s decision to remove the restriction on relief for subsidised expenditure under each of the merged and R&D intensive schemes.

162.Detailed guidance on subcontracted R&D, including realistic examples, must be available to businesses in advance of 1 April 2024 when some businesses will have to apply the new rules. HMRC needs to assure businesses that final guidance will be available before the start date of the merged scheme.

A need for transitional provisions?

163.CIOT told us that, whichever route the Government took in relation to subcontracted R&D: “April 2024 is too soon for businesses to organise their contracts and businesses arrangements to reflect the new rules, particularly when much of the detail remains outstanding”.262 Given that many R&D projects: “involve long-term contracts, spanning several years”, ICAEW told us there could be projects that: “span an existing R&D tax relief scheme and the merged scheme”. The difference between the treatment of subcontracting under the merged scheme and the current RDEC scheme meant that: “the entity entitled to relief under the contract concerned will change [mid-contract], especially where R&D work is subcontracted.”263

164.ICAEW argued for existing contracts to: “continue to be dealt with under existing rules, or [for] the entity currently entitled to the relief … [to] continue to do so for the length of the contract”.264 For ela8, Mr Davies felt that: “with a sensible timetable, transitional arrangements are probably not required … . [but in the case of] … a very aggressive timetable, transitional arrangements would be an eminently sensible thing to do”.265

165.The Financial Secretary recognised that: “for some businesses where there is a lot of subcontracting, this change may require some renegotiation of some of those contracts … [but] that is not beyond the wit of man.” He hoped that after: “some inconvenience from this change … [and] some transitional complications with some subcontractors, … that point in the process will be easier in the medium to long term.”266

166.We acknowledge that changes to the subcontracting rules announced at Autumn Statement 2023 should go some way to assuaging the concerns of larger companies concerning the adoption of the SME model for subcontracting arrangements. Nonetheless, such businesses will have a heavy compliance burden given the need for them to review each subcontracting arrangement in order to confirm eligibility for R&D relief in advance of the merged scheme coming into effect.

167.Transitional rules within the merged scheme would be undesirable: they add to the overall complexity of the transition and could mean that affected businesses are subject to two different regimes (both the RDEC and the merged scheme) in relation to R&D spend until the end of the transitional period. The need for such transitional arrangements would be best avoided by deferring the start date for the merged scheme to allow companies to prepare for the changes.

168.If the Government persists with its current timetable for the merged scheme, we recommend, notwithstanding the reservations set out in our conclusion above, that transitional provisions be included in the legislation so that providers can continue to claim relief for R&D done under an existing subcontracting arrangement for a specified period. This would enable them to review their existing arrangements and negotiate any changes needed for their contracts to remain financially viable. Any such transitional arrangements should be as simple as possible to implement and should last no longer than is necessary to enable those affected to adjust to the new sub-contracting regime.

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