What constitutes subsidised expenditure?

In October 2021, HMRC lost a research and development (R&D) tax case against Quinn (London) Limited at the First-tier Tribunal (FTT) (Quinn (London) Ltd v HMRC [2021] UKFTT 437 (TC)). The case concerned whether Quinn’s R&D expenses were being subsidised indirectly by its clients as part of the commercial projects it carried out. The FTT found against HMRC. HMRC has since updated its guidance in its Corporate Intangibles Research and Development Manual, found at CIRD81650, in relation to when it considers that R&D expenditure has been subsidised.

The backdrop to these changes is that HMRC is taking an increasingly tough line with R&D claims. The R&D Tax Reliefs: Report that HM Treasury released in November 2021 states: “The OBR predicts the reliefs will increase from £7.7bn in 2021-22 to £11.9bn in 2026-27.” The report also highlights the huge increase in the number of actual claims, from 35,565 in 2014/15 to 85,900 in 2019/20. There has been a huge increase in both the number of small and medium-sized enterprise (SME) R&D tax relief claims and amounts being claimed, especially given that HMRC perceives it as less efficient at producing additional R&D expenditure.

Hadee case

In October 2020, HMRC won an R&D case against Hadee Engineering Co Limited that, in part, covered subsidised expenditure (Hadee Engineering Co Limited v HMRC [2020] UKFTT 0497 (TC)). This is also an FTT case, although the conclusion was that most of Hadee’s work was subcontracted to it. This case was covered in the February 2021 issue of TAXline.

HMRC has subsequently taken a particularly narrow reading of the legislation at s1138(1), Corporation Taxes Act 2009 (CTA 2009), which deals with subsidised expenditure – especially s1138(1)(c), which deals with directly and indirectly subsidised expenditure that does not fall into (a) or (b) of the section.

HMRC is looking for a clear and direct link between the payment received and the qualifying expenditure when deciding to what extent the expenditure is subsidised. HMRC’s updated manual page CIRD81650 says: “What is considered to be a ‘clear and direct link’ will depend on the facts in each case. However:

• Payment received for undertaking a contract will be considered to meet expenditure incurred in undertaking that contract.
• Where a company carries out R&D on its own account and subsequently sells goods or services developed as a result of that R&D, receipts from those sales will not be considered to meet the expenditure incurred on the R&D.
• Where a company carries out R&D on its own account, receipts from the sale of goods or services which existed prior to the R&D being undertaken will not be considered to meet expenditure incurred on the R&D.
• Where a company obtains finance on commercial terms this will not be considered to meet the company’s expenditure.”

Quinn judgement

HMRC substantively made these points in Quinn. In fact, the aforementioned changes to HMRC’s guidance were made after the Quinn judgement was published. Given the sequence of events, you would have thought that the judge in the case agreed with these arguments. In fact, Judge Harriet Morgan, who presided over the case, did not agree with the above reasoning at all.

Quinn incorporates all its costs, including those relating to R&D, into the price it charges its clients to achieve a desired commercial return; its clients don’t pay or reimburse particular costs such as R&D expenditure. It also does not agree to carry out the R&D on being paid or reimbursed by clients for doing so. Quinn makes fixed price contracts with the ability to vary the price under certain circumstances.

HMRC sought to rely on Hadee, but the judge went on to state that: “I note that I did not find the decision in Hadee helpful in deciding this issue given the different facts and the lack of information available on the terms of the applicable contracts in that case.”

The judge pointed out that HMRC has read s1138(1)(c), CTA 2009 without taking in the context of ss1138(1)(a) or (b). These respectively deal with notified state aid and a grant or subsidy (other than notified state aid) obtained in respect of the expenditure. The third part, s1138(1)(c), deals with subsidies that don’t fall into the above situations and is written as follows in relation to expenditure that: “to the extent that it is otherwise met directly or indirectly by a person other than the company”.

The judge’s view was that s1138(1)(c) when viewed in the context of the overall SME R&D scheme, “is not intended to apply in circumstances such as those in this case, in the absence of a clear link between the price paid by the client/customer and the expenditure on R&D”, but it is intended as a sweep-up provision that “is ‘met’ in a similar sense to that in which expenditure may be said to be ‘met’ by ‘a notified State aid’ or ‘a grant or subsidy...’”.

The judge said: “The circumstances of this case are far removed from those which are intended to be captured by s1138(1)(c) on a fair reading of it in the context of the whole of s1138 and the overall SME scheme.”

Furthermore, the judge went on to say: “It would be wholly out of kilter with the overall SME scheme, if an SME were to be denied enhanced R&D relief solely because, in doing what is envisaged by the legislation (namely, utilising the relevant R&D for the purposes of its trade), as is usual and to be expected of an entity carrying out a trade on a commercial basis, it seeks to recover some or all of the relevant costs of the R&D under its commercial contracts with its clients entered into in the course of its ordinary trading activities. Indeed, if HMRC’s approach were to be adopted, the circumstances in which an SME could claim enhanced R&D relief would seem to be confined to those where it has no prospect of exploiting the R&D for commercial gain.”

In relation to the timing of customer/client payments and expenditure for the R&D, Judge Harriet Morgan again disagreed with HMRC’s view. She could not see HMRC’s basis for drawing the distinction between the timings of when payments are made. Ultimately payments are made by customers for products or services that the company can use to cover its R&D costs. She went on to say: “Moreover, from its terms, I can see no justification for the view that the application of s1138(1)(c) is to be based on such fine and difficult distinctions.”

Takeaways for taxpayers and their agents

It is always worth remembering that HMRC’s guidance is not law and is therefore open to being challenged where there is an inconsistency between the two.

HMRC has not challenged the ruling in Quinn. FTT results are not binding, although they can be persuasive to the cases that follow. Given HMRC’s view in its updated guidance, it seems strange that it did not challenge the result in Quinn. It may be that there was a concern that in addition to the expense to the taxpayer, an Upper Tribunal result would be binding. If HMRC had lost its appeal, this would enshrine the result of Quinn into binding legal decision.

HMRC’s guidance at CIRD81650 will be used when evaluating future R&D claims that include instances where expenses are encompassed in determining what commercial bargain should be struck with clients. On the basis of HMRC’s guidance, these R&D claims would be rejected as subsidised R&D, but this does not follow the result of Quinn.

HMRC’s lack of challenge to the ruling in Quinn leaves companies and their advisers in a difficult position when deciding if a company uses R&D to provide a solution to a customer’s needs. They will have to choose between using HMRC’s updated guidance or the judge’s analysis in Quinn when considering whether a company’s R&D projects qualify for SME R&D relief. If the Quinn analysis is used, this will be contrary to HMRC’s view and therefore there is a risk of an HMRC enquiry.

A prudent view could be taken. A claim could be made under the R&D expenditure credit (RDEC) rules, which allow claims with subsidised expenditure, mitigating the risk of an HMRC challenge. The disadvantage of this approach is that the tax savings would be significantly less than those available under the SME scheme.

Contractual arrangements between a company and its customers should be reviewed. First, to check whether the company is being subcontracted for R&D and second, to check that the company is merely being reimbursed for expenditure or whether the contract is a fixed price contract where the company is taking the commercial risk of making or losing money. It will be important to know who owns the intellectual property.

If it is decided that the SME scheme should apply, then the company will need to be aware that HMRC may seek to challenge the R&D claim based upon its updated guidance. It is recommended that full disclosure is made of the basis for the claim and the view taken.

Those who work in practice may have noticed an increase in ‘so-called’ R&D specialists who attempt to ‘lure’ clients in, often suggesting they are ‘approved’ by HMRC. This is a red flag as HMRC is very clear that it does not, under any circumstances, approve advisers. Often these R&D specialists have little understanding of the technicalities of the scheme when probed around the compliance of an R&D claim. Agents and businesses should therefore undertake careful due diligence of R&D specialists to ensure they are appropriately qualified to undertake any claim.

It is also worth remembering that when preparing the CT600 on behalf of a client and you are provided with an R&D report prepared by a so-called R&D specialist, there is an obligation under Professional Conduct in Relation to Taxation to ensure that you are satisfied that the client is eligible to claim R&D before submitting the return. Our firm has refused to submit some of these reports as part of the CT600 as the claims did not stack up. 

About the author

Randeep Dhaliwal is a Corporate Tax Manager at Kreston Reeves and a member of ICAEW’s Business Tax committee