Issues over subsidised expenditure and subcontracting have made it difficult for companies to see clearly when it comes to research and development (R&D) tax relief, says Randeep Dhaliwal, who welcomes revised guidance from HMRC.
For accounting periods beginning before 1 April 2024, companies incurring qualifying expenditure on R&D may consider making a claim for R&D tax relief under the rules applicable to small or medium-sized enterprises (SMEs) or, for larger companies and SMEs in limited circumstances, for the R&D expenditure credit (RDEC). A new merged scheme of relief applies for accounting periods beginning on or after 1 April 2024.
In this article I’m primarily interested in the SME regime. All statutory refs are to Corporation Tax Act 2009 prior to the changes made by Finance Act 2024.
Conditions for making a valid claim
A number of conditions must be satisfied for a valid claim to be made under the SME regime, including that the expenditure (s1052 and s1053):
- is not incurred by the company in carrying out activities contracted out to it; and
- is not subsidised. Expenditure is treated as subsidised if it is met in whole or in part by a notified state aid or to the extent that is met:
- by a grant or subsidy; or
- “directly or indirectly by a person other than the company” (s1138(1)).
First signs of trouble
In October 2020, HMRC was successful in the First-tier Tribunal (FTT) case of Hadee Engineering Co Ltd v HMRC [2021] UKFTT 0497 (TC) (Hadee). HMRC had denied the company’s claims to R&D tax relief in respect of a number of projects and the FTT agreed for the most part, finding that only one of the projects potentially qualified for relief. The company’s claim fell at the first hurdle, in that its activities did not amount to R&D, and so other arguments put forward by HMRC were not pursued in detail, including that:
- the company was acting as a subcontractor. HMRC’s submission, as summarised by the FTT, was as follows: “If the [company] was commissioned to design bespoke products and the design of those products is R&D, then that commission to provide a solution for the customer has been contracted out by the customer”; and
- the expenditure incurred was subsidised as it was “met directly or indirectly by a person other than a company” and was therefore subsidised. For HMRC, ‘subsidised’ included “payment for a bespoke product including R&D”.
The approach taken by HMRC surprised many observers as it seemed to be out of step with HMRC’s published guidance. However, HMRC called ‘subsidised’ again in Quinn (London) Ltd v HMRC [2021] UKFTT 0437 (TC) (Quinn), which I covered in detail in an earlier article. In summary, HMRC argued unsuccessfully that if the R&D was conducted in the course of fulfilling a contract with a customer then it would be treated as subsidised. The FTT disagreed with HMRC, finding the ‘subsidised’ test, when viewed in the context of the overall 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”.
HMRC doubles down
Despite that setback, in November 2021, HMRC updated its published guidance on subsidised expenditure (CIRD 81650) to reflect the arguments it had made in Quinn. This left companies and their advisers in the difficult position of choosing between taking the prudent approach of following HMRC’s guidance and therefore making a claim under the RDEC regime; or making a more generous claim under the SME scheme, relying on the judge’s analysis in Quinn and risking HMRC challenging their claim.
Also in November 2021, HMRC updated its guidance on subcontracting (CIRD84250) to include the following sentence, echoing the position taken by HMRC in Hadee: “Where there is a contract between persons for activities to be carried out by one for the other, and those activities form the whole of an R&D project or are part of a wider R&D project, then R&D activities have been subcontracted.”
Taxpayer victories
Approximately three years later, HMRC’s views on subcontracted and subsidised were tested – and rejected – in Collins Construction Ltd v HMRC [2024] UKFTT 951 (TC) and Stage One Creative Services Ltd [2024] UKFTT 1059 (TC).
Collins Construction Ltd
Collins Construction Ltd (Collins) is paid a fixed fee for undertaking bespoke construction contracts, some of which may require the company to incur expenditure on R&D. It is not known at the tender stage if R&D may be required. The copyright in all design documents stays with Collins with a waiver to protect the client. The contract sums may be adjusted in very limited circumstances, none of which relate to the R&D activity. HMRC argued that all work performed under the contracts was either subsidised or contracted out by Collins Construction’s clients to the company. This is because there would have been no R&D carried out by the company had it not undertaken the projects. Effectively, the projects were not standalone projects where the company is the principal.
The bargain made between the parties was not for the company to incur specific costs in return for the clients agreeing to pay those costs
In coming to its decision, the FTT reviewed the concept of ‘judicial comity’, concluding that the decision in Quinn, while not binding, should be followed unless the findings in the case were wrong, which it concluded was not the case. Having found striking similarities between that case and Collins, the FTT ruled that the company’s expenditure was not subsidised as there was no ‘clear link’ between the price paid by the client and the expenditure on R&D by the company. The FTT also examined the ‘contracted out’ conditions, which is particularly interesting as HMRC did not raise this argument in Quinn. Finding for the company, the FTT concluded that the bargain made between the parties was not for the company to incur specific costs, such as the claimed expenditure, in return for the clients agreeing to pay those specific costs.
Stage One Creative Services Ltd
Stage One Creative Services Ltd (Stage One) provides engineering, construction and automation solutions for live events and installations. It takes on commissions for projects that are challenging and it is not always clear at the outset if the company will be able to deliver the result that their clients desire. Some of the projects require pushing the boundaries of science and technology to deliver the required results and therefore they are eligible to make R&D claims. Again, HMRC argued the company’s expenditure was subsidised and/or its activities had been contracted to it by its clients.
In this case, the FTT concluded that the court was not bound by the decision in Quinn and considered the matter afresh. However, the FTT ultimately accepted most of the reasoning in that decision and found that the R&D was not subsidised. The FTT also found for Stage One on the issue of subcontracting, finding that the company’s clients did not have an obligation to pay or reimburse it for the expenditure on the R&D, and indeed that many of the clients would have been unaware of the R&D required at the outset of the contracts. The clients simply agreed a price for their project to be delivered.
The current position
In February 2025, HMRC updated its guidance on subsidised (CIRD81650) and subcontracting (CIRD84250) to reflect the decisions outlined above. HMRC now accepts that payments received from customers “are not considered to subsidise the company’s R&D activities unless the payment is specifically linked to those activities”. The guidance also provides non-exhaustive lists of situations in which expenditure would and would not be treated as subsidised.
HMRC’s guidance also includes (in order of importance) a list of factors that may help to determine if work has been subcontracted. These include the following, which HMRC says may suggest that activities have been contracted to the company:
- the R&D is only incidental to the supply of a product or service to the principal;
- the company has only a limited degree of autonomy over the way in which it carries out its R&D activities;
- the company has only limited financial risk in undertaking the R&D work; and
- the company does not retain any intellectual property arising from the R&D project. The nature of the intellectual property is important, for example, if the principal has exclusive rights this will have more weight than the “know how” that will be retained by the company undertaking the R&D.
Helpfully, HMRC has also provided an example that should reassure many companies.
Example based on HMRC’s guidance
Company B engages Company A to replace the roof on its office building. The contract is in a standard form and specifies only standard requirements such as style and the materials to be used. While the roof is being fitted, Company A undertakes R&D in order to try to use modern fittings in an old building.
HMRC says that:
- “Company A’s R&D activities are not contracted to it by another person.”
- “Company A’s R&D expenditure is not subsidised because the expenditure was an incidental part of the delivery of the project and Company B did not undertake to specifically reimburse such expenditure under the terms of the contract.”
Problem solved?
HMRC’s amended guidance on subsidised expenditure is generally a vast improvement on its predecessor. However, there remain some uncertainties. For example, it states that HMRC considers the following scenario as being subsidised expenditure: “The funding is related to the R&D expenditure, but the company provides nothing in return or provides something which does not represent a commercial return to the funder”. It would be helpful if HMRC made it clear that bad commercial bargains are not included here.
HMRC’s amended guidance on subsidised expenditure is a vast improvement on its predecessor. But some uncertainties remain
Similarly, the updated guidance on subcontracting states that: “The existence of financial risk is not a strong indicator that the work was not contracted to the company”. This is not supported by the FTT decisions referred to above. In Collins and Stage One, for example, the fact that some of the projects were loss making was a key factor in the taxpayers’ victories. Additional guidance, including examples, on the intellectual property factor would also be welcome.
There is also the matter of open enquiries. HMRC has said it intends to close these by 30 June 2025 where possible, and that it is on track to do this. HMRC has also made it clear that it will not consider reopening enquiries where HMRC rejected the claim for SME tax relief and the enquiry was closed on that basis. Companies in this position, and companies that followed HMRC’s guidance and either chose not to make a claim or to make a claim under the less generous RDEC, may well feel aggrieved that they have lost out on relief that they were entitled to.
Looking ahead
Looking further ahead, under the merged scheme, the restriction for subsidised expenditure has been removed and there is updated guidance on contracting out in CIRD160000 which is more comprehensive than the amended guidance for SMEs. However, there is room for disagreement in the supply chain as to who can claim tax relief for an R&D project and I can foresee more FTT cases in the future. Given the events described above, companies and their agents may wish to tread carefully when relying on HMRC’s guidance.
Randeep Dhaliwal, Head of R&D, Kreston Reeves, and a member of ICAEW’s Business Tax committee
