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Subcontracted and subsidised research and development expenditure

Author: Katy Rabindran

Published: 01 Feb 2021

Subcontracted and subsidised research and development expenditure article image

Katy Rabindran reflects on why the First-tier Tribunal decision in Hadee Engineering Co Limited v HMRC, issued in October 2020, provides key pointers on current R&D working practices and HMRC’s approach.

While this case has most significance for SME research and development (R&D) tax relief claimants – in particular those contracting with customers concurrently with R&D activities – there are some broader lessons for all businesses involved in R&D and their advisers.

The case involved an engineering company that undertook bespoke engineering projects for customers. In particular, the case addressed the following key questions:

  • What is a ‘project’?
  • Did the projects qualify for R&D tax relief?
  • Was the work subcontracted to Hadee?
  • Was the work subsidised by customers?

What is a 'project'?

The R&D guidelines issued by the Department for Business, Energy & Industrial Strategy (BEIS) set out the definition of R&D for the purposes of tax, and refer throughout to a ‘project’ without further definition.

HMRC sought to argue that for a project to exist, a claimant should have plans and records to substantiate the project’s activities. The judge referenced the Oxford Dictionary definition of a project as “a plan or scheme; a planned undertaking” and agreed with HMRC that for activities to constitute a project, a formulation of a plan is required.

This meant that some form of record or documentary evidence was expected and, in its absence, that a detailed explanation was needed.

Takeaway: R&D claim narratives should therefore incorporate details of any plan or scheme of work – particularly where this detail is not documented elsewhere in the business. In addition, the fact that the judge cited the dictionary suggests there may be a lack of wider reference to a ‘project’, meaning we may see more interpretation and clarification.

Was the work subcontracted?

The case highlighted that there is limited guidance available to determine whether work is subcontracted out or undertaken individually. The four key points to consider are:

  • intellectual property (IP) ownership;
  • financial risks and rewards of undertaking the work;
  • degree of autonomy in undertaking the work; and
  • deliverables/milestones.

This case covered claims for several projects, most of which were to create bespoke products provided to customers. The taxpayer contended that in none of the projects was the work subcontracted R&D. HMRC disagreed in all but one project.

HMRC’s contention was that if the taxpayer was commissioned to design bespoke products and the design of those products involved R&D, then the R&D activities are subcontracted. HMRC appears to have equated contracted out ‘design’ to include any/all related R&D activities.

The judge confirmed that the contract between the two entities was key here, since the work ‘contracted out’ could be the product, the R&D, or both. In making a judgement, more reference was made to the four key points, but focused particularly on the financial risks and rewards (ie, where design work was paid on an hourly basis, this was taken as a conclusive factor). Unfortunately for the taxpayer, further evidence even included that on one project their customer had successfully filed a patent for design work, demonstrating ownership of the resultant IP.

For many SME businesses seeking to continually invest in their R&D activities, signing up customers and bringing in revenue is key. This can mean customers are signed up before R&D work is undertaken or completed. The judge made clear how important the documentation is here – effectively setting out the intention of both parties. The taxpayer in this case provided no terms of engagement with customers.

Takeaway: Before contracts are signed, clarify the four key points with any customers – particularly those where bespoke and specific product work is undertaken – and discuss the impact for R&D tax relief claims with your adviser.

Advisers should remember that while R&D tax relief is highly beneficial for SMEs (giving relief equal to 43.7% of costs), this is only available on a company’s own R&D. It is important to delineate between customer subcontracted work (only eligible for large company R&D support) and independent R&D. 

Interestingly, under the Irish R&D scheme there is a requirement to notify relevant subcontractors when making an R&D claim in respect of work subcontracted out. While in some respects this is more onerous, it does provide clarity on which company is able to make the claim.

Was the work subsidised?

The legislation here is widely drawn, stating that expenditure is treated as subsidised “to the extent that it is otherwise met directly or indirectly by a person other than the company”.

In my experience, HMRC has not pursued ‘subsidised expenditure’ in any significant way, particularly given a clarification that HMRC’s policy team issued as part of one of the R&D consultative committee meetings where HMRC stated that: “Currently, HMRC took the view that there needed to be a clear and direct link between the payment received and the qualifying expenditure” [to be classified as subsidised].

However, in this case HMRC contended that this includes “payment for a bespoke product including R&D” since the uncertainties are factored into the price charged for a contract. As the judge determined in all but one of the projects that the work was subcontracted to the company, this point was not further debated.

Takeaway: Clearly, once again, the documentation in place (and in particular any contract between the parties) should make it clear whether the payment is linked to the R&D work. Given that the legislation includes that it can be ‘indirectly’ met, this may still be insufficient. It will be interesting to see how HMRC pursues this argument in future cases.

What qualifies for R&D tax relief?

In this case, evidence supplied by the taxpayer was inconsistent and limited. However, in practice this is an area we continue to see HMRC focus on – in particular, demonstration of the pursuit of a “scientific or technological advancement”. From this case, we see that HMRC had researched patents and made google searches to attempt to verify a ‘baseline’.

We continue to see HMRC requiring strong evidence of both the baseline in science or technology, and detail about how a company is seeking to increase this as part of its work. 

Takeaway: Claimants should ensure that the baseline science or technology for a project is clearly explained and, wherever relevant, that third-party sources are referenced to make it simple for HMRC to check.

Summary of points for R&D claims

  1. Maintain good records

This case reiterates the importance of maintaining good records and the reliance HMRC and others will place on wording in contracts and invoices.

  1. Understand and clarify the nature of relationships with customers

Perhaps the most interesting part of this case is HMRC’s interpretation of subcontracted and subsidised R&D work, and the comments of the judge in respect of the former.

Subcontracting for a product may not include any element of subcontracted R&D (ie, the IP developed could rest with the subcontractor, leaving them free to reuse/exploit). However, the wording of any contract will be important here, so it is worth including relevant clarification, both in considering HMRC’s view on whether this is a subcontract or could be interpreted as subsidising R&D expenditure.

  1. Robust project narratives

HMRC recommends that companies submit technical narratives describing R&D projects when R&D claims are submitted. By including a strong justification of the scientific/technological baseline and the advancement sought, a good first line of defence is provided against an HMRC enquiry.

Box: R&D in brief

UK R&D tax relief exists in support of any company undertaking R&D projects. There are two schemes of relief:

2020/21

Value of tax deductions as % of spend

Value of cash credits as % of spend

Small or medium enterprises

43.7%

33.4%

Large enterprises

10.5%

10.5%

Importantly, where work is subsidised, an SME company can only claim that part subsidised under the large scheme (unless subsidised by a notified state aid, in which case the whole project is claimed as large). Where R&D work is subcontracted to an SME company, this can only be claimed under the large company scheme.

The definition of R&D is set out in the BEIS guidelines, which in summary require that a project must:

  • seek to resolve scientific or technological uncertainty/ies; and
  • seek to make a scientific or technological advancement.

About the author

Katy Rabindran is Director of Innovation & Technology at BDO LLP