Research and development tax reliefs: new contracting out rules and overseas restrictions

Among the drastic changes to the research and development (R&D) tax reliefs, are restrictions on R&D activities undertaken overseas and an update to the guidance on contracted-out R&D. The rules apply for accounting periods beginning on or after 1 April 2024 and affect both the merged RDEC scheme and the R&D-intensive SME scheme. Guidance to support the rule changes was provided in February 2024 by HMRC. In this article, we summarise these changes and outline their implications for claimants.

Overseas expenditure

From April 2024, almost all R&D that takes place overseas and the qualifying costs relating to these activities will no longer qualify under the R&D schemes in the UK. There are some exceptions to these rules but for the most part, any R&D undertaken outside of the UK must now be excluded from any submission.

For contractor payments, the requirement is focused on the location of the activity. R&D is regarded as in the UK if the employees are performing duties in the UK, consumables are being used in the UK (although they could be sourced from elsewhere), software and cloud services are being used in the UK (again, even if they are originating from elsewhere) and payments are made to clinical trial volunteers located in the UK.

Where some activity is taking place in the UK and overseas, the contractor or externally provided workers (EPWs) payment should be apportioned on a just and reasonable basis. The company claiming for the contractor payments must take reasonable care to understand where the R&D takes place, and the claimant has a duty to keep and preserve all records, as with all aspects of an R&D claim.

For EPWs, earnings are ‘qualifying earnings’ if either the company or the staff controller is required to operate PAYE and account for Class 1 NICs for them. The usual 65% (for unconnected parties) can be claimed as qualifying R&D expenditure including amounts for the staff controller’s overheads and profit.

Exceptions to overseas restrictions

Expenditure for R&D activities contracted overseas or EPWs who are not subject to UK personal tax, may still qualify if any of the following circumstances are met:

• i. the conditions necessary for the R&D are not present in the UK
• ii. the conditions are present at the locations where the R&D is undertaken
• iii. it would be wholly unreasonable to replicate the conditions in the UK.

The conditions necessary to apply these exceptions are not listed in full by HMRC, but two categories of potential conditions are noted: “geographical, environmental and social” and “legal and regulatory requirements”. Examples are given in the draft guidance - Research and development tax reliefs: new contracting out rules and overseas restrictions – draft guidance - GOV.UK (www.gov.uk).

Contracted-out R&D

Historically, subcontracted R&D has been an area of complication of R&D claims, with contention between HMRC and claimants surrounding the question of “whose R&D is it?”. With the merged scheme coming into effect, the need for clarification on this point has been heightened by the ability of large companies to now include subcontractor costs.

The new guidance states, that where R&D is carried out under a contract, the right to claim R&D tax credits will go to whoever ‘intended or contemplated’ the R&D. It is expected this will generally be the customer rather than the contractor.

Where it is reasonable to assume that the customer ‘intended or contemplated’ that relevant R&D would be done (either a whole project or as part of a project), then they get to make the claim. Otherwise, the contractor can claim on the basis that they have been engaged to carry out specified work for the customer, not engaged to do R&D, so any R&D they do to complete that work is their decision. There is no prohibition for claiming for funded or subsidised activity. The same R&D expenditure should not be claimable by both the customer and the contractor.

Where the customer would normally be able to claim because it meets the above conditions (including ‘intended or contemplated’) but cannot claim (e.g. because it is an overseas company or a UK government department), then the contractor is permitted to claim to ensure that the R&D does get relief somewhere. This will be subject to the contractor’s activities being qualifying R&D expenditure in their own right.

Summary

The newly released guidance gives a much clearer picture of how HMRC will assess the new legislation on both overseas and contracted R&D but does require a change in mindset from claimants when preparing claims to adapt to these changes.

R&D activities undertaken overseas will no longer be qualifying unless the exceptions can be applied and companies will therefore need to assess if they can move R&D functions back to the UK or see a reduction in their claims going forward. Wider tax matters (including those of the overseas territory would need to be considered). Companies completing R&D that is contracted to them by another entity will need to assess on a project-by-project basis if they have the right to claim R&D tax credits.

Slowly, greater clarity is emerging about the changes. However, the melting pot of the new merged scheme, the additional filing requirements that came into effect from August 2023, changes to qualifying expenditure, submitting advance notifications and trying to remember which rules apply for different company accounting periods has made things more complex for claimants. It is now even more important for companies to take early steps to consider the implications of these changes on R&D tax credit claims.

Crowe’s experienced R&D team would be delighted to start the conversation with you. Please contact Stuart Weekes or your usual Crowe contact.