R&D: Contracting out R&D & Externally Provided Workers (EPW)

Contracted-out R&D

Some companies might contract out all or part of the R&D to another person. Specific rules apply when claiming relief for contracted-out Research and Development (R&D). Which rules apply depends on the accounting period for which the R&D relief claim is being made.

• If you are considering an accounting period beginning on or before 31 March 2024, please refer to the Contracting out R&D pre-April 2024 tab
• If you are considering an accounting period beginning on or after 1 April 2024, please refer to the Contracting out R&D post-April 2024 tab.

Externally Provided Workers (EPWs)

EPWs are external workers provided under a contract by a staff provider. An EPW does not include employees of the claimant company. 

The rules for EPW were introduced in 2012 in recognition that a significant number of companies will employ staff through an agency rather than contract with the workers directly. 

For expenditure on EPWs to be qualifying expenditure it must meet several conditions. See Externally Provided Workers (EPW) tab for a summary of the conditions and relief available. 

Relief available 

100% or 65% of the qualifying expenditure incurred on contracted-out R&D and EPWs may be eligible for relief depending on:

• Whether the parties are connected, or not.
• If connected, whether an election has been made to be treated as connected. 

What's new?

From 1 April 2024

New merged R&D expenditure credit scheme (merged scheme) 

Accounting periods beginning on or after 1 April 2024 must apply to the new merged scheme. This will impact the R&D relief that can be claimed on contracted-out R&D. See Contracting out R&D pre-April 2024 tab and Contracting out R&D post-April 2024 tab.

New rules for R&D undertaken abroad: Externally Provided Workers (EPW) & contractors 

The new rules aim to encourage expenditure on UK-based R&D with the intention that the customer rather than the supplier claims relief for R&D costs.

• Where the R&D activity takes place overseas, subject to limited exceptions, Finance Act 2024 will restrict relief on expenditure incurred on contractor payments for R&D and EPWs. 
• There will be a relaxation of the rules where:
  • The company has a registered office in Northern Ireland.
  • Has claimed relief under the new Enhanced R&D Intensive Support (ERIS) scheme.
  • Either trades in goods, or a trade in generation, transmission, distribution, supply, wholesale trading and cross-border exchange of electricity, or has not opted out by notifying HMRC.
• In March 2024, HMRC issued updated draft guidance for contracted-out R&D. See R&D undertaken abroad tab for detailed guidance. 

R&D claims for subcontractor costs

Specific rules apply when claiming relief for contracted-out R&D. Which rules apply will depend on the accounting period for which the R&D relief claim is being made.

The below section covers accounting periods beginning on or before 31 March 2024. If you are considering an accounting period beginning on or after 1 April 2024, please refer to the Contracting out R&D post-April 2024 tab.

Contracted out 

HMRC's guidance at CIRD84250 discusses the concept of 'contracted-out' R&D.

• The guidance explains that R&D will be considered to be contracted out when a company performs activities under a contractual obligation for another party.
• Specifically, it refers to situations where R&D activities are carried out to fulfil the terms of a contract with a customer.

It is important that the claimant company has a clear intent to contract out R&D expenditure under a contract for it to be considered contracted out.

Accounting periods beginning on or before 31 March 2024

There are three different sets of rules:

1. Large Company claims.
2. SME claims: connected subcontractors.
3. SME claims: unconnected subcontractors.

Connected is defined in s.1122 CTA 2010. See Control & connections: Definitions for taxes

Large company claims

In general, no relief is available under the Large Company Scheme for a company that has subcontracted R&D to another limited company.

Where a large company has subcontracted the R&D to an SME company, the SME company can claim R&D Expenditure Credit (RDEC). The large company would not be entitled to any relief.

However, subcontractor costs will qualify for R&D relief, where a large company has subcontracted out R&D to any of the following: 

• An individual.
• A partnership made up wholly of individuals.
• Certain qualifying bodies: including charities, universities and health service bodies.

Where costs are qualifying, then 100% of those costs can be included in the claim.

SME claims: connected subcontractors

The company can then claim R&D tax relief on the lower of:

• The payment that it makes to the subcontractor.
• The relevant expenditure of the subcontractor.

100% of the payment is allowed, there is no further restriction to 65%.

Relevant expenditure is not capital or subsidised and must be spent on:

• Staffing costs.
• Externally provided workers.
• Consumables.
• Software.

The relevant expenditure must be incurred in delivering the R&D. If the company and the subcontractor are connected, the subcontractor must carry out the work itself and not subcontract to a third party.

SME claims: unconnected subcontractors                             

• Relief is available for Small to Medium-sized Enterprises (SMEs) that have subcontracted R&D. 
• A subcontractor does not have to be UK resident and subcontracted work does not need to be performed in the UK.
• If the company and the subcontractor are unconnected, the company can claim R&D tax relief on 65% of the payment it makes to the subcontractor i.e. you would apply the 86% enhancement to 65% of the amount paid if claiming enhanced relief under the SME scheme.
• The subcontractor does not have to do the work itself but may farm it out to a third party.
• Contracts should be reviewed to determine whether someone is a subcontractor or an externally provided worker.

The main areas that can help to decide whether R&D is subcontracted include:

• Who retains ownership of the resultant Intellectual Property (IP) created? It is possible that IP may be created during different stages of any R&D project and this may not be a straightforward question.
• Who has financial risks and rewards in undertaking the work?
• Whether someone has a degree of control and independence over their own work.
• How the project is arranged and scheduled. 
• In all cases written contracts can assist in determining the relationship between parties.

Election to be connected

There are circumstances when it would be more beneficial for unconnected companies to be treated as connected for the purposes of an R&D claim.

Under s.1135 CTA 2009 a company and unconnected subcontractor may jointly elect by written notice to HMRC to be treated as connected.

The companies will then be treated as connected for all payments made under the same contract or arrangement.

This election must be made within two years of the end of the claimant company's accounting period in which the contract is made. This is the same time limit as that for the claimant company's claim for R&D relief.

Relief for the subcontracting company (the company carrying out the R&D). 

To avoid double relief being given, the subcontracting company carrying out the R&D cannot claim relief under the SME scheme and may only claim relief under RDEC if the R&D has been: 

• Subcontracted out to it from a large company.
• From a person otherwise than in the course of carrying on a chargeable trade. 

If the subcontracting company itself is an SME claiming under RDEC, it will need to apply the same rules for connected and unconnected subcontractors:

• If the company and the subcontractor are unconnected, the subcontractor can claim R&D tax relief on 65% of the payment (or make the election of being connected), and
• If the company and subcontractor are connected, the subcontractor can then claim R&D tax relief on the lower of:
  • The payment that it makes to the subcontractor.
  • The relevant expenditure of the subcontractor.

R&D relief for contracted-out R&D

Specific rules apply when claiming relief for contracted-out R&D. Which rules apply will depend on the accounting period for which the R&D relief claim is being made.

The below section covers accounting periods beginning on or after 1 April 2024. If you are considering an accounting period beginning on or before 31 March 2024, please refer to the Contracting out R&D pre-April 2024 tab.

Contracted out 

The legislation has introduced a new definition of 'contracted out'. This definition identifies the decision maker of the R&D to determine who is entitled to claim relief. 

A person 'contracts out' research and development if:

1. The person enters into a contract under which activities are to be undertaken for it (whether by another party to the contract or by a sub-contractor).
2. The activities undertaken to meet the obligations owed to the person under the contract include research and development.
3. It is reasonable to assume, accounting for the terms of the contract and any surrounding circumstances, that the person intended or contemplated when entering into the contract that research and development of that sort would be undertaken to meet those obligations.

Under this definition, if the R&D undertaken differed from what was intended, the right to claim R&D relief would be with the contractor company (the company undertaking the R&D).

As there is some subjectivity in interpreting the legislation, HMRC have issued detailed guidance on this definition. See Consultation outcome Research and development tax reliefs: new contracting out rules and overseas restrictions – draft guidance

Accounting periods on or after 1 April 2024 

The new merged R&D expenditure credit scheme (merged scheme) will apply for accounting periods beginning on or after 1 April 2024.

• Under the new merged scheme, relief will be claimed by the company that plans, initiates and funds the R&D, rather than the company undertaking the R&D. 
  • The company contracting out the R&D (contracting company) to another party will be able to claim under the merged scheme in relation to that expenditure.

The company that is carrying out the R&D (contractor company) will only be able to claim R&D relief on qualifying expenditure:

• In cases of 'hidden R&D'. Broadly in situations where a supplier undertakes its own R&D activities and bears its own R&D costs without passing on these excess costs
• Where the company that is contracting out the R&D (contracting company) is unable to claim relief, this includes where:
  • The company contracting out the R&D is an ineligible body.
  • The person is not acting in the course of a trade, profession or vocation within the charge to tax. 
• An ineligible body is:
  • An individual.
  • A partnership made up wholly of individuals.
  • Certain qualifying bodies: including charities, universities and health service bodies.
  • A contracting party that has been elected to be ineligible by a group of companies (see Groups below).

These rules represent a change. Where a large company contracted out R&D to an SME company:

• For accounting periods beginning on or before 31 March 2024, the SME would have been able to claim RDEC and the large company would not be entitled to relief. See Contracting out R&D pre-April 2024.
• For accounting periods beginning on or after 1 April 2024, the large company may claim relief under the merged scheme. The SME will only be able to claim relief in limited circumstances (see above). 

Merged Scheme claims: connected 

The company can claim R&D tax relief on the lower of:

• The payment that it makes to the company carrying out the R&D (contractor company).
• The relevant expenditure of the company carrying out the R&D (contractor company).

100% of the payment is allowed, there is no further restriction to 65%.

Relevant expenditure is not capital or subsidised and must be spent on:

• Staffing costs.
• Externally provided workers.
• Consumables.
• Software.

The relevant expenditure must be incurred in delivering the R&D. If the contracting company and the company carrying out the R&D (contractor company) are connected, then R&D cannot qualify for relief if it is undertaken by a third party (i.e. the work is subcontracted to a third party).

Merged Scheme claims: unconnected                               

• Relief is available for companies that have contracted out the R&D (contracting company). 
• From 1 April 2024, there are special rules when R&D is undertaken abroad. See R&D undertaken abroad tab
• If the contracting company and the contractor company are unconnected, the contracting company can claim R&D tax relief on 65% of the payment it makes i.e. you would apply the 86% enhancement to 65% of the amount paid if claiming enhanced relief under the SME scheme.
• The contractor company does not have to do the work itself and may subcontract the work to a third party. Please refer to HMRC’s guidance for further details: Consultation outcome Research and development tax reliefs: new contracting out rules and overseas restrictions – draft guidance
• Contracts should be reviewed to determine whether someone is a contractor or an externally provided worker.

The main areas that can help to decide whether R&D is contracted out include:

• Who retains ownership of the resultant IP created? It is possible that IP may be created during different stages of any R&D project and this may not be a straightforward question.
• Who has financial risks and rewards in undertaking the work?
• Whether someone has a degree of control and independence over their own work.
• How the project is arranged and scheduled. 
• In all cases, written contracts can assist in determining the relationship between parties.

Election to be connected

There are circumstances when it would be more beneficial for unconnected companies to be treated as connected for an R&D claim.

Under s.1135 CTA 2009 a company and unconnected company may jointly elect by written notice to HMRC to be treated as connected.

The companies will then be treated as connected for all payments made under the same contract or arrangement.

This election must be made within two years of the end of the claimant company's accounting period in which the contract is made. This is the same time limit as that for the claimant company's claim for R&D relief.

Groups

When R&D is contracted out to another company within a group, an election can be made to determine which company will claim the relief.

This relaxation will allow groups in which the R&D is carried on by specified companies which have previously all claimed relief for this under RDEC, to continue to do so.

Transitional rules

The merged scheme applies for accounting periods beginning on or after 1 April 2024. As a result, there may be instances where a contractor and the contracting company are using different R&D schemes.

In these instances, transactional rules will apply to ensure that relief is only claimed once.

See HMRC guidance Research and development tax reliefs: new contracting out rules and overseas restrictions – draft guidance

The rules for Externally Provided Workers (EPW) were introduced in 2012 in recognition that a significant number of companies will employ staff through an agency rather than contract with the workers directly. 

For expenditure on EPWs to be qualifying expenditure for relief it must meet a number of conditions: 

• EPW expenditure must be attributable to qualifying R&D being undertaken by the claimant company. 
• To qualify as an EPW, a worker must:
  • Be an individual i.e. not a company.
  • Personally provide services to the company. 
  • Not be an employee or director of the company.
  • Be subject to supervision, direction or control by the company as to how those services are provided.
  • The services of the individual must be provided to the claimant company by a staff provider.
    • Before April 2012, the EPW was required to provide their services under the terms of a contract between them and the staff provider.
    • Since April 2012 they can provide those services under the terms of a contract between them and the staff provider OR between them and a third party, such as a Personal Service Company (PSC).

To claim relief the EPW costs must be paid. From 1 April 2024, special rules apply where the R&D is undertaken overseas. See R&D undertaken abroad tab. 

Contracts should be reviewed to ensure that an individual is not a subcontractor or self-employed rather than an EPW.

Connected staff provider 

If the company and the staff provider are connected, the company can claim R&D tax relief on the lower of:

• The payment that it makes to the staff provider. 
• The staff controller's ‘relevant expenditure’
  • This includes expenditure on staffing costs or agency workers' remuneration. 
  • From 1 April 2024, the expenditure must be attributable to 'qualifying earnings' of EPWs (see R&D undertaken abroad). 

100% of the payment is allowed, there is no further restriction to 65%. 

Connected is defined in s.1122 CTA 2010. See Control & connections: Definitions for taxes

Unconnected staff provider 

Only 65% of the payment for the services of an EPW may be claimed if you are unconnected to the staff provider. 

Election to be connected

There are circumstances when it would be more beneficial for unconnected companies to be treated as connected for the purposes of an R&D claim.

Under s.1130 CTA 2009, a company and staff provider/controller may jointly elect by written notice to HMRC to be treated as connected.

The companies will then be treated as connected for all payments made under the same contract or arrangement.

This election must be made within two years of the end of the claimant company's accounting period in which the contract is made. This is the same time limit as for the claimant company's claim for R&D relief.

Example

Research Ltd is conducting a qualifying R&D project. Rather than employing staff directly, it contracts with an agency, Staffing Supplies, to provide individuals to work on the project. 

Staffing Supplies arranges for two individuals to work at Research Ltd, Jenny and Bob.

Jenny has a contract with Staffing Supplies, but Bob contracts with Staffing Supplies through a Personal Service Company, Bob Ltd.

Before April 2012

Jenny has a contract with Staffing Supplies and provides services to Research Ltd under the terms of that contract. She qualifies as an EPW.

Bob has no contract with Staffing Supplies. He does not qualify as an EPW as the requirement for a contract between the individual and the staff provider is not met.

From April 2012

The requirement for the individual to have a contract with the staff provider has been removed. Bob now qualifies as an EPW.

Warning

If Research Ltd contracts with Bob Ltd directly and not through Staffing Supplies, for Bob to qualify as an EPW, Bob Ltd must be acting as a staff provider and the contract between Bob Ltd and Research Ltd must be for the supply of Bob's services. If the contract with the Personal Service Company is for the provision of consultancy services generally rather than the personal services of an individual, then Bob will not qualify as an EPW. If this is the case then it is likely that Bob Ltd will be a subcontractor. 

• Pre-1 April 2024, this will make no difference to an SME claim where the company is conducting R&D activities on its own behalf. There will be an impact if a large company is making a claim, or if an SME is making a Large Company claim on the basis that it is carrying out R&D activities on behalf of a large company. Generally, payments to subcontractors do not qualify for relief under the Large Company scheme.  See Contracting out R&D pre-1 April 2024 tab. 
• Post 1 April 2024, this will make no difference to companies claiming under the new Merged R&D Expenditure Credit or Enhanced R&D Intensive SME Support (ERIS). See Contracting out R&D post 1 April 2024 tab. 

R&D undertaken abroad

Under the new rules, entities must list the EPWs (the external resources who augment the company’s technical team) working on R&D activities, along with the staff provider’s PAYE reference to confirm these individuals are UK-based. See R&D undertaken abroad tab. 

See HMRC guidance Research and development tax reliefs: new contracting out rules and overseas restrictions – draft guidance

From 1 April 2024 

Where the R&D activity takes place overseas, subject to limited exceptions, Finance Act 2024 restricts relief on expenditure incurred on:

• Contractor payments for R&D.
• Externally Provided Workers (EPWs).

For accounting periods beginning on or after 1 April 2024, expenditure on payments to contractors and EPWs will only qualify for relief if it relates to expenditure on R&D:

• Undertaken in the UK
  • For EPWs, the staff controller must operate Income Tax under the PAYE regulations and Class 1 National Insurance contributions to meet the condition. 
• Undertaken outside the UK (overseas) and all of the following circumstances apply:
  • The conditions necessary for the R&D are not present in the UK.
  • The conditions are present in the location where the R&D is undertaken.
  • It would be wholly unreasonable for the company to replicate the conditions in the UK. Limitations are placed on what those ‘conditions’ can be. They include:
    • Geographical, environmental or social conditions.
    • Legal or regulatory requirements as a result of which the R&D may not be undertaken in the UK.
    • Excluded conditions include the cost of R&D and the availability of workers to carry out the R&D.
• Where the UK location requirement is partially met (i.e. were performed between UK and overseas), R&D costs can be apportioned on a just and reasonable basis, e.g. by:
  • Proportion of workers.
  • Proportion of salary costs.
  • Number of days worked.
• The restriction only applies to contractor payments and payments for EPWs.
  • It does not apply to staffing costs, consumables, software, data and cloud computing, or payments to clinical trial participants.

R&D Tax Relief: Enhanced R&D intensive support for loss-making SMEs based in Northern Ireland

• From 1 April 2024, there is a relaxation of the rules which restrict claims for contracted-out overseas expenditure for affected companies.
• The restrictions on relief for overseas spending on contracted-out R&D and EPWs do not apply to 'affected companies'.
• Affected companies are those that:
  • Are SMEs that have claimed relief under the new Enhanced R&D Intensive Support (ERIS) scheme.
  • Have a registered office of the SME in Northern Ireland, and
  • Satisfy one of the following:
    • Trades in goods.
    • Trades in generation, transmission, distribution, supply, wholesale trading and cross-border exchange of electricity.
    • Does not trade in either of the above and has not opted out by notifying HMRC.
• Affected companies will be subject to a three-year limit. Above this limit, relief will be available under the new merged scheme and the restrictions will continue to apply for any residual amounts claimed under the merged scheme.
• Claims for ERIS that go over this limit are not allowed and HMRC has the power to address any inaccuracies in tax returns.

The three-year limit

• For affected companies, the excess in amount of benefit claimed under ERIS over the equivalent claim under RDEC must not exceed £250,000 over three years (on a rolling basis) 
• SMEs can opt out if the SME’s business activities involve no element of trade in:
  • Goods.
  • In generation, transmission, distribution, supply, wholesale trading and cross-border exchange of electricity
• To opt-out, SMEs must notify HMRC in writing, this can be done as part of the Additional Information Form requirements.
• If an SME opts out of the relief:
  • The overseas restrictions will apply.
  • The limit on the amount of relief obtainable in a rolling three-year period will not apply.

See Consultation outcome Research and development tax reliefs: new contracting out rules and overseas restrictions – draft guidance

In Gas Recovery And Recycle Ltd v HMRC [2016] UKFTT TC05473, a claim for subcontractor costs was disallowed as no payment was made to the subcontractor until after the claim was made.  

• Despite disallowing the appeal, the First Tier Tribunal (FTT) disagreed with HMRC's interpretation of the legislation. HMRC’s interpretation of CIRM82100 is that payment does not have to be made by the end of the accounting period, but does have to be made before any claim is submitted.
• The FTT interpreted it as requiring payment to be made in the accounting period for which relief is claimed, which is the accounting period that the expense is deductible for Corporation Tax purposes. This is a much stricter deadline and would have a significant impact if it were adopted by HMRC.
• To date, HMRC has not changed its guidance as a result of this case. 

In AHK Recruitment Ltd v HMRC [2020] TC7718, the First Tier Tribunal (FTT) denied claims of SME Research & Development (R&D) relief. The conditions for relief were not met as there was no evidence of an advance in science or technology. In particular, relief was denied for subcontractor costs because there was no clear link to the qualifying R&D project. Formal documentation should be kept to evidence the R&D.

In Hadee Engineering Co Ltd v HMRC [2020] TC07969, the company made a lot of bespoke products for its customers. It failed due to a lack of evidence to meet the qualifying criteria for all but one of its R&D projects. It argued that it was not a sub-contractor, however, HMRC challenged this. The court found that contracted work could be a product, R&D or both, the company was largely involved in working as a sub-contractor.

In Strictly Money Ltd v HMRC [2024] TC09296, SME R&D relief for subcontractor expenditure was denied because the costs were not wholly and exclusively incurred for the company’s trade. No relief was available for the subcontractor payments because the subcontractor had not performed any 'meaningful' work for the company during the relevant period.

HMRC guidance 

HMRC guidance, Research and Development (R&D) Tax Relief: Enhanced R&D intensive support for loss-making SMEs based in Northern Ireland.

Consultation outcome Research and development tax reliefs: new contracting out rules and overseas restrictions – draft guidance

Legislation 

Corporation Tax Act 2009, Part 13, Expenditure on Research and Development

Statutory Instrument 2024/348 The Research and Development (Chapter 2 Relief) Regulations 2024.

Finance Act 2024, Schedule 1.