Consultation outcome

Draft guidance (updated): Research and Development (R&D) tax reliefs - new contracting out rules and overseas restrictions

Updated 27 March 2024

1. Overview

Legislation included in Finance Act 2024 (FA24) introduces changes to the research and development (R&D) reliefs, which apply for accounting periods beginning on or after 1 April 2024 (subject to transitional provisions).

In particular, the legislation:

• restricts the extent to which payments to contractors for R&D, and payments for externally provided workers (EPWs) can qualify for R&D relief where the R&D activity takes place overseas
• introduces new rules for contracted-out R&D

This is HMRC guidance on the effect of both these changes. It does not address wider aspects of the legislation. The guidance sets out HMRC’s view of the legislation. HMRC will publish full guidance on the changes later in 2024. The guidance in this note will be incorporated into the Corporate Intangibles and R&D Manual – HMRC’s guidance on the R&D reliefs – at the same time.

FA24 makes these changes by amending the Corporation Tax Act 2009 (CTA09) and other supporting legislation (such as Schedule 18 to Finance Act 1998). This guidance should be read alongside FA24 and the existing legislation.

References to legislation, unless otherwise noted, are to provisions of CTA09 after amendment by FA24. The guidance uses the same convention for referring to legislation as the existing R&D guidance in HMRC’s Corporate Intangibles and R&D manual (CIRD), so for example CTA09/S1053 refers to section 1053 of CTA09.

2. UK and overseas expenditure: restrictions on eligibility for R&D reliefs of contractor payments and of payments for externally provided workers

FA24 restricts the extent to which payments to contractors, and payments for EPWs can qualify for R&D relief where the R&D activity takes place overseas.

For contractor payments the restriction applies based on the location of the activity. For EPWs, it applies through a requirement that the EPW’s earnings are subject to Pay As You Earn (PAYE) and Class 1 National Insurance contributions (NICs).

For both contractor payments and EPW payments there are exceptions where the R&D activity meets certain conditions – broadly, that the activity necessarily takes place abroad.

The guidance below explains what evidence might be kept to support a claim, how the rules for contractor payments and for EPWs work which categories of expenditure are not affected and discusses cases where exceptions apply. See section 6.1 for the details of the exceptions.

2.1. Evidence to support a claim

It is worth repeating that as CIRD 80550 states, ‘There is no record keeping requirement specifically for the purposes of claiming R&D relief, but the general CTSA requirement to keep sufficient records applies’. HMRC’s Guidelines for Compliance give further advice on record keeping in connection with R&D claims . The current version will be updated to specifically address the overseas restrictions.

In claiming relief for contractor or EPW payments, a company is self-assessing that the expenditure meets all the conditions for relief, including the overseas restrictions. The company needs to take reasonable care to determine where the R&D takes place. HMRC cannot specify exactly how this is done, as circumstances will vary widely but businesses have a duty to keep and preserve records (see Part III of Schedule 18 Finance Act 1998). This duty applies to all aspects of R&D relief claims.

If businesses have an established relationship, the customer may already know where the contractor carries out their activities. If the parties have not done business together before, the customer may have chosen the contractor because they have particular facilities or expertise. So it may already be clear where the activities take place. There may be arrangements to supervise or quality assure aspects of the R&D activities, which would allow the location to be understood and monitored. The contract may require that the activities take place in the UK.

Similarly, it is reasonable to expect a customer to understand where EPWs who are supplied to it will be working, particularly if they are located at one of its own sites.

The supply of R&D is similar to other aspects of the customer’s supply chain. Businesses need to understand their supply chain in order to operate successfully and to understand and control any risks.

The R&D reliefs claim process will not require upfront evidence of this, or of the company’s justification for carrying out activity abroad where it relies on one of the exceptions.

As with other aspects of the company’s tax affairs, the company may need to produce evidence to support overseas aspects, should HMRC request this. In this case, the evidence will need to show that the customer is complying with the overseas.

This requirement would, however, be pragmatic and proportionate to the risk. For example:

• if a contractor is small and has a UK trading address, evidence of this address would be sufficient. It would be prudent for a company to identify and retain information such as, contracts, confirmatory letters or emails from contractors and invoices

• if the company is relying on an exception to the overseas rules it would be prudent to retain meeting minutes or project plans to support the necessity for the work and any additional evidence, for example that UK capacity was not available at a testing centre, including responses from third parties where these provide direct evidence

• HMRC appreciates that third parties may may consider some information to be sensitive and may not share it

3. UK and overseas expenditure: contractor payments

The new rules apply to accounting periods beginning on or after 1 April 2024 and affect both enhanced R&D intensive support (ERIS) for loss-making small or medium enterprises (SMEs) and the new merged R&D Expenditure Credit (RDEC). Under the new rules, to qualify for relief, expenditure on payments to contractors is required either to be incurred on R&D undertaken either:

• in the UK (CTA09/S1134(3)(e), CTA09/S1136(3))
• outside the UK in the circumstances described in CTA09/S1138A(2) - for guidance on the application of this section, see section 6.1 below

3.1. When does a contractor undertake R&D in the UK?

To decide whether or not a payment to a contractor attracts relief because the R&D is done in the UK, we need to look at the location of the contractor’s, that is, the company being paid to carry out the work, activities.

R&D is undertaken in the UK to the extent that the activities actually take place in the UK, regardless of the nationality of the workers or where consumables, data or software are sourced from.

This would therefore include expenditure by the contractor on the normal cost categories for the R&D relief, including on any of:

• employees of the contractor who are engaged in R&D activities and carrying out their duties in the UK (in England, Scotland, Northern Ireland or Wales)

• consumable items used by the contractor in R&D activities, which are used or consumed in the UK (note they may be sourced from elsewhere)

• software, data and cloud services used by the contractor for R&D activities undertaken by workers in the UK (although the software, data or cloud services may, again, be sourced elsewhere)

• payments to clinical trial volunteers located in the UK

It is important to remember that not all expenditure on R&D activities within the tax definition qualifies for relief – there are some costs that do not fall within the categories listed above, for example rent. It may be necessary to consider whether expenditure in such categories suggests that the R&D, or a part of it, it not being done in the UK. In general however it is likely that the location of the activities in the list above will give a good indication of where the R&D is taking place.

To the extent that the condition is partially met, with some activity taking place in the UK and some not, the contractor payment should be apportioned to the UK element of the activity on a just and reasonable basis. This will depend on the contractor’s circumstances, but it could, for example, be based on one of:

• the number of workers in the UK versus overseas
• the proportion of salary and other costs attributable to (that is used or consumed in) the UK versus overseas
• the number of days worked in the UK versus overseas

Example 1

Company A, the customer, is a producer of agricultural seeds. It wishes to improve its processes for grading seeds and approaches an unconnected contractor, Company B, to carry out the work, developing AI techniques for analysis of seed texture. Company B operates across several sites with locations in the UK, Spain and Germany. In negotiating the contract Company A states that it would prefer all the work to take place in the UK so that it can claim the full amount of relief, however Company B cannot guarantee this.

Company B agrees that 50% of its staff costs will be provided by workers located in the UK. None of the exception factors apply, so Company A cannot claim for overseas costs. When A claims R&D relief, it can claim for 50% (the UK portion) x 65% (provided by the normal rules for unconnected contractor payments) of its payment to Company B, or 32.5%. Note this assumes that those staff are equally engaged in the R&D. If staff at different sites spent different proportions of their time on it, it might be appropriate to base the calculation on hours worked on the R&D.

4. UK and overseas expenditure: externally provided workers

For accounting periods beginning on or after 1 April 2024, to be qualifying expenditure (see CTA09/S1129(3)(d) and CTA09/S1131(2)), expenditure on payments for provision of EPWs  must be attributable to ‘qualifying earnings’ (see CTA09/S1132A). This means that either:

• the staff controller or the company in respect of which they are an EPW must be required to account for PAYE and Class 1 NICs. This condition is discussed in section 4.1 below

• the earnings must be attributable to R&D to which CTA09/S1138A applies. This condition is discussed in detail at section 6 below, as it is the same condition which must be met for overseas contracted-out R&D to qualify for relief

4.1. Qualifying earnings

The worker’s earnings meet the condition at CTA09/S1132A(2) if either the company or the staff controller is required to operate PAYE and account for Class 1 NICs in respect of them, whether wholly or in part. The PAYE/NICs requirement therefore functions as a gateway. If it is met for a particular worker then all of the worker’s earnings (that are connected with the relevant activity) are qualifying, and the appropriate part (for example 65% in the unconnected case) of any payment by the customer attributable to those earnings is qualifying expenditure.

For this purpose HMRC accepts that the condition is met where either:

• an employer pays workers a salary that falls between the primary and secondary NICs threshold so the employee effectively pays primary Class 1 NICs at a nil rate and the employer pays no secondary Class 1 NICs

• workers come from overseas to work in the UK on a temporary basis and are exempt from UK tax or NICs under a double taxation agreement or social security agreement

A payment attributable to qualifying earnings is not simply the part of the payment from which the earnings are met. Typically an EPW payment will also cover other things such as the staff provider or staff controller’s overheads and possibly an element of profit, but it is all occasioned by the supply of the EPW, so is attributable to their earnings if those earnings are qualifying.

Note that this prevents a ‘double reduction’ of qualifying expenditure through the application of the 65% factor to an amount that already excluded some of the payment – a possible effect of the draft legislation published in July 2023.

Example 2

A UK company engages an unconnected staff provider to supply 10 specialist workers as EPWs to meet a particular need. There is no election under CTA09/S1130 for connected person treatment. Because their skills are in short supply, the staff provider is only able to provide 6 workers in the UK. They will work at the claimant’s UK site. The staff provider is able, via its international networks, to locate 4 additional workers who are based in Mexico. They do not wish to relocate temporarily to the UK and it is agreed that they will perform their functions remotely. The workers based in the UK are subject to UK PAYE NICs, those based in Mexico are not. The UK claimant makes a single staff provision payment to the staff provider to cover the provision of the 10 workers.

Assuming that the wage levels are the same, 6/10 or 60% of the staff provision payment is attributable to qualifying earnings and therefore 65% of that amount is qualifying expenditure, meaning 39% (= 65% x 60%) of the payment made.

Example 3

An automotive business owns a test track in Scandinavia via a subsidiary in that territory, specifically for harsh weather conditions testing. They have a harsh weather conditioning environmental test unit in the UK but this is not suitable for en-masse testing (it can only do one vehicle at a time) or longer term durability testing. They plan to send vehicles to the overseas test track.

The subsidiary will supply drivers as EPWs and recharge for fuel (consumables).

There is no restriction on the cost of consumables used overseas.

The EPW costs meet CTA09/S1138A (see section 6 below) because there is nowhere in the UK that has the required conditions for most of the year, or dependably in any year, and they can’t reasonably extend the one unit they have to meet demand for the testing.

5. UK and overseas expenditure: other qualifying cost categories

No similar restrictions regarding overseas expenditure apply to other categories of expenditure by the company beyond contractor payments and payments for externally provided workers. Therefore there is no territorial restriction on the company’s own staffing costs, consumables, software, data and cloud computing costs, or payments to clinical trial participants.

For example, if employees of a UK company need to attend a contractor’s overseas site to carry out elements of an R&D project such as assuring that the contractor’s work has been done according to specification, then those employees’ attributable staffing costs which meet the conditions in CTA09/S1123 would still be qualifying expenditure as it always has.

Example 4

A construction business sends a team of UK engineers overseas for 18 months to work on a specific construction project for a client, which includes developing new construction techniques on-site. The UK engineers continue to be paid via UK payroll and also work with locally based EPWs who need to be present on-site to support the R&D activity.

The overseas restrictions do not apply to staff costs so does not affect the payment for the UK engineers.

The EPWs need to be on-site, the site is abroad and there are regulatory conditions which require the activity to take place in the foreign country so that the R&D can be supervised by the local Ministry of Construction. So there are conditions in that country which can’t be replicated in the UK) meaning that the EPW costs will satisfy CTA09/S1138A (see section 6 below) although the business should be prepared to state why they need to be on site).

6. Externally provided workers and contractor payments: When overseas expenditure is claimable CTA09/S1138A

6.1. Background

Overseas expenditure on contracted out R&D, and on payments for EPWs who are not subject to UK PAYE/NICs, may still qualify for relief if certain circumstances are met. These are set out in CTA09/S1138A(2).

There are 3 circumstances. They must all apply for the expenditure to qualify:

• the first circumstance (see CTA09/S1138A(2)(a) is that conditions necessary for the R&D are not present in the UK
• the second (see CTA09/S1138A(2)(b) is that the conditions are present in the location where the R&D is undertaken
• the third (see CTA09/S1138A(2)(c)) is that it would be wholly unreasonable for the company to replicate the conditions in the UK

6.2. Necessary conditions

Whether or not a condition is necessary for the R&D is for the company to judge. Like other business activities companies will wish to control their costs and the presumption should be that they will not be undertaking activity that is unnecessary, but there may be alternative ways to achieve things. Project documentation may set out why whether an activity is necessary and what alternatives there might be.

Just because it is necessary to carry out one or more activities of the R&D project outside the UK does not mean that this circumstance applies to other activities of the project. Each must be judged on its own merits.

6.3. Not present in the United Kingdom/present in another location see CTA09/S1138A(2)(a) and (b)

It will not always be clear whether conditions are or are not present, and this may be a matter of degree with alternative ways of proceeding available. HMRC would expect that, in project planning, a company would consider alternatives and identify the best way forward and that this planning could be used to identify and justify choices made.

6.4. Wholly unreasonable CTA09/S1138A(2)(c)

Whether it is wholly unreasonable for the company to replicate the conditions in the UK will depend upon the R&D, the circumstances of the company and the reason for undertaking the work abroad.

In particular, time pressure may make it wholly unreasonable to do this. Time pressure may arise either from the demands of the R&D itself (for example, samples may have a limited life, a particular result may be needed before the next iteration of a test run) from commercial, legal or contractual factors (for example, requirement to deliver by a particular date) or from a mixture of both. There may be evidence to demonstrate this in project planning documentation, commercial documentation or less formally (for example, communications between staff or between companies as the project evolves). Time pressure will affect different companies in different ways, depending on their size, resources and capacity.

There will be instances where it is obvious that time pressure is relevant, such as where unanticipated events occur which disrupt or change plans. In other cases time pressure will be apparent at an earlier stage when it becomes clear even then that some necessary condition will not be present in the UK. Each company’s situation needs to be taken into account – what is wholly unreasonable for one may be reasonable for another.

In cases where the criteria of CTA09/S1138A apply to some aspects of a project but not to all, it would be reasonable to apply different treatment so that some of the costs qualify and some do not. That may include making an appropriate apportionment. See example 7 below for an illustration of this.

Example 5

A company wishes to carry on destructive testing of its product, using a commercial testing lab (to which the work would be contracted).

If suitable test facilities exist both in the UK and abroad, the following apply:

• if a UK test facility is available on the required timescale, the activity would not qualify if contracted outside the UK because the necessary conditions exist in the UK

• if there is time pressure and UK facilities are available but are fully booked on the required timescale, the condition at (2)(c) would apply because it would be wholly unreasonable to replicate the conditions in the UK so if the activity were undertaken outside the UK the contract payment could qualify

• if suitable test facilities do not exist in the UK, the question is whether the company (not somebody else) can reasonably replicate them in the UK

• if doing this meant the company would be required to own and run a testing facility which would see sufficiently little use as to make its creation uncommercial, it would be wholly unreasonable to replicate the conditions in the UK so if the activity were undertaken outside the UK the contract payment could qualify. If the company already operates similar facilities in the UK which could be easily adapted (assuming other factors do not prevent this, for example time pressures, or that doing so would prevent the facility being used for other necessary work) and provide the capacity required, it could be reasonable to expect it to do so. In this case, the condition at (2)(c) would not be met, and if the activity were undertaken outside the UK the contract payment would not qualify

• if there is time pressure, and the replication of a facility in the UK would take too long, it would be wholly unreasonable to replicate the conditions in the UK so if the activity were undertaken outside the UK the contract payment and overseas expenditure could qualify

Example 6

A disease with no prevalence in the UK requires a clinical trial to be undertaken outside the UK and the company decides to run the trial in Japan where the disease is prevalent. A contract research organisation (CRO) needs to be appointed with local knowledge and so a Japanese company is appointed.

Some of the activities it performs such as project management and data analysis do not need to be undertaken at the trial site. The Japanese CRO does not have operations in the UK and it would not be reasonable to expect the claimant to engage another party to do this because adding another would make the structure of the project more complicated, slower and prone to error. The entire cost paid to the CRO would therefore meet the conditions of CTA09/S1138A(2) and the qualifying element of the payment would attract relief.

In contrast, had the appointed CRO been a multi-national enterprise with personnel in the UK who could undertake the project management and data analysis, the expenditure attributable to those activities would be ineligible if the activities were not undertaken in the UK.

Example 7

A pharmaceutical business engages a contractor to collect samples of newly identified plant species not native to the UK to determine their value as medicines. This requires a condition (the presence of the plants) that is not present in the UK, and one which is present in the foreign country. It would be wholly unreasonable, indeed impossible, to replicate this condition in the UK. And it is a condition that exists in places outside the UK. So this activity could qualify if undertaken in a location where the necessary conditions arise.

The question arises as to whether plant samples, gathered in a tropical country, should be analysed locally or brought back to the UK for this work. The answer to this will depend on a number of factors. It may be that the samples are unstable and need to be analysed quickly and this makes it necessary to do the work locally. Or possibly, the volume of samples from different countries means that some sort of initial screening is necessary, with only the most promising candidates brought back to the UK for follow up.

Either of these could justify a claim for overseas expenditure. If due to differences such as stability of the samples, some need to be analysed quickly while others do not, then the cost of doing the former overseas could qualify, but not the latter. In these circumstances an apportionment might be appropriate.

Example 8

A company is conducting R&D to develop a prefabricated wall panel for an overseas market which has different regulatory standards/building practices to the UK.

Development requires the company to work in territories where the different standards and practices obtain so that the prototypes can be integrated with them and outcomes tested, and so that views of the local regulator as to compliance can be sought. These conditions are not present in the UK. It would be wholly unreasonable to replicate these conditions in the UK and these conditions exist in places outside of the UK.

Therefore, this activity would satisfy CTA09/S1138A(2) if undertaken in a location where the necessary conditions arise.

Example 9

A company is conducting R&D in the development of a software service for the commercial banking market in the US.

Development requires the company to have a collocated team in the US due to access regulations within the US banking sector. This requires conditions (the presence of US banking systems and regulatory requirements) which are not present in the UK, and which would be wholly unreasonable to replicate. This condition exists in the US.

Therefore, this activity would satisfy CTA09/S1138(2) if undertaken in the US, where the necessary conditions arise.

Whether or not conditions can be replicated in the UK is not necessarily an either/or question. It may be possible to replicate them in part, either numerically or qualitatively.

Example 10

Company A, the claimant, commissions Company B to undertake a clinical trial in the US. As this is contracted-out R&D for Company A, the overseas rules apply.

In this case there is no regulatory requirement for the work to be done in the US.

Company B is able to recruit 100% of the trial participants in the US in a reasonably efficient timeframe. Prior to submitting the claim, relevant public databases indicate that it would not have been unreasonable to recruit 20% of the participants in the UK on the same timescale. As it was reasonably possible to recruit 20% of the trial participants in the UK. Company A limits its qualifying expenditure to 80% of the relevant cost, the amount of the contract cost relating to activity that it was not reasonable to replicate in the UK (in contrast, had it been clear that the UK recruitment could not be managed on a reasonable timescale, the full cost could qualify).

Under a different contract, Company B undertakes a clinical trial recruiting 50% of the participants in Europe and 50% in India. Although relevant public databases show that 10% of the trial participants could have been sourced from the UK, this would have significantly disrupted the business plan resulting in delays and increased execution risk. In this instance the entire cost of the trial can be included as this factor means that is satisfies CTA09/S1138A.

We discuss below how some conditions are excluded from being used to justify overseas contracting or EPW use. One of these is the availability of workers to carry out the R&D. Please bear in mind that in this example that is not relevant, as clinical trials volunteers are not workers carrying out the R&D.

6.5. The conditions CTA09/S1138A(3)

The legislation does not include an exhaustive list of the conditions necessary for the R&D that may be considered in applying CTA09/S1138A(2). The term ‘conditions’ is fairly wide, and while CTA09/S1138A(3)(a) sets out some of them in 2 categories, (geographical, environmental and social conditions at CTA09/S1138A(3)(a)(i) and legal or regulatory requirements at CTA09/S1138A(3)(a)(ii)), these lists are not exhaustive. A valid condition may fall under either or both of CTA09/S1138A(3)(a)(i) or (ii) or, possibly, neither of them. However, it is convenient for the purposes of this guidance to consider examples of possible conditions under the 2 headings.

Geographical, environmental and social conditions (CTA09/S1183A(3)(a)(i))

These are features of the world (whether natural in origin, such as a disease, or the result of human activity, such as a test facility) and of human society. HMRC’s view is that this includes (but is not limited to):

• medical circumstances such as incidence of a disease or availability of participants to trial a drug or other medical treatment (participants here covers both participants with particular relevant characteristics and willing participants in general, in particular note that there is a particular class of eligible costs for both reliefs that covers clinical trial participants)
• animal or plant distribution
• physical or geophysical circumstances (deep oceans or high altitudes; volcanic or seismic conditions; minerals and geology; fortuitous features such as deep mines suitable for locating particle detectors)
• centres of human expertise such as university or other research groups (but see section 6.6 for the distinction between this and availability of workers)
• the presence of machinery or facilities to which a company may require access (and which it would be wholly unreasonable to replicate in the UK)
• Environmental sustainability (for example the carbon impact of shipping materials or equipment long distances or the choice to use green energy or be able to recycle waste)

Other geographical, environmental and social conditions may also exist.

Legal or regulatory requirements CTA09/S1138A(3)(a)(ii)

The legislation also states that legal or regulatory requirements may be relevant conditions.

HMRC’s view is that this includes (but is not limited to):

• explicit legislative requirements (such as that activities must take place in a particular country or according to recognised regulatory principles which do not obtain in the UK) whether set out in national legislation, international agreements or treaties or elsewhere
• the requirements and decisions, formal and informal, of regulatory bodies (so for example, if testing of a drug must be done according to a method agreed by a regulatory body and that body decides that activity must take place in a particular country, or imposes requirements that make that necessary, then this is a regulatory requirement, even if it is not stated somewhere in legislation)
• guidance from regulators, local and state government and professional or accreditation bodies (for example specific accreditation from an industry body for a newly developed product)
• agreement by the regulator to a process that the company has proposed to ensure the trial complies with good clinical practice standards and that any proposed manufacturing facilities comply with Good Manufacturing practice standards
• factors such as IP ownership (for example, the company may not hold UK rights to IP which it needs to have in order to conduct the R&D, but may hold rights for another region)

HMRC’s view is however that legal or regulatory requirements do not include the terms of any contract under which activity is being undertaken abroad.

It is possible that commercial factors could constitute a valid condition, depending on the reason for them. For example, in the defence and security sector, work may take place in a particular country due to requirements of a nation state customer. Ultimately this is a national requirement of a government, albeit one that may obtain through a contract rather than legislation, and in this particular case it can therefore be a valid factor, since it is analogous to a regulatory requirement. This does not mean that in general, adding such a requirement to a contract will satisfy CTA09/S1138A.

Example 11

Motorcycle and Motor Car Grand Prix regulators restrict their testing sessions to specific tracks, normally overseas. If a manufacturer uses such a facility for expenditure attributable to R&D that is affected by the overseas restriction (such as EPW costs) then CTA09/S1138A(2) therefore applies (a condition is necessary that it not present in the UK but is present abroad and which it would be wholly unreasonable to replicate). This is a condition covered by CTA09/S1138(3) – a regulatory condition, albeit one imposed by the sport’s governing body, not by a government – so the conditions of CTA09/S1138A(2) would be met.

Example 12

A SME life sciences business undertakes a range of clinical trials which include overseas EPW/contracted activities. Some clinical trials relate to treatments for diseases more commonly present in the UK. The company uses a global CRO to identify clinical trial participants, and UK and overseas clinical trial sites are used.

There are no regulatory requirements to carry out the studies overseas. However, the company is keen to utilise an ethnically diverse population sample (which is becoming increasingly important to regulators) – to achieve this diversity it requires them to undertake the trials in multiple overseas locations.

This could satisfy CTA09/S1138A(2), allowing the expenditure to qualify.

Example 13

A SME life sciences business undertakes a range of clinical trials which include overseas EPW subcontract activities. Some clinical trials relate to treatments for diseases more commonly present in the UK. The company uses a global CRO to identify clinical trial participants, and UK and overseas clinical trial sites are used.

There are no regulatory requirements to carry out the studies overseas. However, the company is keen to utilise an ethnically diverse population sample (which is becoming increasingly important to regulators) – to achieve this diversity it requires them to undertake the trials in multiple overseas locations.

This could satisfy CTA09/S1138A(2), allowing the expenditure to qualify.

Example 14

A drug company is required to run a trial in Germany to provide evidence in that territory such that the authorities will agree an appropriate price reimbursement for a drug after it is approved for use by the regulatory authorities.

In the absence of that evidence, it is unlikely that it would be economically viable to supply the product in Germany. The payment for the cost of the trial would therefore meet CTA09/S1138A(2).

In this instance the relevant conditions are both economic and regulatory. However, had the primary reason been a lower cost of carrying out the trial, this would not satisfy CTA09/S1138A(2).

The company might evidence this, if necessary, using a vendor selection form with a detailed description as to why a certain UK subcontractor or overseas subcontractor is chosen to conduct its R&D work. Alternatively, if there is specific correspondence from the regulatory body underlying the choice of supplier, this would also be useful evidence as might notes of meetings or calls.

Since, as stated above, the list of conditions that would justify overseas expenditure is not exhaustive, it is not possible to provide a list of evidence that would justify their use. HMRC would expect that in managing the R&D project, plans and proposals would consider and identify what activity is needed and where, and these would be the starting point.

6.6. Exclusionary conditions CTA09/S1138A(3)(b)(i) and (ii)

The legislation at CTA09/S1138A(3)(b) excludes 2 specific things from being conditions, as defined in (3)(a), that would meet the test in CTA09/S1138A(2). These are:

• cost of the R&D activity
• availability of workers to carry out the R&D activity

These are the only conditions that are excluded. Unlike CTA09/S1138A(3)(a), the list in (3)(b) is exhaustive.

It may therefore be necessary to consider whether the condition or conditions relied on are covered by (3)(b). As long as cost and availability of workers are not the only conditions relied on, however, the expenditure will still qualify, assuming it satisfies the circumstances in CTA09/S1138A(2).

Cost of R&D

Cost of the R&D will often be a factor in deciding where work is to take place. Where it is the only or main reason for activity taking place abroad, it will not justify the activity meeting the criteria, because of CTA09/S1138A(3)(b)(i). Where cost is a factor however it will often not be the only one. For example, if time pressures mean that R&D cannot wait until a new facility is developed in the UK, the fact that the staff to operate the facility once it is ready are in short supply, and therefore expensive to employ, does not mean that CTA09/S1138A(3)(b)(i) and (ii) prevent the conditions in 1138A(2) being met. The conditions are met because another factor – the facility to carry out the R&D – would not be available.

Cost of the R&D and availability of workers will often go together, given that worker costs are a significant factor. But for the avoidance of doubt the same reasoning applies to both. If either cost or staff availability on their own, or a combination of them, is the main condition that cannot be met for the R&D to take place in the UK, then overseas expenditure will not qualify. But where other factors are significant, the mere existence of cost and staff availability will not in itself disbar the overseas expenditure.

For clarity, the cost factor here is the cost of the R&D. HMRC regards this as meaning the cost of the R&D project Other costs are not excluded by (3)(b)(i). Whether a cost is or is not a cost of the R&D will depend on the facts. For example, rent for a the facility referred to above would be a cost of the R&D. It would not though be a cost that qualifies for R&D relief, not all costs of R&D qualify for R&D relief). So locating R&D in a country where rents are low could not be used as a justification.

Example 15

Raw materials required to undertake the R&D are only available overseas, and the alternative to carrying out the work abroad would be to incur significant cost and carbon footprint of shipping the materials to the UK just to do the R&D testing.

However, if transporting the materials to the UK is part of the cost of the R&D, this alone would not allow exemption from the overseas restriction. If concerns around the environmental impact of transporting materials, or the need for a steady supply of material, were overriding factors, they might be relevant.

Whether the condition in CTA09/S1138A(2) is satisfied therefore depends on the wider facts.

Availability of workers to carry out the R&D

The second excluded condition is the availability of workers to carry out the R&D.

Example 16

A company needs AI computer scientists for an R&D project. There are many AI computer scientists in the UK, however the company has advertised open positions for a prolonged period but not enough people have applied. The company however finds several AI scientists from a well-known university outside the UK and engages them on an EPW basis under the supervision, direction and control of the core UK development team.

As availability of workers is not a condition that can be taken into account for the purposes of CTA09/S1138A(2), the related EPW costs will not qualify unless other conditions exist.

Example 17

A software business designing software for use by financial services customers has teams of EPWs overseas to build software that links with the local stock exchanges. Workers with the required coding skills are easier to hire in many of the overseas locations, and the business also regards this as necessary due to the engineers needing detailed knowledge of the financial regulations in that territory in order to link with the stock exchange in a compliant manner.

However availability of workers is not a factor that can be considered, and both of these justifications are based on that factor (availability of people with coding skills and with knowledge of local regulations) so would not justify the overseas activity. The ‘availability of workers’ exclusion in CTA09/S1138A(3)(b)(ii) relates to personnel undertaking the R&D. It does not extend to other ‘people-related’ factors such as location close to key investors or to a centre of expertise such as a leading university research group – unless the investors or the staff at the research group are actually workers carrying out R&D. Such location benefits might include advice or guidance, or access to shared facilities. Such factors might justify activity taking place abroad, but each case will depend on its merits (for example, is there a comparable UK university research group that could provide the same quality of input?).

The policy objective is to draw more R&D activity to the UK. Consequently, the condition is widely drawn and covers the capabilities of those workers whether connected or through a third party. Consequently, skills, know-how and expertise linked to the individuals undertaking the activities are not conditions that would permit the expenditure to be eligible.

Example 18

A company is looking to undertake pre-clinical research on a new biologic drug candidate in a rare disease. Although there is some knowledge of this disease type in the UK the pre-eminent specialists are based in Switzerland and are able to conduct the pre-clinical research.

Notwithstanding the fact that the company is able to provide evidence that the team in Switzerland have a level of technical capability that is not available in the UK, availability of workers to carry out the R&D is not a condition that can satisfy CTA09/S1138A(2). If other factors applied, for example if the availability of the specialist researchers in Switzerland was linked to access to specialised equipment and facilities required for the R&D to happen, this could bring the Swiss activities into scope for the R&D claim.

As set out above, in determining whether or not it is wholly unreasonable to replicate conditions, existing abroad, in the United Kingdom, time pressure may be a consideration. Given the need for the R&D project to deliver results within a certain timeframe it may not be reasonable for the company to replicate the conditions. Given more time, the answer might be different.

Since the availability of workers to carry out the R&D is excluded as a condition that can affect this judgement, it follows that if timeliness is an issue solely because of staff availability, it cannot be grounds for meeting the conditions in CTA09/S1138A(2). If, however, there are wider timing issues, besides staff availability, the condition may still be met

Example 19

Developing example 3, the company owns a testing facility in the UK which is mothballed. It could be recommissioned quickly, but the company has no specialist staff to operate it, and training them would take too long. Apart from the availability of staff, then, it would be reasonable for the company to carry on the activity in the UK but availability of staff is not a factor that can be can be taken into account (CTA09/S1138A(3)(b)(ii)). Therefore the conditions are not met.

7. Contracting out R&D: new rules

The part of the draft guidance addresses issues around activity involving 2 or more parties, and how to determine which party, if any, can claim the relief provided under Chapters 1A and 2 of Part 13 of CTA 2009.

The simplest situation, often referred to, is one where a customer (generally referred to as Company A in this guidance) commissions some work and a contractor (Company B) undertakes it. The term used in this guidance for this is ‘contracting’ not ‘subcontracting’ which is reserved for cases where there are 3 or more parties. This contrasts with the pre April 2024 guidance which applies to the earlier legislation and uses the term ‘subcontracting’, in line with that legislation.

7.1. Basic principle

The objective of the R&D reliefs is to increase the overall levels of R&D in the UK economy to generate productivity growth by reducing the cost of R&D, counteracting a market failure which would otherwise reduce the amount of R&D taking place. This market failure arises because the value of R&D to the broader economy exceeds the immediate economic benefit of the R&D, and because of the risky and uncertain nature of R&D. To ensure that the relief is effective in this, it is important that the company making the decision to undertake R&D gets the relief for that expenditure. Allowing the decision maker to claim best incentivises decisions to undertake more R&D.

To meet this objective, where R&D is carried out under a contract, the new R&D expenditure credit, and the enhanced support for loss-making R&D intensive SMEs from April 2024, both give the right to claim for contracted-out R&D to the customer, subject to certain exceptions.

The concept of contracted-out R&D is therefore key and this is defined in CTA09/S1133.

R&D is defined as contracted out where it is reasonable to assume, having regard to the terms of the contract and any surrounding circumstances, that the customer intended or contemplated this sort of R&D would be done. Such a contract might cover an entire commercial project (including R&D and other activities), an entire R&D project or aspects of an R&D project such as testing components. The rules apply equally to all 3 cases. The legislation also generally excludes claims for expenditure by the contractor, but with important exceptions. See below for more detail on both points.

The legislation provides that the same rules apply for both upstream and downstream contracting out, that is whether the company considering its eligibility is Company A or Company B.

However, if a Company B is contracted to do work for a customer, Company B does related R&D and – having regard to all the relevant circumstances – it is not reasonable to assume that Company A intended or contemplated R&D of the sort carried out should be done, then (subject to meeting the other rules of the relief) Company B can claim. This is not R&D contracted to Company B under the new rules, because the decision to initiate R&D was taken by Company B, which is important for the reasons set out in the first paragraph in this section. Company B has been engaged to carry on specified work for Company A, not to carry out the related R&D, so this R&Dis initiated of Company B’s own volition.

While the exact details of who should claim the relief will depend on the specific contract and the circumstances around it, this potential for the contractor claiming is a departure from the previous rules in the R&D SME scheme.

Neither ‘intended’ nor ‘contemplated’ is defined in tax legislation. A dictionary definition of ‘intend’ is ‘to propose or plan’ and of ‘contemplate’, ‘to think about intently and at length’ – neither indicating a minor or fleeting consideration but a more substantial intention (definitions from Collins English Dictionary, first edition).

‘Intended or contemplated’ therefore goes beyond mere general awareness that R&D will take place, the customer must go beyond merely listing project challenges and constraints – they must specify the required R&D, understand the R&D and articulate the nature of the R&D.

Example 20

A company, B, is contracted to provide a product or service which is not R&D, such as constructing a building or developing a software product. From the contract, which simply refers to the product and does not give a detailed specification of the work required to provide it, and the nature of the negotiations to agree it, it is clear to all parties that the customer, A, had no understanding or intention that any R&D should take place. If B undertakes R&D in delivering that product or service, it would be able to claim relief even though it is undertaking R&D on an activity contracted out to it.

CTA09/S1133 defines when R&D is contracted out, and when it is not, for the purposes of CTA09/S1042D, CTA09/S1042E, CTA09/S1042F, which set out what expenditure a company can claim for in RDEC and CTA09/S1052, CTA09/S1053 and CTA09/S1053A, which set out what expenditure a company can claim for in ERIS.

In particular, there are cases where Company B can claim even where the conditions of CTA09/S1133 would not be met (for example where the customer is an ineligible company within CTA09/S1142, such as a charity, so would not be able to claim itself). These are covered at section 7.5 and on below. However, the interpretation of CTA09/S1133 is generally key to who can claim in a given situation and to ensuring that there is not double claiming.

Regardless of which party is able to claim, for a claim to succeed all the other rules will need to be satisfied (for example, expenditure must be revenue and it must satisfy one of the qualifying categories such as staff costs).

7.2. CTA09/S1133: Meaning of ‘contracted out’

Purpose

CTA09/S1133 ensures that the costs of contracting out R&D by a customer to a contractor can attract relief for the customer. Where the customer is not contracting out R&D, the contractor can claim relief, if it carries out relevant R&D.

CTA09/S1133(1)

This applies the section for the purposes of Part 13, that is, it applies equally for the reliefs provided by Chapter 1A (the merged expenditure credit) and Chapter 2 (ERIS).

CTA09/S1133(2)

Subsection (2) defines where a person (Company A) contracts out R&D, and therefore also when another person (Company B) has R&D contracted to it. There are 3 conditions, all of which must be met for R&D to be considered contracted out. Together these identify who was the decision-maker for the R&D, and who may claim relief. Unless all these conditions are satisfied then the customer cannot claim for any payments it makes to the contractor. If any is not met, the contractor may be able to claim, if it carries out R&D.

The contract CTA09/S1133(2)(a)

The first condition, at CTA09/S1133(2)(a) is that there must be a contract, which may be written, verbal or implied. It could be for R&D services alone, or could be a broader contract for other activities, so long as it was intended or contemplated when the contract was entered into that R&D of the sort undertaken would be carried out as part of these activities. In either case any claim for relief by the customer will only be for the expenditure attributable to the R&D.

Example 21

Company A, asks a UK third party, Company B, to do some routine testing activity for it, on the understanding that Company A will pay for this activity. The testing is part of Company A’s R&D project for which it will claim relief. Company B does not consider the work to be R&D claimable by Company B itself. There is no written contract for the testing activity, but when the testing is complete Company B invoices Company A.

While there was no written contract, in law the conditions for a verbal contract for services did exist between the 2 companies. Therefore, the requirement in CTA09/S1133(2)(a) is met.

However, if Company A had either donated, lent or otherwise given money to Company B without any expectation of services being provided by Company B in return, and Company B had subsequently carried out R&D activity, this might not meet the conditions for a contract for services. In such a case, Company A might not be able to claim R&D relief in respect of these transfers of money.

(2)(a) is not addressing whether or not R&D is specified – simply requiring that there is a contract. However, it follows that if there is no contract, then even in a situation where Company A is funding another company (B) which performs R&D, A cannot claim R&D relief in respect of its payments. In such a scenario, unlike the previous SME scheme but like the previous RDEC scheme, company B may be able to claim for any R&D it does despite the fact that A funds it, as there is no prohibition on claiming for funded or subsidised activity.

Meeting an obligation CTA09/S1133(2)(b)

The second condition, at (2)(b) is that to meet the obligations under the contract, R&D is undertaken. If for example company A and company B agree a contract for provision of software in the expectation that specified R&D will be needed but, in the event, the R&D is not carried out (for example because it was found not to be needed) then company A cannot claim for its payments. (If the R&D had been carried out, Company A might be able to claim, subject to (2)(a) and (2)(c) also being met).

Company A intended or contemplated R&D CTA09/S1133(2)(c)

The third condition, in subsection (2)(c), is that it is ‘reasonable to assume’ that the customer (that is, Company A) ‘intended or contemplated’ that R&D would be undertaken to meet the obligations of the contract, and that this is R&D of the sort that is referred to by subsection 2(b).

Neither ‘intended’ nor ‘contemplated’ is defined in tax legislation. A dictionary definition of ‘intend’ is ‘to propose or plan’ and of ‘contemplate’, ‘to think about intently and at length’ – neither indicating a minor or fleeting consideration but a more substantial intention (definitions from Collins English Dictionary, first edition).

This might be done in the contract itself, or in discussions leading to the contract, or in internal customer documents showing how the activity was required as part of the wider R&D. Because the activity might be a particular part of the customer’s wider R&D – or indeed commercial – project, the customer may not consider it necessary to share this with the contractor. A customer will be able to claim, under either of the reliefs, for activity which is in the contractor’s hands ‘routine’ but which is R&D as part of the customer’s project.

For example, a standard test. In such a case there is little chance of Company B considering that this is R&D it might claim for, and it should be clear if necessary from a review of Company A’s project documentation why it meets the condition. In cases where this is less obvious, the party claiming should ensure that it can if necessary justify the claim. It may be helpful to discuss with the other party if this would help to resolve any doubt, although HMRC recognises that this may not always be possible

Understanding and articulating the nature of the R&D means that Company A will need to have or draw on some capability (whether in-house or from elsewhere). HMRC’s view is that the level of capability needed for this requires a competent professional though Company A having this is not the condition that the legislation sets. Mere speculation or acceptance that R&D may be needed will not be sufficient to satisfy CTA09/S1133(2)(c).

Therefore if the customer, Company A, albeit knowing that work to be taken under the contract could require R&D, is indifferent to this fact, they do not intend or contemplate that it be carried out.

The legislation requires that this assessment is made ‘having regard to the terms of the contract and any surrounding circumstances’. The language of the contract is therefore important as a source of evidence in assessing what Company A intended or contemplated, but so are the surrounding circumstances. HMRC would expect that where R&D is intended or contemplated, a number of commercial factors will align with that and form part of the ‘surrounding circumstances’ referred to in the legislation. These circumstances might include (but are not necessarily limited to):

• ownership of patents – if Company B retains patent ownership, this supports its being the decision maker
• financial risk in undertaking the work. One would normally expect this to be borne by the decision maker
• autonomy in how the activity is executed. If Company B has less autonomy, it is less likely that it could be the decision maker
• means by which the R&D is ultimately to be exploited. Similarly to IP ownership, one would expect that the party ultimately exploiting the R&D will be the decision maker
• the decision-making process (for example whether the motivation to undertake the R&D flows from the customer’s wider strategy or an immediate tactical challenge recognised by the contractor)
• nature of the parties (for example if it is evident that Company B specialises in providing R&D services and the contract is typical of those R&D activities this would support it being a contractor)

These circumstances will not necessarily all be equally relevant or helpful in every case – for example, the question ‘who bears the risk’ can be complex in the case of bespoke, complex risk-sharing arrangements in some sectors, such that unpicking who bears the R&D risk will not give a simple unambiguous answer (and the answer may well vary for different aspects of R&D on a single project).

In some situations it might be reasonable for the companies to include a clause in the contract to confirm both parties’ understanding of the facts in terms of who is initiating the R&D and to provide a declaration within the contract regarding which party intends to make an R&D claim based on the agreed facts.

Whilst the companies cannot choose who is the claimant, such a clause could constitute a useful disclosure of the nature of the arrangement in place and the parties’ best understanding of the how the law should be applied. Such contractual declarations, made in good faith, will be considered by HMRC to be persuasive in terms of interpreting the rules where these declarations reflect the economic reality and are informed by a correct reading of the legislative test.

Example 22

A manufacturer (Company A) contracts a third party (Company B) to provide specialist tooling and knows that R&D by Company B is likely to be required to develop this. The contract however is just for the provision of the prototype tooling.

Although Company A understands that R&D is required and provides a detailed specification of product requirements, it does not possess the specialist expertise in this specific area of engineering.

Although Company A understands that R&D will be required by Company B to fulfil the contract, Company B undertakes the associated economic risk. Furthermore, Company A does not specify for Company B, or set out internally, the R&D required (it is unable to as it lacks the expertise in this area) Company B would therefore (assuming it meets all other conditions) be in a position to claim the R&D relief.

Company A would not have contracted out R&D and would not be able to claim relief for any payment made to Company B. Even if the requirement for the tooling arises as part of an R&D project of Company A it is still possible for the facts to support Company B, not Company A, making a claim. But this will depend on an analysis of those facts.

Example 23

Company A (in the chemical sector) has a product which requires an intermediate to be produced which is combined to form the final product. Company A has one source of supply for this intermediate but commercially this is a risk point, and so contracts Company B to produce the intermediate. The contract is for supply of X tonnes at a cost of £Y per tonne.

Company B has a completely different process train (equipment) from that which Company A developed its process for the intermediate, and which is different again from that of the current contract manufacturing organisation (CMO) supplier. Company A is aware of the difference in Company B’s process train, and understands at a high level that Company B will need to develop a process to deliver the intermediate in the quality, quantity and cost of goods required.

Company A may be aware of the requirement for R&D by Company B in order for it to fulfil the contract. Importantly however, Company A is unable to specify the R&D that would be required. Company B would be in a position to claim for the relevant expenditure.

High level wording in a contract that R&D was required would not be enough to satisfy CTA09/S1133(2)(c). This could be added by a customer which wanted to reserve to itself the right to claim (and thereby deny the contractor this right) should any R&D actually be needed.

In such a case, looking at the wider circumstances, it might be that Company A had not substantiated what R&D was to be done or why it was needed. It would not therefore be reasonable to assume that Company A intended or contemplated that R&D of the sort that took place would be undertaken.

The condition is that it must be reasonable to assume that R&D was ‘intended or contemplated’, not that ‘the contract says X’. Just as mere formal language in the contract does not mean Company A has contracted out R&D, so the lack of that language should not be determinative that it has not.

Even if a contract is not explicit that R&D is needed, it may be reasonable to assume that it was intended or contemplated having regard, for example, to factors such as those listed above.

Involvement by competent professionals may be relevant to this, for example, if Company A is to meet the condition that it was reasonable to assume that it intended or contemplated that R&D of the sort undertaken should be done, then it will need to draw on the expertise of competent professionals (meaning employed by it or brought in to advise on the issue) to inform the requirements of the contract. This may result in it specifying results that clearly required specific R&D. A less sophisticated customer might even rely on the Company B’s competent professionals during the contract discussion and specification phase. In such a scenario the Company A could still be making a decision to contract out R&D.

However, Company A just having competent professionals does not mean that it is entitled to the R&D claim. The converse is also true. What occurs in practice is key in determining the decision maker, including their role. Have they shaped the requirements of the contract, as described above? Is their role to specify the R&D, or is it to ensure that Company B’s methods and outputs fit the specification (and therefore might have little to do with understanding the process of the R&D)? Company A may sign off on the plans (and may engage competent professionals to check and approve proposals) but Company B may still initiate, lead and direct the R&D.

Example 24

Company A, an online retailer which requires a new HQ, commissions Company B, a construction firm, to supply a landmark new building. The building’s size, location, and required performance parameters (including carbon neutrality, safety features, lifespan) mean that company B will need to conduct R&D.

While company A appreciates this, it does not, in contract negotiations or the eventual contract itself, specify this work in anything but a general sense. It does not state what it requires to be done or how this should be done (and it neither uses internal expertise nor seeks external input, for example from consultants or partners, on this). What is important to Company A is the result, meaning that the building performs as required.

In approaching contract negotiations with potential suppliers, Company A takes expert advice on Company B’s capability to carry out the required work, looking at their track record and general proposals. But it does not take advice on the detail of the R&D, nor does it plan or scope the R&D and it would not be able, for example, to state what advances might need to be sought or how that is to be done. It does not have an R&D project. Company A is not in a position to intend or contemplate that R&D of a particular ‘sort’ (as referred to in CTA09/S1133(2)(c)) will be undertaken. In this instance Company A does not therefore meet the definition for contracting out R&D and any claim would rest with Company B. This would still be true if Company B were paid on a time and materials basis, and Company A had the right to supervise, direct or control how Company B executed the contractual obligations.

Example 25

Company A is a software developer which undertakes qualifying software development, and requires a bespoke building to house its development team. Company A included the input of its competent professionals into the contractual requirements of the landmark building being delivered by Company B to ensure the computer laboratory and server room met their requirements. However, this would still not necessarily be evidence that Company A was intending or contemplating R&D of the sort undertaken to execute the contractual obligations.

The competent professionals of Company A are not competent professionals with reference to construction technology, and so in this scenario we would not expect Company A to claim any contracted out R&D to Company B, the construction company. Conversely, as outlined in example 24, Company B could make a claim in respect to the R&D they undertake.

Example 26

Company A is a construction company engaged to provide a building. It does not have the required resource to design certain elements of this to meet certain net zero criteria, which is why it has engaged Company B as a contractor. Competent professionals do however input into the contractual requirements for the work contracted out to Company B, for example specifying the technological uncertainties that Company B should explore. This may be considered evidence that Company A was intending or contemplating R&D was required (on the basis that those individuals providing input to Company A are competent professionals in the specific area of R&D that will be undertaken by Company B). Equally if Company B is a construction firm that specialises in net zero technologies, developing its own IP in this area, then it may be the party which articulates the specific advances and uncertainties associated with any R&D activity contracted to Company B which would support Company B in claiming.

The drafting of subsection (2)(c) also ensures that it is the position at the time that the contract was entered into which is key – not assessing the work done with the clarity of hindsight. This principle extends to there being a series of contracts. At any particular moment, the position of the companies is governed by a contract or contracts and what matters for the application of CTA09/S1133 is those contracts. If contracts are renegotiated or varied the answer may change for work done after that point.

Work is often undertaken under an overarching Master Service Agreements (MSAs) and subsequent Statements of Works (SOWs), as opposed to a single contract. HMRC would have regard to not only the MSA or the original contract between the parties, but also to the relevant SOWs and any amendments or addendums to the original contact would also be considered where the original contract had been renegotiated or extended.

Example 27

Company A and Company B enter into a contract for development of a widget. Little consideration is given to the need for R&D, as neither party considers this necessary for the widget to meet the required tolerances. Company B, the contractor, later realises – based on advice from relevant competent professionals – that by doing some R&D, it can simplify the design and reduce the cost. The R&D was not included in the contract and is not reflected in the price and if it fails, Company B will carry the risk. Company B is therefore the decision maker in these circumstances and if it decides to proceed, it, not Company A, will potentially be able to claim relief.

Commercially it is possible that in these circumstances, before proceeding, Company B would seek to renegotiate the contract, with the R&D specified, producing a contract which then does contract out R&D to it. In this scenario Company A would also need to act with the benefit of advice from competent professionals such that it would then understand what it was now commissioning from Company B, and presumably the price would reflect the new terms. As a result Company A, not Company B, might now claim relief – Company A has now entered into a contract with B that requires B to do specific R&D for Company A, Company A did not have to do this – it could have let things proceed under the previous contract with Company B doing the R&D or not as it wishes. Therefore it has decided that the R&D should be done (and presumably funded it).

The legislation operates to prevent the same R&D expenditure being claimed for by both Company A and Company B.

In many cases (both contracting out of routine activities that form part of the customer’s R&D project, and contracts whose goal is to have a significant and defined piece of R&D done) it should be clear that the customer alone canclaim, meeting this objective. In other cases, discussion between the parties may be helpful. Whether or not that takes place, it is incumbent on all claimants to assess all available information and to be able to justify their reasoning based on this.

Where HMRC identifies that both Company A and Company B may have claimed in relation to the same activities , it will address this via compliance activity. Typically this will take the form of fact finding into both claims, with a view to examining the full fact pattern to determine which of Company A or Company B satisfies CTA09/S1133(2)(c).

HMRC accepts that, for contractual and other reasons, it may not have been possible for the parties to share information (including information about their tax position) and will not reject or question claims simply because this has not been done.

It is important to recognise that there can and will be cases where both parties are claiming for different expenditure relating to the same commercial project, because R&D has arisen for the contractor of a sort that the customer did not intend or contemplate.

Example 28

Company A is a UK automotive original equipment manufacturer (OEM) developing a new vehicle, where the activities meet the definition of R&D. It contracts a variety of testing requirements to Company B, an unconnected UK Test House. Company A intends to claim the expenditure paid to Company B for the contracted testing activities. Although in their own right these are expected to be routine in nature, these testing activities would be eligible for Company A to claim, as they are necessary as part of their R&D project, to confirm if any technological uncertainties remain.

Company B begins to execute the routine testing activities for Company A, which do not constitute R&D for Company B. In undertaking these routine tests, Company B identifies that the advances in vehicle technology evidenced by Company A indicate they will need to redevelop some of their testing methodologies to measure certain parameters to higher levels of accuracy than currently possible.

Company B decides to instigate a new R&D project to advance their own testing methodologies, and uses some of the testing cycles required to perform the testing activities for Company A to validate and test these new methodologies. It is anticipated that these new testing methodologies will have broader application and use outside the services provided to Company A.

In this scenario Company A would be able to claim on the contracted out testing, and Company B would be able to claim on the activities undertaken to develop a new testing technique.

Where Company B uses testing cycles contracted out by Company A to validate some of its own R&D activities, CTA2009/S1042D prevents the same expenditure being treated as in-house R&D for Company B because it doesn’t meet Condition C, which requires the R&D to be not contracted out to the company.

In this scenario, it is possible that both Companies may disclose R&D related to the same testing criteria application.

Example 29

In a slightly different scenario, Company A is again a UK automotive OEM developing a new vehicle, where the activities meet the definition of R&D. It subcontracts a variety of testing requirements to Company B, an unconnected UK Test House. As part of the contracting process, Company A identifies that the advances in vehicle technology will require the development of new testing methodologies to measure certain parameters to higher levels of accuracy than currently possible.

Company A prescribes that Company B will develop these testing methodologies and use the testing cycles required to perform the testing activities for Company A to validate and test these new methodologies. This is detailed in the contract and the terms of said contract reflect this.

Company A is in a position that it intends Company B to undertake R&D activities on its behalf and Company B is being compensated for this. As such, Company A is in a position to claim the costs (assuming all other conditions are met) as contracted out R&D on the development of the new testing methodology and execution of the testing itself.

7.3. CTA09/S1133(3) to (6): Subcontracting chains

For simplicity the discussion above has assumed that there are only 2 parties (Company A and Company B) involved. In reality there may be more, and the legislation allows for this.

CTA09/S1133(4) and CTA09/S1133(5) set out that research and development remains contracted out (and claimable by the ultimate customer, not the contractor or any sub-contractors at one or more removes who undertake contractual responsibility for the actions) if it meets the conditions of subsection CTA09/S1133(2), even if the immediate contractor subcontracts it on (and so on down the chain).

A person to whom activity is contracted on is referred to in CTA09/S1133(4)(b) specifically as a sub-contractor (which is why the legislation and guidance use the term ‘contractor’ in general).

Likewise, where any parties in the chain instigate their own R&D, they can claim for the R&D instigated by them.

Example 30

Company A commissions a construction firm, Company B, to supply a new landmark building. Under the terms of the contract with Company A, Company B is responsible for the design and build of the structure, ensuring that the programme and performance requirements have been met. Company B engages an engineering consultancy, Company C, to assist with the design and build of the new building.

Company B engages Company C to design the façade of the structure. During the design stage, Company C encounters significant technical problems with designing the façade. An R&D project is undertaken to develop an alternative design solution for the façade. Company B collaborates with Company C to fully resolve the uncertainties associated with developing the new façade design.

Company A does not have the knowledge or capability to understand how the façade will be constructed, in anything but a general sense. Its contract with Company B did not address the need for the R&D required for the façade, which was not understood or known about at that stage. Company B’s competent professionals collaborate with Company C, reviewing design iterations and assessing the technological feasibility of the R&D design proposals. Even though Company C is the party that has identified that R&D may be required, it is reasonable to assume that Company B contemplated R&D of this sort may have been required, given its close involvement in undertaking the R&D. In this instance, Company B is entitled to claim:

• Company A has not contracted out R&D to Company B as it did not meet the condition of CTA09/S1133(2)(c), Company B is entitled to claim
• Company B has contracted out R&D to Company C as the conditions at CTA09/S1133(2) are met. Company C is not entitled to claim because Company B has contracted R&D to it
• if the technological feasibility of the work was not discussed in detail between Company B and Company C at the time the contract was entered into, Company C could claim, as it would not be reasonable to conclude that Company B intended or contemplated that the R&D would be done by Company C

7.4. CTA09/S1133(7) and CTA09/S1133(8)

Subsection CTA09/S1133(7) provides that a payment that is only partly for contracted out R&D should be apportioned on a just and reasonable basis for the purposes of CTA09/S1133(6). This reflects that a claim may be for the whole or part of a project, and that the conditions of CTA09/S1133(2) may be met for part of a payment but not for all.

What is just and reasonable will depend on the detailed circumstances of the claim, and there may be more than one method of achieving this for any given circumstances. Consistency of the approach with any other apportionments made elsewhere in the claim and with other years’ claims may support the approach, and inconsistency support the need to provide further explanation or justification. Likewise the nature of any evidence needed to show that the apportionment is just and reasonable will depend on that approach. It is therefore not possible to give prescriptive guidance on what method ought to be adopted.

Subsection (8) applies the same rules as previously applied to determine the qualifying element of a contractor payment.

7.5. CTA09/S1042F and CTA09/S1053A: Exception – where the customer cannot claim

As section 7.1 above notes, there are cases where a contractor can claim even where the conditions of CTA09/S1133 would not be met. This is distinct from the contractor doing some R&D of its own (and therefore, effectively, not acting as a contractor in respect of that R&D).

This applies to some specific circumstances where the customer, Company A, cannot claim, even if it would otherwise satisfy CTA09/S1133(2). In these specified circumstances the contractor, company B, may still be able to claim even if R&D has been contracted to it. This is intended, so far as possible, to ensure that relief is given for the activity.

Qualifying expenditure in these circumstances is defined at sections CTA09/S1042F (for the new merged reliefs) and CTA09/S1053A (for the enhanced relief for R&D intensive loss-making SMEs).

Three conditions must be met for expenditure to qualify.

First (see CTA09/S1042F(2) and CTA09/1053A(2)) R&D must be contracted to company B, following the rules in section 1133. That is, the situation must be the sort in which, according to section CTA09/S1133, Company B would not normally be able to claim. If the R&D is not contracted to Company B, but initiated by it according to section CTA09/S1133, then Company B would be able to claim anyway under either CTA09/S1042D and CTA09/S1042E or CTA09/S1052 and CTA09/S1053 as appropriate.

Secondly, Company A, the customer, must be either:

• an ineligible company
• not contracting out the R&D in the course of a trade, profession or vocation within the charge to tax

Company A might, for example, be an overseas company not within the charge to CT, or a UK Government Department otherwise than via a trading subsidiary vehicle within the charge to CT. (The requirement is that every person contracting out the R&D to Company B satisfy one of these conditions – see section 7.3 and onwards for chains of subcontractors).

Finally, the expenditure claimed for must be expenditure that would qualify under CTA09/S1042D / CTA09/S1042E (or CTA09/S1052 or CTA09/S1053) but for being contracted to the company. This requires that the expenditure is attributable to relevant (to the company) R&D being undertaken by it. In other words the R&D must be R&D of Company B. This will not always be the case. (The exception to this requirement is where Company A and Company B are members of a group who have jointly elected that Company A will be treated as an ineligible company, in which case it would be sufficient for the activity to be relevant R&D of Company A).

7.6. CTA09/S1142: Ineligible companies

An ineligible company is defined in section CTA09/S1142. It includes charities, institutions of higher education, scientific research associations, health service bodies and any other body prescribed by the Treasury as ineligible.

Example 31

A UK CRO carries out clinical trials for both UK and overseas pharma companies. Trials carried out for overseas companies not within the charge to CT satisfy the conditions of CTA09/S1042F or CTA09/S1053A, if the trials constitute R&D (which they might not do for the CRO if, for it, they are ‘routine’ activities falling short of being R&D in their own right). The UK CRO can therefore claim relief for its expenditure. Where the work is contracted to the CRO by a UK pharma company, which can claim will depend on the application of CTA09/S1133 – see above.

Two companies, Company A and Company B, which are members of the same group may jointly elect under CTA09/S1142(5) that, in respect of particular R&D contracted by A to B, Company A is to be considered ineligible, so that Company B may be able to claim rather than Company A.

This is a relaxation intended to enable 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 rather than their several customers claiming.

An overseas member of the group is unlikely to be be contracting out the R&D in the course of a trade, profession or vocation within the charge to tax so this election would not be necessary for that company.

The election will not affect Company A’s ability to claim for any other R&D (meaning R&D undertaken on its own behalf, or contracted to another person other than the named group member). The election remains in force until revoked by either company, or the companies are no longer in the same group.

To facilitate this relaxation, where an election is in force, in determining whether activity is research and development for the purposes of the reliefs, anything done by one of those companies under the contract is treated as if done by the other to the extent that this makes a difference to what is R&D in the hands of the party in question.

CTA09/S1140A provides that the definition of group for this purpose is the same as that in Part 5 CTA2010.

An election for this purpose needs to be made in writing Customers with a Customer Compliance Manager (CCM) should provide them with a copy and include the election with the first claim to which it applies. Customers without a CCM should include the election with the first claim to which it applies.

Example 32

In a large group, Company A commissions a number of R&D projects carried on by Companies B, C and D, which have all previously claimed RDEC, in some cases making use of the previous deeming provision under old CTA09/104W which allowed Company A’s R&D to be R&D of Companies B, C or D (‘dispersed R&D’).

Following introduction of the new rules in s1133, Companies A, B, C and D jointly write to the group’s CCM, electing that A should be treated as an ineligible company in respect of any R&D Companies B, C or D do for it. The election is made before Companies B, C or D make their first claims under the new rules. When each company makes the next return to which the election applies, it includes a pdf copy with the return.

7.7. Claims by contractors: CTA09/S1042F and CTA09/S1053

As set out above in section 7.5 of this guidance, in some circumstances a contractor may be able to claim for R&D it carries out even where it has been contracted to do that work. CTA09/s1042F and CTA09/s1053A both require that, for the contractor to be able to claim, all the parties contracting out the work to that company must satisfy the conditions of those sections.

Example 33

Company B is contracted to carry out a piece of R&D work directly by a UK Government Department, Department A. If the work had been contracted by another UK company, Company B would not be able to claim. However, Company B can claim R&D relief, as Department A is not carrying on a chargeable trade.

If Company B were contracted to by an intermediate contractor between it and Department A, it might not be able to claim as the intermediate contractor might not satisfy the conditions of CTA09/S1042F or CTA09/S1053A (that the R&D is contracted out in the course of a trade not chargeable to corporation tax).

However, if Company B were working for Department A on a ‘pass through’ contract via a prime contractor, P, meaning a contract where Company B is the sole party carrying out R&D, where the R&D programme was agreed between Company B and Department A, and P is just providing a procurement service or route on behalf of Department A, Company B may still be able to claim R&D relief.

CTA09/S1133(4) states that:

(4) Research and development contracted out by a person is contracted out ‘to’:

• the party to the contract who undertakes the obligations referred to in subsection (2)(b)
• any sub-contractor who undertakes contractual responsibility for the activities needed to meet those obligations

Depending on the terms of the contract or contracts, it may be possible that P meets neither condition, so the R&D is not contracted out ‘to’ P but to Company B. So P is not contracting anything (in the sense of the legislation) to Company B, so CTA09/1042F(3) is met and Company B can claim.

The following example shows, in contrast, how the condition that CTA09/1042F(3) must be met by everyone by whom R&D is contracted out to the company prevents double claiming.

Example 34

UK Automotive Company A contracts R&D to an unconnected US Company B to develop a new gearbox. The development of the gearbox is R&D in its own right but would also form part of the Company A’s R&D. The US Company B then subcontracts the work on to its UK subsidiary, a connected party, Company C.

Company A can claim. It contracted R&D to another person, and the activity is occurring in the UK so CTA09/1138A is not relevant.

The US Company B can’t claim (because it is not carrying on a trade chargeable to UK CT).

The UK company doing the work, Company C, cannot claim because Company A is able to claim.

While Company C has been subcontracted the work by a company not within the charge to tax (the US parent) and therefore apparently meet the condition in CTA09/S1042F(4)(b), CTA09/S1133(4)(b) applies to the activities subcontracted to company C by the ultimate customer (Company A) but neither CTA09/S1042F(4)(a) nor (4)(b) applies to Company A itself so CTA09/S1042F(3) prevents the UK subsidiary (Company C) from claiming.