SSRO determination on the treatment of Research and Development Expenditure Credit when determining allowable costs under a qualifying defence contract
In October 2021, the SSRO was asked by the Secretary of State for Defence to make a determination under section 20(5) of the Defence Reform Act 2014. The referral concerned the extent to which research and development (R&D) costs applied indirectly through cost recovery rates to the referred contract were allowable.
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In accordance with our procedures for referrals, the SSRO has published an anonymised account of its determination on the treatment of Research and Development Expenditure Credit (RDEC, a form of tax relief) when determining the extent to which research and development (R&D) costs are allowable costs under the referred qualifying defence contract. The determination was made having regard to the specific costs and contract under consideration.
The referred contract concerns the support and maintenance of equipment. The estimated allowable costs of the contract include bid costs and labour costs. These costs are calculated by applying hourly labour rates to an amount of hours for which staff are expected to be engaged in performing the requirements of the contract. The contract was agreed with a provisional price as the labour rates that would be used to price the contract remained subject to agreement. The treatment of RDEC in determining the amount of R&D costs to include in the rates was one of the matters requiring agreement.
For a particular year, the total amount of costs included in the calculation of actual labour rates included R&D expenditure in respect of which RDEC was received by the contractor through the UK corporation tax system. The majority of the qualifying R&D expenditure in that year was labour costs incurred in the performance of R&D under other contracts. The remainder was the result of non-contract (self-directed) R&D.
The UK Government has for many years been committed to promoting R&D as a driver of economic growth. It seeks to ensure that the UK provides an internationally competitive environment for companies to innovate. To this end, it provides corporation tax reliefs (including RDEC) for companies that work on innovative projects in science and technology. Chapter 6A of the Corporation Tax Act 2009 (CTA 2009) establishes a legislative scheme for RDEC.
The SSRO was asked to determine whether the amount of the R&D costs that the contractor had included in calculating its actual cost recovery rates for the particular year should be offset by an amount of RDEC received by the contractor in respect of those costs.
In making its determination, the SSRO considered the evidence available and the SSRO’s statutory guidance on the requirements of allowable costs. The SSRO’s determination is that there is no need for RDEC received by the contractor in respect of its R&D costs for the particular year to be taken into account when determining the amount of those R&D costs that are allowable costs applied indirectly to the referred contract through cost recovery rates. The SSRO is satisfied that its guidance on allowable costs does not require RDEC to be offset from the referred R&D costs in order to ensure that:
- good value for money is obtained in government expenditure on qualifying defence contracts, and
- persons (other than the Secretary of State) who are parties to qualifying defence contracts are paid a fair and reasonable price under those contracts.
The SSRO found no compelling evidence to suggest that applying the referred R&D costs to the contract at their full amount would result in an outcome that was not comparable to what occurs in contracts under competition. The determination reflects our understanding of the Government’s intention under the RDEC scheme to make R&D activity more profitable for companies, through the payment of RDEC, to encourage greater levels of R&D activity and bring consequential benefits to the UK economy and society.
Further information on the SSRO’s consideration of matters referred to it can be found on our website.