The update is welcome, as many companies have been put off submitting claims when the risk of an enquiry is so high. It does go some way to clarify of HMRC’s new position, but there are a few questions they have yet to answer.

Updates to subcontracting rules

On 27 February 2025, HMRC made changes to the guidance at CIRD 84250 (meaning of subcontracted R&D) and CIRD 81650 (subsidies), both of which are relevant to claims for R&D tax relief through the SME Scheme.

Let’s look at each of the updates and see how they might affect your clients. To keep things clear, we’ll refer to the two parties of any contract as “the customer” and “the subcontractor” throughout this article. While HMRC refer to “contractor” in their guidance, we find this is a little too similar to “customer” so stick to ‘subcontractor’ for clarity.

Contract terms for subcontracted R&D

Firstly, from the perspective of the subcontractor, the most significant change is the absence of the statement: “Any activities carried out in order to fulfil the terms of a contract are considered to have been contracted to the company.”

HMRC had been using this statement to argue that whenever an R&D project was related to delivering any kind of contract, the subcontractor who undertook the project couldn’t claim, because the R&D was ‘contracted out’ to them by the customer. The 2024 tribunal decisions firmly rejected this interpretation, so it has been removed.

The new guidance now states “The terms of the contract between company and customer are not the only factor to be considered”. It goes on to explain that even if the contract says ‘Any R&D conducted to carry out the contract belongs to the customer’ that doesn’t necessarily mean that the customer contracted out the R&D – other factors may indicate otherwise.

This is a significant difference in interpretation from the previous guidance. It supports the argument upheld by many companies and R&D advisors that just because a subcontractor is developing a product or providing a service to a customer, that doesn’t mean the related R&D activities have been subcontracted to it.

HMRC goes on to clarify those factors that should be considered and provides some useful examples.

Incidental R&D and “awareness that R&D is required”

Instead of looking at the contract terms, the most important factor to consider now is whether the R&D claimed for is incidental to the supply or a product or service, or if it is required for the supply of that product or service.

The claim for incidental R&D is likely to sit with the subcontractor and not the customer, because the subcontractor could have delivered the contract without undertaking R&D.

Also, HMRC now says that “awareness that R&D is required” is an important factor in deciding which party can make a claim. In other words, if the customer was aware that R&D was required, the claim belongs to the customer.

This is an important point, and is a more generous approach for the customer, compared with the new Merged and ERIS schemes. In these new schemes, the claim sits with the party that “intended or contemplated” R&D. This is actually a fairly high bar – in the new schemes, merely being vaguely aware that R&D is required isn’t enough to allow the customer to make a claim.

Given the differences in treatment, subcontractors may feel penalised when trying to claim through the SME scheme. Under the revised guidance for the SME Scheme, if the customer is aware that R&D is required, the claim technically sits with the customer – not the subcontractor.

Autonomy and direction

Other factors that HMRC consider include the degree of autonomy the subcontractor has over the R&D, and the level of intervention, guidance and direction from the customer.

An interesting point is that if the specification defined by the customer also defines the technological advance, it’s likely that this would count as evidence that R&D activities have been contracted out, meaning the customer would be entitled to claim.

Financial risk and intellectual property

Two further factors to consider are financial risk and the intellectual property. Whichever company holds the highest level of risk and has the most ‘protectable’ IP is likely to be the owner of the R&D.

So, if the R&D is unsuccessful, does the subcontractor still get paid for these activities? If so, it is likely that the R&D has been contracted out and the claim belongs to the customer.

The question of intellectual property is less definitive. HMRC comments that the “know-how” of how precisely a particular advance has been achieved is less convincing evidence than the ability to exploit this “know-how” for commercial gain, which is usually achieved through a patent.

Explaining the advance and activities

One final point raised by the new guidance relates to a specific expectation for the customer. When a customer claims it has contracted out some or all of its R&D, it should be able to explain the advance sought by the project, and how the contracted activities relate to that R&D project.

Things get a little more complex when the activities in question are routine but essential for the R&D, like routine testing, and the guidance is a little unclear.

HMRC acknowledges that in some cases, routine testing costs contracted out by a customer could indeed meet the definition of contracted out R&D activities, because it was controlling and directing the work undertaken by the subcontractor.

However, there are times when the subcontractor carries out routine activities as part of the R&D, without the direction or involvement of the customer.

Some additional clarity from HMRC on routine activities associated with R&D would be welcome here.

New rules for Subsidised R&D expenditure

The most significant update regarding subsidised R&D expenditure is the removal of this statement: “Payment received for undertaking a contract will be considered to meet expenditure in undertaking that contract.” In cases where the customer has not contracted out the R&D activities, this now allows the subcontractor to separate any R&D activity to fulfil a contract from the payment it receives to deliver it.

HMRC has also provided clarity on what it considers a subsidy, highlighting that this is not limited to payments received by way of a grant or a public funded body. The new guidance clarifies that subsidies can extend to monies received by a company where nothing, or something not representing a commercial return, is returned to the funder, including connected or third parties.

It also states that to be considered a subsidy there must be a clear link between the provision of those funds and expenditure incurred on an R&D project, although this position had been communicated previously.

Thoughts on the updated guidance on Subcontracted and Subsidised R&D

Overall, HMRC’s updates to its guidance concerning subcontracted and subsided R&D are welcome.

The subcontracted issue still favours the customer, requiring only an awareness that R&D was required in order to make a claim. But the amendments to the subsidy guidance do allow subcontractors to claim relief where R&D is not specified or required to fulfil a contract.

Ultimately, HMRC’s aim is to prevent relief being paid twice for the same activities. Whilst we can still envisage scenarios where neither the customer or subcontractor can claim owing to evidence in place, or the lack thereof, it is a welcome step towards clarity on matters that have caused significant uncertainty for both taxpayers and tax advisors over the last several years.

The background to these changes

R&D advisors and claimants have been unsatisfied with HMRC’s guidance ever since they changed it in 2021 following a First-Tier Tribunal (FTT) decision against them in the Quinn (London) case.

HMRC finally responded with an update after two further FTT decisions went against them in 2024. These two cases, Collins Construction Ltd and Stage One Creative Services Ltd, had significant implications for businesses claiming R&D tax relief for activities related to a contract.

HMRC’s decision not to appeal these cases signalled a shift in their approach.

Changes to the guidance in 2021

HMRC’s decision to change their guidance in 2021 seemed designed to rule out ‘double dipping’, in which both the customer and subcontractor claim relief for the same activities. Unfortunately, the approach they took encompassed an incredibly broad definition of ‘contracted out’ R&D.

HMRC amended their guidance (CIRD84250), to add the sentence: “Any activities carried out in order to fulfil the terms of a contract are considered to have been contracted to the company”. At the same time, it removed the statement, “it may be useful to examine the degree of autonomy enjoyed by the person engaged, the ownership of intellectual property, and the economic risk in any arrangements.” Claimants and advisors had relied on this latter sentence for many years to determine who was eligible to claim tax relief on a given project.

This change in wording essentially declared that all R&D undertaken to fulfil a contract with a customer was “contracted out.” This meant it was almost impossible for the subcontractor to claim relief on any R&D associated with a customer contract – even in cases where the customer clearly had no idea that R&D was required.

The tribunal in Collins and Stage One have rejected this broad interpretation, suggesting that the legislation should be interpreted based on its intention instead. The Quinn case also demonstrated this approach, noting that a narrow interpretation of the legislation would mean that “the circumstances in which an SME could claim enhanced R&D relief would seem to be confined to those where it has no prospect of exploiting the R&D for commercial gain”.

Key issues raised in 2024 tribunal decisions against HMRC

The Collins and Stage One cases both centred around HMRC’s denial of R&D tax relief, with HMRC arguing that the companies’ R&D expenditure was either “subsidised” or “contracted out.” The tribunal rejected these arguments in both cases, highlighting several key points:

• Rejection of HMRC’s Broad Interpretation of “Contracted Out”: The tribunal rejected HMRC’s view that any activity carried out to fulfil a contract is “contracted out”. Instead, the tribunal emphasised that for activities to be considered “contracted out”, the contract must specifically require or commission R&D activities.
• Contracts for “Works,” Not R&D: The tribunal determined that the contracts in question were for the provision of “works” in return for payment, not for specific R&D activities.
• Not All R&D is “Freestanding”: The Tribunal rejected HMRC’s assertion that only “freestanding” R&D qualifies for SME relief. HMRC defined this as independent research conducted by a company for its own innovation, rather than to fulfil a specific client contract.
• Emphasis on the prevention of double relief: The tribunal in both cases highlighted that the purpose of the “contracted out” rules is to prevent double relief for the same R&D, and that it is intended to allow the company that has commissioned and paid for the R&D activity to claim for the costs.
• Adherence to Quinn: The Collins decision followed a similar approach to that taken in Quinn (London) Ltd v HMRC. This case was not an R&D tax relief case, but it did affirm that payments made for goods and services under an arm’s-length contract were payment for an agreed result, rather than a subsidy of R&D expenditure.

HMRC’s response

Following their defeat at in these two cases, and upon reviewing the tribunals’ rejection of their interpretation of the legislation, HMRC announced in December 2024 that they would review the guidance relating to subcontracted and subsidised R&D, and provide an update in February 2025.

Subcontracted R&D in the Merged and ERIS schemes

In the 3 years between the guidance changes in 2021 and the tribunal decisions in 2024, the Government introduced new rules for R&D claims through the Merged and ERIS schemes. In the legislation and guidance for these schemes, the rules for subcontracted R&D were significantly changed.

When you look at the changes to the subcontracted R&D rules, you can see a much clearer interpretation compared to the SME scheme.

The guidance for new Merged RDEC and ERIS schemes states that the claim lies with the company who “intended or contemplated” the R&D, which may be the customer or the subcontractor.

The customer doesn’t need to direct or specify the work in every detail in order to own the claim. Any work that falls substantially outside the customer’s intention is not considered R&D contracted out by the customer, meaning the subcontractor may claim for it instead.

Also, if the customer is ineligible to claim (because they don’t pay UK corporation tax, for example), then the subcontractor can claim instead, if they provide evidence of this.

Next steps for SME claims related to work under a contract

If you are working with clients on an upcoming subcontracting claim, whether they’re a customer or subcontractor, you need to make sure you have things prepared in line with the updated guidance.

Make sure you:

• Review Documentation: Highlight where the contracts and other documentation clearly outline the scope of work and whether any R&D was specifically commissioned.
• Seek A Second Opinion: Where the evidence isn’t clear, it’s worth passing everything by another R&D expert to ensure you are accurately interpreting the new guidance. Our Claim Support service can help you with this.
• Be Prepared for Continued Scrutiny: Even with these decisions, R&D claims are still likely to be scrutinised by HMRC, and it is important for businesses to have good documentation and be prepared to justify their claims.

What about previous claims denied on the basis of the old subcontracting guidance?

If you have previously prepared a claim for a client that was affected by the old subcontracting guidance, the chances are they’ll be keen to resurrect it based on the updated guidance.

If you’re still within the window to amend the R&D claim on the tax return, that is the first port of call.
If you are outside the amendment window, HMRC suggest you follow the process for late claims set out in their Guidance for Compliance (GfC3). When doing so, you’ll want to read their “Statement of practice 5” and present a clear argument for why delay in the updated submission was outside the taxpayers control.

More guidance on Subcontracted R&D

If you’re looking to learn more about the rules for subcontracted R&D, membership includes our course “Subcontracting in the SME scheme: The rules & how they’re applied in practice”. This explains many of the points raised in this article in a clear and visual way.

Alternatively, if you need help with a specific case, our Claim Support team are on hand to help too – simply send us request for support and we’ll come back to you with an estimate, based on our hourly rate.