A tax expert has warned construction companies they need to be fully aware of updated legislation surrounding ‘contracted out’ research and development (R&D) tax relief claims or find themselves in deep water.

Businesses can claim tax relief for the cost of R&D which is contracted out to or from another party, generally a sub-contractor, for accounting periods beginning from 1 April 2024, but HMRC is closely scrutinising applications and the language used in contracts.

Emma Hussey, Tax Director at UK top 10 accountancy firm Azets, said:

“The contracted-out legislation update has been welcomed as a sensible approach but is still open to interpretation. Anyone submitting a claim must ensure their eligible contracting project and associated working relationship has a robust, watertight and fully documented argument.”

Under previous legislation, contracted project eligibility came down to the size of the company as to who could claim, which was a positive for contracting SMEs, but not for the subcontractors who were actually doing the R&D, and who could only claim under the old RDEC system, if at all.

This led to situations where contractors were thinking they were undertaking R&D, but the field expertise lay with the subcontractor who felt its activity was routine – thus false R&D claims were being made on matters such as specialist engineering and software development.

Conversely, although a great deal of R&D would be going on, such as on a design and build contract, the contractor may not have known about it, so no claims would be made.

The situation was further complicated by First-tier Tribunals (FTT) late last year, one involving a construction company, in which HMRC’s claim that R&D activity was subsidised and therefore invalid was dismissed, and the company’s claim for R&D relief upheld. This led HMRC to update legislation.

Emma said: “The updated contracted-out legislation certainly offers more clarity, however, there remain technical difficulties.

“Now for R&D to be contracted out to a company, there must be a contract between two companies for R&D-based activities to be done. That contract can be written, verbal, or implied, and the R&D can be further subcontracted. However, in writing that contract, for the client to claim, they must have intended or contemplated that R&D of that sort would be done.

“Whether R&D of that sort was intended or contemplated is suitably vague for a reason. HMRC wants to leave it up to reasonableness rather than contractual wording – it is not enough to just write in the contract ‘I own the R&D’ to claim relief."

“Intended or contemplated, there must be more than just an awareness that R&D will take place – it is a requirement for this type of R&D. The client cannot be indifferent to how the end contract is completed as then they may not be intending for R&D to take place"

“Also, the phrase ‘of the sort’ expands the scope – while the R&D doesn’t need to be precisely detailed, the work done needs to be similar to what was needed by the contract. In that case, considering the definition of R&D for tax purposes, the claim needs someone experienced in the engineering discipline and industry who can explain the technological advance and uncertainty."

“We must also look at the working relationship outside of the contract. For instance, how much autonomy does the contractor have, who controls how the R&D is exploited, who is involved in the decision making, who owns the resulting intellectual property?"

“In theory, this legislation should make it easier for those holding the R&D risk to reap the benefits, but I’m sure there will be more tribunal decisions arising from the changes in the next few years.”

Latest available figures show there were 65,690 R&D tax credit claims for the tax year 2022 to 2023, a decrease of 21%. The total R&D tax relief support claimed for the tax year 2022 to 2023 was £7.5 billion, an increase of 1%.

Photo: Emma Hussey, Tax Director at UK top 10 accountancy firm Azets, is advising construction firms to be vigilant over updated legislation surrounding ‘contracted out’ research and development (R&D) tax relief claims