Merged R&D tax relief regime – further draft guidance published

Following the Autumn Statement, the Government published Finance Bill 2023/24 (commonly known as the Autumn Finance Bill) covering the new merged Research and Development Expenditure Credit (RDEC) regime, along with the introduction of the overseas R&D restrictions for accounting periods beginning on or after 1 April 2024 (subject to transitional rules). HMRC have now published draft guidance on the practical applications of the overseas restrictions as well as the subcontracting rules that form an important part of the new merged RDEC regime. With the new merged regime due to come in from 1 April 2024, HMRC have requested feedback on the draft guidance by 1 March 2024. This article covers the key aspects of the draft guidance along with the practical implications that claimants will need to consider for future R&D incentives claims.

For accounting periods beginning on or after 1 April 2024, expenditure on overseas R&D activities will generally no longer be qualifying for the R&D incentives regimes. The exception to the general rule is where conditions necessary for the R&D are not present in the UK, are present in the overseas territory and it would be wholly unreasonable for the claimant to replicate them in the UK. 

The draft guidance clarifies that for contractor payments, it is the location of the activity that determines whether the overseas restriction applies, whilst for payments for externally provided workers (EPW), it is whether the EPW’s earnings are subject to PAYE and Class 1 NICs that determines whether the restriction applies.

From an evidential perspective to support a claim (i.e. to evidence that the contracted-out activity was undertaken in the UK, or that the EPWs were subject to PAYE and Class 1 NICs), the R&D reliefs claim process will not require the presentation of upfront evidence of this to HMRC. However, HMRC expect claimants to have an understanding of their supply chain and, to the extent that some activity takes place in the UK and some not, the payment to a contractor (or supplier of EPWs) should be apportioned to the UK element of the activity on a just and reasonable basis. The guidance does suggest that HMRC’s approach when requesting evidence that the R&D was undertaken in the UK should 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.” 

Overseas expenditure on contracted out R&D, and on payments for EPWs who are not subject to UK PAYE/ NIC, may still qualify for relief if certain circumstances are met – these are:

• That conditions necessary for the R&D are not present in the UK;
• That the conditions are present in the location where the R&D is undertaken; and
• That it would be wholly unreasonable for the company to replicate the conditions in the UK.

All three of these must apply for the expenditure to qualify for the exemption. HMRC may request evidence, such as project documentation, which may set out why or whether an activity was necessary and what alternatives there might have been, and 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.

Non-exhaustive examples are given of fact patterns that may suggest it would be ‘wholly unreasonable’ for the claimant to replicate conditions in the UK; these include:

• Time pressure to undertake the R&D, e.g. from a commercial, legal, or contractual perspective, or where the R&D itself demands it (e.g. where samples have a limited life);
• Medical circumstances, such as incidence of a disease, or availability of participants to trial a drug or other medical treatment;
• Physical or geophysical circumstances;
• Presence of machinery or facilities to which a company may require access;
• Environmental sustainability; and
• Legal or regulatory requirements (including explicit legislative requirements, as well as requirements, decisions, guidance, and agreements of regulatory bodies).

The guidance also reiterates the specific exclusion of cost of the R&D activity and availability of workers with the necessary skills as factors relevant to whether it was ‘wholly unreasonable’ to undertake the R&D activity in the UK. That said, the guidance and examples appear to indicate a less strict interpretation than previous drafts of the legislation. For example, the draft guidance suggests that whilst overseas expenditure will not qualify where cost or staff availability on their own are the only or main factor as to why R&D is conducted overseas, where other factors are significant, (such as time pressure, or the cost of constructing or adapting a test facility) the mere existence of cost and/or staff availability as a factor in the overall fact pattern will not in itself disbar the overseas expenditure.

Claimants that do conduct R&D activities overseas should consider if the exemptions to the overseas restriction would apply. There are a number of practical examples included in the draft guidance and claimants should consider these to determine if they provide sufficient guidance on how the overseas restrictions will apply in practice.

The draft guidance aims to provide further clarity on how the subcontracted rules will work in practice under the merged RDEC regime. The subcontracted rules are an important aspect of the merged regime and where a company sits in the supply chain and the means by which it contracts with third parties to undertake R&D will determine who can access relief under the merged regime. It should be noted that subcontracted R&D rules under the merged RDEC regime are different to the subcontracting rules under the current SME R&D tax regime.   

The draft guidance outlines that the intention is for the initiator of the R&D to be able to claim under the merged regime. Where R&D is carried out under a contract, the right to claim for contracted out R&D is generally for the customer, subject to certain exceptions. For these purposes, R&D is defined as having been contracted out where it is “reasonable to assume that the customer intended or contemplated that R&D of this sort” would be done under the contract. If it is not reasonable to assume the customer intended / contemplated R&D at the point of contract, and the contractor initiates R&D, then the contractor may claim.

Example 18 will be of particular relevance to many claimants: “A company 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, and the nature of the negotiations to agree it, it is clear to all parties that the customer had no understanding or intention that any R&D should take place. If the contractor 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.”

The draft guidance states that, in order for the customer to claim in relation to the payments to the contractor, the nature of the R&D that was to be undertaken (such as a statement of the advance in science or technology and what uncertainties need to be addressed) must be articulated, in order to show that it was intended or contemplated that R&D of a particular sort should be undertaken. This must go beyond listing project challenges and constraints. The customer must be able to specify the required R&D, understand the R&D and be able to articulate the nature of the R&D. Consequently, the draft guidance appears to indicate that the customer will need to have some technical capability in order to have the ability to subcontract out specific R&D activities. Mere speculation, general awareness, or acceptance that R&D may be needed will not be sufficient.

Ultimately, the guidance states that HMRC will have regard to ‘the terms of the contract’ - and ‘any surrounding circumstances’, including (but not limited to):

• Intellectual property ownership;
• Financial risk in undertaking the work;
• Autonomy in how the activity is executed;
• The experience and seniority of decision-makers; and
• The nature of the parties (e.g. whether it is evident that the contractor specialises in providing R&D services and the contract is typical of those R&D activities).

As such, claimants will want to retain evidence of both the contract itself and any documentation to support the position taken, e.g. discussions between the customer and the contractor leading to the contract, or in internal documents showing how the activity was required as part of the customer’s wider R&D.

Finally, the guidance clarifies that there are scenarios where a contractor to whom R&D has been contracted will still be able to claim, regardless of the above; this includes where the customer is unable to claim on the basis that it is, for example, an overseas company not within the charge to UK Corporation Tax, an ineligible company such as a charity or higher education institution, or a UK Government department.

Claimant companies should seek to understand how the practical approach to the overseas restriction and subcontracting rules outlined in the draft guidance would impact their future claims. This may include a review of the existing relationships with contractors and EPW providers and, in particular, the associated contractual arrangements in respect of any R&D activities. Where R&D is conducted overseas claimants will need to consider if the exemptions to the restriction may apply and if they do how this can be effectively evidenced. 

If you wish to provide feedback in respect of the draft guidance or are concerned as to how these reforms might impact on future R&D claims, please speak to your usual KPMG in the UK R&D claims advisor. Please also let us know if you have any comments you would like us to consider for our own response to the consultation.

For further information please contact:

• Carol Johnson 
• Patrick Fletcher