R&D tax credits – Stage One Creative Services FTT decision
Emphatic win for taxpayer in favour of their interpretation of the ‘subcontracted’ and ‘subsidised’ R&D rules for SME claimants
Taxpayer win in relation to ‘subcontracted’ and ‘subsidised’ R&D rules for SME claimants
Hot on the heels of the recent Collins Construction ruling, the First-tier Tribunal (FTT) has found in the taxpayer’s favour in Stage One Creative Services Ltd v HMRC [2024] UKFTT 1059 (TC) when considering the application of the subcontracted and subsidised small and medium-sized enterprise (SME) scheme conditions for research and development (R&D) associated with commercial contracts.
Background
Stage One Creative Services Ltd (SOCS) incurred expenditure on R&D for the provision of engineering, construction and automation solutions for live events and installations. SOCS’ claims for enhanced research and development relief under the ‘SME scheme’ were refused by HMRC on two grounds (the ‘Substantive Issues’):
- That the expenditure on R&D was not qualifying expenditure as it was ‘subsidised expenditure’; and/or
- That the expenditure had been incurred in carrying on activities which were ‘contracted out’ to SOCS.
HMRC argued that the above conditions should be interpreted such that a company incurring R&D expenditure to meet contractual obligations to its customers is automatically both contracted out and subsidised. SOCS appealed to the FTT in respect of the Substantive Issues. SOCS also challenged Discovery Assessments which had been raised by HMRC on the basis the relevant claims had been made consistently with HMRC’s ‘practice generally prevailing’ at the time as contained in their pre-November 2021 guidance.
SOCS’ appeal was allowed by the FTT on both of the Substantive Issues and in respect of the Discovery Assessments.
Whether the expenditure was ‘subsidised expenditure’?
This issue was whether the expenditure was ‘met directly or indirectly’ by another person within the meaning of s1138(1)(c) Corporation Tax Act 2009, i.e. the same issue considered by the FTT in Quinn (London) Ltd v HMRC [2021] UKFTT 0437 (TC).
SOCS relied on the Quinn decision and argued that the same approach should be taken in this case, given Quinn had been expressly approved by the Upper Tribunal in HMRC v Perenco (UK) Ltd [2023] UKUT 169 (TCC). HMRC argued that the Judge in Quinn had erred in law, and that support for Quinn derived from Perenco was misplaced as that related to a different statutory regime.
Although the FTT agreed with HMRC that they were not bound by the decisions in either Quinn or Perenco, the FTT considered those decisions to be highly persuasive and (as the facts of this case and Quinn had ‘numerous similarities’) adopted the same approach as Quinn. This included the comments in Quinn as to the correct interpretation of s1138(1)(c), including that a ‘clear and direct link’ is needed between the payment received from the third party and the qualifying expenditure in order for the expenditure to be subsidised.
As a result, the FTT found that the R&D expenditure was not subsidised expenditure.
Whether the expenditure had been ‘contracted out’?
It was agreed by the parties that the R&D expenditure was incurred to fulfil SOCS’ contractual obligations to its customers.
HMRC argued that, had the contracts not been in place, SOCS would not have incurred the R&D expenditure, and this was sufficient to mean that R&D was ‘contracted out’ to SOCS, i.e. only ‘freestanding R&D’ (i.e. R&D undertaken where there is no customer in place) would qualify for relief.
SOCS argued that the obligation under the contracts was to deliver the specified end product and not to conduct any particular R&D. R&D was not mentioned in the contracts. Further, SOCS had complete autonomy as to how and if it carried out any R&D, it owned the intellectual property arising in respect of the R&D, and bore the financial risk of undertaking R&D as part of the process of delivering the end product.
The FTT considered the meaning of ‘contracted out’ in its context and in light of its legislative purpose which included the prevention of relief being claimed twice for the same R&D. It concluded that the ‘contracted out’ condition means that SME relief is not available in circumstances where R&D is carried out on behalf of someone else.
The FTT rejected HMRC’s ‘freestanding R&D’ argument and largely accepted SOCS’ arguments that the R&D was not contracted out in circumstances where SOCS’ clients did not know the detail or extent of any R&D and they owned the intellectual property.
As such, the FTT found that the R&D expenditure was not contracted out expenditure.
Discovery Assessments
The FTT went on to consider two issues in respect of the Discovery Assessments:
- Whether on looking at the R&D reports provided to HMRC, a hypothetical officer could not have been reasonably expected to have been aware that the assessments had become insufficient. This needed to be demonstrated by HMRC for the Discovery Assessments to be validly made; and
- Whether SOCS’ tax returns had been made on the basis of or in accordance with ‘the practice generally prevailing’ (PGP) at the time they were made. If SOCS could show that the returns had been made in accordance with the PGP, the Discovery Assessments would not have been validly made.
The FTT considered HMRC’s Corporate Intangibles Research and Development Manual (CIRD), and the amendments made to it on 30 November 2021 and heard evidence from HMRC and on behalf of SOCS as to HMRC’s approach to the contracted out and subsidy issues. HMRC argued that the new version of the CIRD simply expanded upon the old version of the guidance and that HMRC’s views had not changed.
However, the FTT disagreed, holding that HMRC had changed their position and that there was a PGP based on the pre-November 2021 version of the CIRD. This recognised that it was possible for an SME to satisfy the ‘contracted out’ condition where, for example it had autonomy, bore the risks and retained ownership of the intellectual property arising from its R&D. In respect of whether expenditure was subsidised, the FTT considered that HMRC’s position had also changed – their pre-November 2021 position had been to look for a ‘clear and direct link’ between the payment and the incurring of the expenditure rather than a payment under a contract with a customer necessarily meaning that the cost of R&D was met by another person.
The FTT found therefore, that not only was there a PGP, but that SOCS’ tax returns were submitted in accordance therewith. As a result, the Discovery Assessments were not validly made.
Implications of this FTT decision
This decision is a comprehensive victory for the taxpayer and follows similar taxpayer successes on the ‘contracted out’ and ‘subsidised expenditure’ issues in Quinn and Collins Construction. These issues have regularly been raised by HMRC in enquiries. We understand HMRC will not appeal either the Collins Construction or SOCS cases and that new guidance will be issued in February 2025 setting out HMRC’s views on the wider implications of these judgments.
The FTT’s conclusions as to PGP are potentially also significant for any taxpayer who has an open enquiry for periods ending on or before 30 November 2021 in which HMRC are arguing R&D expenditure is subsidised expenditure and/or contracted out expenditure contrary to their guidance in the CIRD, as it stood at the relevant time. This is in addition to any potential issues with threatened or issued Discovery Assessments for periods earlier than 30 November 2021.
The KPMG Law Tax Disputes and Investigations team have extensive experience and expertise in both R&D and Discovery Assessment-related dispute resolution with HMRC. Please contact the authors, Andrew James or Joe Pyne if these issues are raised by HMRC.
Claims made for accounting periods commencing on or after 1 April 2024 fall within the new merged RDEC scheme which has a new definition of ‘contracted out’, and the new legislation should be considered by companies with regards to future claims.
