R&D Tax Relief for Subcontracted Work: HMRC’s Revised Interpretation Under Fire

Recently, the First Tier Tribunal (FTT) case of Stage One Creative Services Ltd (SOCS) vs. HMRC, has challenged HMRC’s stance on whether subcontracted or subsidised R&D can be considered as qualifying expenditure.

This case has highlighted the growing tensions between HMRC’s revised interpretation of subcontracted and subsidised R&D, and the practical realities faced by businesses.

This ruling has raised significant questions about HMRC’s approach, with potential implications for businesses and the future of R&D tax policy in the UK.

Background: HMRC’s Revised Interpretation

Previously, HMRC’s guidance on subcontracted R&D focused on a multi-factor analysis of the facts in each case. To assess which party was allowed to make a claim, it considered factors such as the degree of autonomy enjoyed by the person engaged, the ownership of intellectual property and the economic risk in any arrangements.

However subsequently, this shifted towards a stricter interpretation:

• In a July 2020 Research and Development Consultative Committee (RDCC) meeting, HMRC emphasized their view that expenditure incurred by an SME company in carrying out activities contracted to it, did not qualify for SME relief. They argued that this condition applied even if the R&D didn’t constitute a distinct project in itself and wasn’t explicitly stipulated as an R&D project in the contract.
• In November 2021 there was a revision to CIRD documentation where HMRC replaced the multifactorial analysis with a more definitive statement: “Any activities carried out in order to fulfil the terms of a contract are considered to have been contracted to the company.” This revision consolidated the shift in HMRC’s position, implying that R&D undertaken to fulfil any contractual obligation would now be deemed subcontracted, regardless of factors like autonomy or intellectual property ownership. In other words, the company carrying out the work, would not be able to claim for it.

This revised interpretation of what constitutes subcontracted or subsidised R&D has become a contentious issue. Recent cases which we explore below illustrate how these guidelines are being challenged by companies that feel that they have performed genuine R&D but cannot fully benefit from it.

The Role of the Hadee Case

A ruling frequently cited by HMRC to justify their revised interpretation is the Hadee Engineering case (Hadee Engineering Co Ltd vs. HMRC) where HMRC successfully argued that the taxpayer’s claims for R&D tax relief did not meet the legislative requirements under the SME scheme.

Specifically, HMRC contended that the activities described by Hadee Engineering lacked sufficient evidence to demonstrate they qualified as R&D under the relevant tax definition, and that claimed expenditures were either subsidised or not directly attributable to qualifying R&D activities.

However, a closer examination of the Hadee case revealed a key nuance: HMRC’s victory was to an extent due to inadequate documentation provided by Hadee and their subsequent inability to demonstrate that it met the tax definition of R&D—not the correctness of HMRC’s interpretation of subcontracted or subsidised R&D.

The distinction is critical because it undermines HMRC’s reliance on Hadee as a precedent for defending their current position, leaving their interpretation vulnerable to further challenges.

The Role of the Quinn and Perenco Cases

The Quinn v. HMRC UKFTT 0437 (TC) decision in 2021 involved a taxpayer, Quinn, who claimed enhanced R&D tax relief for expenditures on research and development activities conducted for clients under commercial contracts. HMRC argued that Quinn’s R&D expenditure was subsidized because clients indirectly “met” the expenditure through their payments for Quinn’s services.

The Tribunal Judge rejected HMRC’s interpretation of section 1138(1)  of the Corporation Tax Act 2009, which defines "subsidised expenditure”. The judge determined that in the absence of a clear link between the price paid by the client and the expenditure on R&D, section 1138(1)(c) does not apply in situations like Quinn’s.

Following this, in 2023, the Upper Tribunal ruled in favour of Perenco, an oil and gas producer that received payments under transportation and processing agreements (TPAs) while incurring costs for environmental compliance upgrades.

HMRC argued these payments subsidised Perenco’s expenses, but the tribunal found them to be consideration for services rather than subsidies. In July 2023, the Upper Tribunal upheld this decision, aligning with the earlier Quinn case to reinforce that payments under standard commercial contracts are not automatically subsidies.

This ruling limited HMRC’s ability to broadly disqualify expenditures and provides a balanced interpretation favouring innovative businesses. While tied to the Oil Taxation Act, the case’s principles are broadly applicable to R&D tax relief, particularly for projects where R&D is incidental to broader contractual delivery.

Together with Quinn, Perenco has become an important case in challenging HMRC’s restrictive interpretations and offers important clarity for businesses pursuing R&D tax relief.

The Collins Construction Case

HMRC recently lost a case against at the FTT against Collins Construction Limited where they challenged HMRC's stance that the expenditure was either “subsidised expenditure” or “expenditure incurred in carrying out sub-contracted R&D activities”.

Again, HMRC argued that the payments Collins received from clients for construction projects indirectly met the expenditure on R&D, classifying it “subsidised expenditure” However, the Tribunal, relying heavily on Quinn rejected this interpretation.

The Tribunal found that the circumstances in the Collins case mirrored those in Quinn, emphasizing the following points:

• Contractual Agreement: Collins agreed to deliver specified works for an agreed price. The clients were not agreeing to pay for or reimburse specific R&D costs.
• Factoring R&D into Pricing: Like Quinn, Collins factored potential R&D costs into their pricing to achieve their desired profit margin. However, this does not equate to the client directly or indirectly meeting those costs.
• No Direct Link: The Tribunal determined that there was no clear link between the payments made by Collin’s clients and the specific expenditure on R&D.

The Tribunal also addressed HMRC's arguments that Quinn was wrongly decided. However, the Tribunal disagreed and maintained that the decision in Quinn correctly interpreted the "subsidised expenditure" clause.

The Tribunal further highlighted the Upper Tribunal’s agreement with the FTT's approach in Quinn in the HMRC v Perenco (UK) Ltd decision, emphasizing its persuasive value.

HMRC also contended that the expenditure was incurred by Collins in performing activities "contracted out” to them by clients.

They argued that the R&D undertaken by Collins was necessary to fulfil the terms of the construction contracts and, therefore, fell under the "contracted out” definition in sections 1052(5) and 1053(4) of the CTA 2009.

However, the Tribunal again disagreed with HMRC’s broad interpretation of the “contracted out" condition. They found that the purpose of this condition, in conjunction with the provisions allowing SMEs to claim for "contracted out R&D," is to prevent double relief for the same R&D activities.

The Tribunal emphasized the following points:

• R&D Not the Contracted Activity: While the contracts required Collins to deliver a finished product, there was no explicit or implicit requirement for Collins to conduct R&D. The R&D activities were undertaken by Collins at their own discretion and risk to meet the client’s' design and construction specifications.
• Ownership of Intellectual Property: Collins retained ownership of any intellectual property rights relating to their innovations, further supporting the argument that the R&D activities were not "contracted out” to them.

Drawing on the Explanatory Notes, the Tribunal concluded that the "contracted out" condition aimed to prevent situations where "sub-contractors" performing R&D on behalf of another person, could claim R&D tax relief for that work. The Tribunal determined that this was not the case with Collins, as they were not simply carrying out R&D activities on behalf of their clients.

The Role of the SOCS case

The SOCS case (Stage One Creative Services Ltd v HMRC) coming rapidly on the back of Collins construction, is the latest in significant legal rulings that addresses whether payments received for client projects involving R&D can be classified as "subsidised" or "contracted out," disqualifying them from SME R&D tax relief.

In 2024, the First-tier Tribunal ruled in favour of SOCS, a creative design and construction company, which argued that their R&D activities were incidental to broader project delivery. The tribunal found that SOCS retained full autonomy over their R&D processes, bore the financial risk, and retained ownership of intellectual property, which distinguished their activities from being subcontracted or subsidised. The contracts with clients focused on end-product delivery without specifically reimbursing R&D expenses.

Drawing on precedents like the Quinn and Perenco cases, the tribunal reinforced that payments under commercial agreements do not automatically disqualify R&D expenditures from tax relief. This ruling provides further clarity for businesses undertaking innovative projects, emphasising the importance of autonomy, financial risk, and ownership in determining R&D tax relief eligibility.

What’s Happening Now?

The First-tier Tribunal (FTT) decision in the SOCS case appears to deliver another blow to HMRC’s revised interpretation, reinforcing the idea that HMRC’s narrow view of subcontracted and subsidised R&D may not hold up under legal scrutiny

The immediate question is whether HMRC will appeal this FTT decision to the Upper Tribunal (UTT).Such an appeal could establish binding case law, potentially cementing or dismantling HMRC’s position. However, it also carries significant risks for HMRC. A defeat at the UTT could set a precedent that weakens their ability to challenge R&D claims under their current interpretation.

What Are the Options for HMRC?

Over the next two weeks, HMRC faces a decision in the SOCS case:

• Appeal to the UTT: This move would subject their interpretation to higher judicial scrutiny. While it could create case law in HMRC’s favour, it could also backfire if the UTT rules against them, creating a precedent that benefits companies in a similar situation.
• Avoid the UTT: Alternatively, HMRC may opt not to appeal, avoiding further challenges to their interpretation. This would allow them to continue relying on Hadee and similar rulings, albeit with a weaker footing.

Implications for Businesses

For businesses engaged in R&D, this situation underscores the importance of the payment arrangements, contractual wording, and having clear and comprehensive records of R&D activities and funding sources can protect against challenges under HMRC’s stringent interpretation.

At the same time, the evolving legal landscape offers a glimmer of hope for taxpayers. If HMRC’s interpretation is ultimately overturned or softened, it could pave the way for broader access to R&D tax relief for companies performing genuine R&D while fulfilling a commercial contract.

Looking Ahead

This dispute reflects a broader tension in the UK’s R&D tax regime: the balance between ensuring compliance and fostering innovation. HMRC’s approach, seen by some as overly aggressive, risks stifling legitimate claims and deterring businesses from pursuing R&D activities.

As the next steps unfold, the stakes are high—not just for HMRC, but for the future of R&D tax relief in the UK. Businesses should stay informed and prepared to adapt to any changes in guidance or legal precedent.

Conclusion

Whether HMRC appeals to the UTT or sidesteps the issue, the outcome could have far-reaching implications for businesses navigating this complex and contentious area.

Key Takeaways:

• HMRC’s interpretation of subcontracted and subsidised R&D is increasingly under scrutiny.
• Future rulings could significantly alter the landscape for R&D tax relief claims.

Stay tuned for updates as more developments unfold.