To understand this in more detail, it is necessary to firstly examine the rules on subcontracting. There are 2 separate sets of rules on subcontracting.
What is subcontracting for R&D purposes?
Where there is a contract between persons or companies for R&D activities to be carried out by one for the other, then the R&D activities have been subcontracted. A contract to provide services rather than to undertake a specific part of the activities is not subcontracted R&D. Nor is a contract of personal employment. It is therefore necessary to examine the contract and also understand if the reality of the situation is reflected within it.
There are obviously a considerable variety of possible contractual arrangements. The typical example of subcontracting given by HMRC is where one company engages another company to carry out R&D activity on the first company’s behalf in exchange for payment, with the first company having rights to the intellectual property resulting from the R&D then that is subcontracting of the R&D to the second company.
However HMRC will assess each case on its particular facts and may consider the degree of autonomy enjoyed by the person engaged, the ownership of intellectual property, and the economic risk in any arrangements. Where, for example, a consultant simply provides expert advice and charges for his time, HMRC state that this does not amount to subcontracting of the R&D.
In the case where a contractor's company has a defined deliverable, and can demonstrate that they have a degree of autonomy in how they perform their activities, these are indicative of a subcontract arrangement.
Subcontracting - differences in rules for SMEs and large companies
The rules in regard to qualifying expenditure for subcontracted R&D ( CIRD84200
) differ under the SME scheme and the large company scheme. Before considering mounting any arguments you should consider the appropriate tax treatment, so as to better focus attention on those areas where tax is at risk. In broad terms, a Large company can claim for R&D work subcontracted to it, while an SME cannot. Conversely, a Large company cannot claim for work it subcontracts out but an SME can. This is a separate topic but also means that SMEs subcontracting R&D work can claim for this, even if the company to which they are subcontracting is part of the same group.
Why most IT contractors are excluded from R&D claims Before 1/4/2012
There is a category of allowable costs in an R&D tax relief claim known as Externally Provided Workers (EPWs). This is intended to alllow the inclusion of costs incurred on supplementary staff. However, large companies that try to include contractors are frequently unable to do so. There are various provisions on these type of arrangements that need to be fulfilled but the key element that usually excludes most IT contractors is that there has to be a 3-party arrangement in the engagement of the contractor. The view of HMRC is that there should not normally be a need to examine the detailed terms of the contract between the staff provider and the worker. Instead a straightforward way to check whether the conditions are met may be to ask the staff provider if it is operating PAYE in relation to the worker.
We can look at a couple of example scenarios to illustrate this.
Example 1: The following arrangement, typical in many IT contracts, is not valid as there are 4 parties involved.
Company performing R&D->[contracts with] Agency->[contracts with] Personal Service Company->[employs] Joe Contractor
Example 2: The following arrangement however is valid
Company with R&D Project ->[contracts with] Personal Service Company->[employs] Joe Contractor
Example 1 above is typical of many agency arrangements.
Although contracts between the agency and the personal service company may be 'IR35 Friendly' and the contract oriented to be a subcontract arrangement, from an R&D tax relief perspective this helps neither party- the Large company cannot claim the cost of the worker as an EPW due to the 4 parties involved and even if there is a subcontract arrangement, in place the contractor cannot claim because the subcontract rules state that the subcontracted R&D must be directly undertaken on behalf of the company and not further subcontracted (from the agency to the personal service company).
Why most IT contractors are includable in R&D claims After 1/4/2012
One of the changes in Finance Bill 2012 was that for expenditure on or after 1/4/2012, the tripartite requirement is now a minimum rather than an absolute number. Thus, in example 1 above which has 4 parties, the contractor could be claimed for, whereas self-employed consultants are still not includable as there are only 2 effective parties.