Qualifying R&D – should sub-contractors be listed as connected vs unconnected?

In this briefing we explain, in outline, the difference between connected and unconnected companies and the impact on R&D tax relief and RDEC claims, when claiming for costs related to R&D work undertaken by sub-contractors. This topic can be complex, and so we have not covered all the details and angles that will need to be considered by your accounting team and an expert tax advisor, during the preparation of an R&D tax claim. If you have any questions on the way to process a claim for sub-contractor costs, please contact your Easy R&D consultant or our Business Support team and we can advise you on the optimal and HMRC compliant approach to sub-contractor costs.

The UK government offers Research and Development (R&D) tax relief to businesses that engage in qualifying activities. Subcontracted activities are one of the qualifying categories for expenditure that may form part of a company’s R&D claim.

When it comes to claiming sub-contractor costs for R&D tax relief and RDEC in the UK, it's important to understand the difference between connected and unconnected companies. 

• Put simply, a connected company is one that has a certain level of control over the other company, whereas an unconnected company operates independently.
  
• HMRC defines a connected company as one that has more than a 50% interest in another company's ordinary share capital, or has the ability to control more than 50% of the voting rights in another company's general meetings. 
  
• Conversely, an unconnected company is one that doesn't meet these criteria and operates independently.

Why is this important? Well, if you're claiming R&D tax relief or RDEC for sub-contractor costs, the rules around connected and unconnected companies can impact the amount of relief you're entitled to claim against. In general, claiming for sub-contractor costs from unconnected companies tends to result in a higher level of relief. Incentivising the use of unconnected subcontractors, over connected companies, is designed to stimulate collaboration and cross-company innovation.

It is also important to understand that unconnected and connected subcontractor expenditure is treated differently for the SME R&D tax relief scheme and the large company scheme (RDEC).

• Under the SME scheme, the qualifying subcontractor costs are capped to 65% of the payments made to an connected subcontractor. 
  
• However, in the SME scheme, if the subcontractor is unconnected, 100% of the payments made to the subcontractor or the subcontractor’s relevant expenditure, whichever is lower, may be included in the claim.
  
• The large company scheme only allows subcontractor costs if the work is directly undertaken by a qualifying body or individual. In practice, this will restrict the eligible costs to work done by charities, universities or health-service bodies, and individuals or partnerships that only have individuals as members.

An example where Alpha-One Limited and TechnoPlus are unconnected companies, and the claimant is an SME:

Location of a sub-contractor: You may have seen announcements that costs related to overseas contractor will no longer be deemed eligible R&D expenditure. This was the case, with a plan to change the scheme from April 2023. Given that a large number of SMEs will sub-contract IT and data analytics R&D work to expert overseas contractors, who are often cheaper and have different skills than UK providers, this was a significant and unwelcome change. However, the timing of this new policy has been delayed after recent consultations with UK businesses and tax advisory firms. Following the Spring 2023 budget statement, the relief on subcontractor costs for SMEs is now likely to become territorial from April 2024. This means that the R&D work will have to take place in the UK to be eligible from April 2024, unless, of course, the government reviews this policy again in the light of feedback from the business community. 

The difference between “externally-provided workers” and sub-contractors: When making an R&D claim it is important to distinguish between sub-contractor and external worker costs. The provision of externally-provided workers and the payments for these services relate to the provision of external staff who are individuals and not connected to the claimant company, and are directly managed by the claimant company. There are a number of criteria that are used to establish the difference between a “externally-provided workers” and subcontractors, which our team can help you assess as we prepare a claim.

As you can tell from this summary, the rules around connected and unconnected companies and sub-contracting, can be complex and can require expertise and judgement to assess properly. It's always a good idea to seek expert advice if you're unsure about your eligibility for R&D tax relief or RDEC and how to optimise and check HMRC compliance, especially if you claim for sub-contractor costs.