R&D contractor costs: connected vs unconnected under the Merged Scheme

Once it has been established that the claimant can include the contracted-out R&D, the next question is whether the contractor is connected to the claimant. 

The definition of a connected person is broader than simply looking at share ownership. The Corporation Tax Act rules consider control and can also take account of relationships between individuals, companies, partnerships and certain trusts.

Unconnected contractors

Where the contractor and claimant are unconnected, the claimant can normally include 65% of the qualifying portion of the contractor payment. 

For example, if a company pays an unconnected UK contractor £100,000 and the full amount relates to qualifying contracted-out R&D, the amount included as qualifying contractor expenditure would normally be: 

£100,000 × 65% = £65,000 

This £65,000 forms part of the company's qualifying R&D expenditure; it is not the value of the R&D tax credit itself.

Connected contractors

Different rules apply where the claimant and contractor are connected. 

Broadly, the amount that can qualify is the lower of: 

• the payment made to the contractor; and
• the contractor's relevant expenditure on carrying out the R&D. 

Relevant expenditure can include qualifying staffing costs, software, data licences, cloud computing, consumables, qualifying externally provided workers and certain clinical trial costs. 

For example, if Company A pays a connected contractor £100,000 and the contractor incurs £80,000 of relevant qualifying expenditure carrying out that R&D, Company A may normally include £80,000 rather than applying the standard 65% restriction. 

This means it is not correct to assume that using an unconnected contractor automatically results in a larger R&D claim. The outcome depends on the circumstances and, for connected contractors, the contractor's underlying relevant expenditure.

The rules for overseas R&D also changed from 1 April 2024. 

In general, contracted-out R&D must now be undertaken in the UK for the associated contractor expenditure to qualify. 

There are limited exceptions where conditions necessary for the R&D are not present in the UK, are present overseas and it would be wholly unreasonable to replicate those conditions in the UK. Examples can include particular geographical, environmental, social, legal or regulatory requirements. 

However, choosing an overseas contractor simply because the work is cheaper or because suitable workers are more readily available overseas does not, by itself, meet the exception. 

This makes the location in which contractors actually carry out their R&D an important consideration when preparing a claim. 

It also remains important to distinguish contractor payments from payments for externally provided workers (EPWs). 

EPW expenditure is subject to its own qualifying conditions, including rules relating to the worker, the staff provider and UK PAYE, as well as the restrictions on overseas R&D expenditure. 

The contractual relationship and the way individuals are supplied and managed should therefore be reviewed rather than assuming that all external development or technical costs fall into the same category. 

Under the Merged Scheme, reviewing contractor expenditure involves more than identifying whether a supplier is connected or unconnected.

Companies should consider:

• who decided that the R&D needed to be undertaken;
• whether the R&D was contracted out under the new rules;
• which activities within the contract actually qualify as R&D;
• whether the contractor is connected or unconnected;
• where the R&D activities were physically undertaken; and
• whether the payment and supporting expenditure meet the relevant qualifying conditions.

Getting these questions right can make a significant difference to both the value and compliance of an R&D tax relief claim.