Advice & Best Practice

Why are ‘connected-party’ subcontractors treated differently in R&D tax credit claims?

By Khaled Fatheldin, tax analyst at specialist tax consultancy Catax

One of the most appealing aspects of the R&D tax credit scheme is that companies can claim for subcontractor costs. Use of external expertise in R&D is commonplace and this rule can significantly enhance the size of the benefit available.

However, when the companies providing subcontractors or Externally Provided Workers (EPWs) are classed as ‘connected’, the qualifying expenditure is subject to special rules that will normally cut the total qualifying costs but won’t always reduce the ultimate benefit.

Companies are typically classified as ‘connected’ based on control and ownership. This can be official ownership via shares in a company or through lineal family relationships where children, siblings and parents control or own a connected firm.

The reason why special rules apply to connected companies is rooted in attempts by HMRC to prevent abuse of the R&D tax credit scheme through inflated claims.

Subcontractor and EPW costs in R&D tax credit claims

Companies that are not connected are subject to rules, in any case, that reduce the qualifying expenses available for subcontractor and EPW provider costs. This stems from HMRC’s desire to ensure that only the real cost of R&D activity benefits from the generous 130% uplift that is offset against profits — and not the profit margins added on top.

This is why, when unconnected claimant companies obtain services from third parties or EPW providers, HMRC makes the assumption that there is a degree of profit built into this expenditure.

It adjusts this expenditure, therefore, by a notional 35% to take account of this assumed profit margin. The remainder of the costs are treated as fair game, and can be included in the R&D tax credit claim.

What changes when subcontractors and EPW providers are ‘connected’?

However, this approach isn’t sufficient when the parties are controlled by the same individual, or group of individuals, because companies seeking to abuse the scheme could simply inflate the amounts charged for services to boost their tax credit claim.

For this reason, HMRC has special rules for payments made to connected-party subcontractors and EPW providers.

The claimant company can only claim R&D tax relief on the lower of:

  • the payment that it makes to the subcontractor (or EPW provider)

  • the relevant expenditure of the subcontractor

Relevant expenditure includes staffing costs, EPWs, consumable items, software costs and the subjects of clinical trials. It excludes capital and subsidies. The relevant expenditure will always be lower than the payment made, unless the supplier has made a loss on the contract.

Staffing costs include gross salaries and wages, bonuses, qualifying reimbursed expenses, employer National Insurance Contributions (NICs) and employer pension fund contributions. Dividends and benefits in kind don’t qualify.

The good news, however, is that the 65% cap typically applied to expenditure associated with unconnected subcontractors or EPWs does not apply when dealing with connected-parties. In some circumstances, this will more than make up for the negative effects of the connected-party rule.

Example

Jack and Jill run a software company and during the relevant accounting period their firm paid £100k (excluding VAT) to a company they control for qualifying R&D activity.

However, the relevant expenditures incurred by the connected-party subcontractor only totalled £50k. This means Jack and Jill can only claim for £50k of expenditure, as this is the lower of the two amounts under the test.

The amount that can be offset against profits is £65k (after applying the 130% uplift). If the companies hadn’t been connected, their firm would have been able to offset £84.5k (after the 65% cap had been applied).

By comparison, if Jack and Jill’s firm had paid £65k in total to the subcontracting firm and that firm’s expenditure was still £50k, the amount it could offset against profits would have been £55k as an unconnected company, and remained £65k as a connected company. Being a connected party won’t necessarily result in a lower claim — it will depend on the size of the profit margins involved.

Connected companies barred from the SME scheme

It’s also worth remembering that connected party rules can also prevent some businesses from accessing the more generous SME scheme, because connected-party companies are judged on their combined scale.

Connected companies must have a combined head count of fewer than 500 employees, as well as either a turnover of less than €100m (£85.9m) or assets of less than €86m (£73.9m) to qualify for the SME scheme. If being connected pushes a group of businesses over this threshold, they must claim relief through the RDEC (Research & Development Expenditure Credit for large companies) scheme.

Byline by Khaled Fatheldin, tax analyst at specialist tax consultancy Catax.

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