R&D Expenditure Credit (RDEC) and merged scheme

What is the merged R&D scheme? 

The merged R&D scheme represents one of the largest set of changes to the UK R&D rules in the last 10 years. The changes are intended to simplify and improve the R&D tax incentive schemes in the UK, by merging the SME scheme and RDEC R&D schemes into one above the line credit scheme that broadly follows the RDEC rules. The merged scheme runs alongside the SME R&D intensive scheme, known as the Enhanced R&D Intensive Scheme (ERIS).

The merged scheme applies to accounting periods beginning on or after 1 April 2024. The latest rates of relief are set out here. 

Why is it important for your business? 

Most claimant companies will be subject to RDEC rules going forward. The old SME scheme rules will be used for ERIS, but the circumstances in which relief can be claimed are stricter and are subject to new R&D intensity criteria.

The rules covering contracted out and contracted by arrangements are new and can reverse previous entitlements in certain contract situations. 

Although some narrow exceptions are allowed, non-UK costs will broadly no longer be eligible. 

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Overseas R&D costs  

R&D activity has to be physically located in the UK, or undertaken by individuals subject to UK payroll taxes, for the costs to be included in R&D tax relief claims – although the are some exceptions for ‘Qualifying Overseas Expenses’.  

Qualifying Overseas Expenses are costs paid to overseas group companies or third parties where: 

1. The conditions (geographical, environmental, social, legal and regulatory) necessary for the R&D to take place are not present in the UK 

2. The conditions are present in the location where the R&D is undertaken 

3. It would be wholly unreasonable to replicate those conditions in the UK. 

There is guidance covering what is meant by “wholly unreasonable”, but HMRC does expect clear, independent evidence that this was the case – for example, correspondence from the regulatory body. R&D carried out overseas on cost grounds alone or because of the availability of suitably qualified workers are not relevant factors. However, certain costs can qualify, such as some group company secondments to the UK. 

The restriction on overseas costs does not apply to the R&D ‘nexus fraction’ required to calculate patent box relief – so overseas R&D costs will still increase the proportion of tax relief that can be claimed under the patent box scheme. 
 

It should be noted that the non-UK restriction only covers outsourcing costs. Other costs such as imports of consumables or even staff costs relating to overseas branches may still qualify. 

Contracted-out R&D under the merged scheme 

As the rules have completely changed, the best way to explain is to compare the new contracting in and contracting out rules to the old rules and consider them as upstream and downstream supplies in a supply chain. 

The old rules: 

Companies claiming under the old RDEC scheme (for accounting periods starting before 1 April 2024) could only claim for the costs of downstream outsourcing their R&D if the work was sub-contracted out to a limited number of ‘qualifying bodies’ (e.g. universities and other not-for-profit organisations) and to individuals or partnerships. SMEs, however, could claim 65% of the costs of most downstream subcontractor payments regardless of the subcontractor’s identity. 

However, when viewed upstream, companies claiming under RDEC could only include qualifying projects if their upstream customer was itself large or outside the scope of UK corporation tax. This included those SMEs who were subject to RDEC because they did not qualify for the old SME scheme due to the subsidised and/or subcontracted R&D provisions.  

Companies claiming under SME rules had to consider upstream supplies to customers to the extent these represented subsidies or contracted out R&D (in which case RDEC rules applied), but had no restrictions on downstream contracts, apart from the 65% of cost limit. 

The new rules: 

Under the merged scheme (for accounting periods starting on or after 1 April 2024), it is easier to consider upstream and downstream supplies separately. Only one party to the contract can claim for the underlying R&D activities and HMRC have stated that this will be enforced.  

Upstream  

The basic rule is that only the company that makes the decision to carry out (broadly, commission) the R&D activities can claim the RDEC. However, there are four exceptions: 

• Where the customer is either ineligible (broadly, non-UK tax paying such as Charities, Universities, State Sector organisations and non-UK corporates),  
• By election, in a UK group scenario,  
• Where it was always “contemplated and intended” that the R&D activities would be carried out by the subcontractor, or: 
• There is no supply chain – i.e. this is their own in-house R&D and is unrelated to a customer contract  

Downstream 

A company can now claim relief for contracting out costs, where it subcontracts R&D activities to a supplier and also if that contractor in turn contracts out the R&D activities again. If the R&D activities are set out by the customer, it is usually clear that they were commissioned by the customer, and it was neither contemplated nor intended that the R&D activities would be commissioned by the subcontractor. 

New complications 

The new rules surrounding “contemplated and intended” are likely to cause most confusion. HMRC have published guidance to support this, but the ultimate customer at the top of the supply chain is most likely to be best placed to control who is entitled to claim the R&D. 

One outcome is that every company within the supply chain now needs to review its upstream and downstream contracts. If the upstream contract is deemed to belong to the customer, it is possible that the RDEC claim could shift from the supplier to the customer. 

This can have serious implications on accounting disclosures and overall profitability, given the impact of RDEC on EBIT, company valuations and contract negotiations as well as tax considerations such as Corporate Interest Restrictions.  

These consequences can be cascaded the whole way through the supply chain and companies towards the bottom may find themselves unable to claim any RDEC. 

Moreover, if the “wrong” company claims the RDEC, say as a result of contract provisions that are not supported by the fact pattern, HMRC guidance states that they could deny the claim to that company even though the claim period may have elapsed for the other party.  

Other consequences 

As the new rules take effect for accounting periods starting on or after 1 April 2024, there are transitional rules where there could be a timing conflict caused by differing accounting periods: in such cases, the old rules take precedence – generally favouring subcontractors in most instances. 

Further, as a result of the changes to the contracted-out R&D rules, the old rules relating to subsidised expenditure have been removed from the legislation. This means that in most cases relief will be now available to companies that have R&D projects which are either subsidised or grant funded. 
 

What should your company be claiming for?

There are now multiple tax benefit and tax credit rates, depending on if you are a profit or loss-making company. There is the inclusion and exclusion of certain cost categories depending on a company’s period end; further complicated by periods straddling either 1 April 2023 or 2024. The concept of an SME still exists and needs to be considered, following the introduction of an enhanced R&D intensive company scheme (which runs alongside the merged scheme). 
 
While changes in the subcontractor rules attempt to provide some clarity on who should be claiming R&D relief, they could easily create additional confusion, uncertainty and are unpractical in many real-life situations.  

We can help you review your current and proposed contract for contracting out R&D and advise on who will be able to claim the R&D relief. Our expert team can also help you design your future contracts.

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