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HMRC’s new interpretation of customer-led R&D for SME R&D tax relief claims

by James Norcott

It has recently become more known that HMRC are challenging a number of Small & Medium Sized Entity (SME) Research and Development (R&D) tax relief claims for “customer-led” R&D, on the basis that this type of R&D is becoming more frequently argued by them as being subsidised by customers.

HMRC are particularly seeking to treat projects that are undertaken for a specific customer as being subsidised by that customer and not therefore eligible for the beneficial SME R&D tax relief. These types of projects will instead be eligible for the less generous Research and Development Expenditure Credit (RDEC) scheme.

Under the SME scheme, a company can typically claim back up to 25p for every £1 spent on qualifying R&D activities, whereas under the RDEC scheme, a company can generally claim back up to 11p for every £1 spent on qualifying R&D activities.

It is anticipated that this change of approach by HMRC could impact many businesses across the UK. In particular, businesses that claim R&D on projects that are tailored towards meeting specific customer requirements.

HMRC’s argument is that, while subsidised R&D is generally seen as applying where a specific grant has been given to a company for an R&D project, that where a customer is paying a supplier to deliver something for them that involves R&D, that supplier is guaranteed a contribution towards that innovative work and therefore there is less risk involved for them.

Examples of when HMRC’s new/updated view may or may not apply are provided below.

  1. A specialist manufacturer undertakes R&D work to develop a new facial recognition scanner using new materials, new design features and new production methods that outperforms the facial recognition scanners already on the market.
    Following completion of the R&D project, customers enter into contracts to purchase the new facial recognition scanners. This type of R&D project should still qualify for SME R&D tax relief.
  2. A specialist manufacturer is engaged by a company that manages airports to supply its facial recognition scanners for passport control purposes.
    The airport and the specialist manufacturer enter into a contract whereby the specialist manufacturer will develop the facial recognition scanners with advanced capabilities.
    HMRC may now consider the R&D of the specialist manufacturer to be subsidised as it is undertaken to fulfil the customer contract.

However, there is potentially some light at the end of the tunnel for UK businesses who claim SME R&D tax relief on customer-led R&D. HMRC recently lost a First-Tier (Tax) Tribunal case where they had challenged an SME R&D tax relief claim by a construction company. HMRC argued that if R&D activities were part of a project to deliver goods or services that were being paid for by a client, any expenditure on that project should also be treated as subsidised.

The judge, Harriet Morgan, made the following verdict: “it would be wholly out of kilter with the overall SME scheme if an SME were to be denied enhanced R&D tax relief solely because… it seeks to recover some or all of the relevant costs of the R&D under its commercial contracts with its client”.

It is important to mention that while this judgement arguably decisively overturns HMRC’s recent repositioning on subsidised expenditure, it is not a binding decision in terms of interpreting the legislation. This means that HMRC may continue to challenge the eligibility of customer-led R&D projects.

A company undertaking customer-led R&D projects may, instead of ceasing to claim the SME relief or simply taking no action, may want to consider taking out tax fees protection insurance. The idea being that this should then cover all or most of the professional fees for liaising with HMRC in an enquiry scenario. Please let us know if you’re in this scenario and if this is potentially of interest to you.

If you believe HMRC’s change in view of the rules may affect your business, please contact us for a second opinion and we can advise the appropriate next steps to take.

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