R&D Tax Relief and HMRC’s Stricter View on Customer Funded Projects
It is critical that R&D advisers consider the situation which arises where a company (“the researcher”) is approached by a customer (“the customer”) to design and/or develop a particular product or solution. This is a relatively common situation as it is unusual for a company to engage in expensive research purely speculatively where it has not previously established a market.
In recent years, HMRC has increasingly taken a much stricter view on customer funded projects and has looked much closer at contractual relationships. HMRC has two possible arguments to deny R&D tax relief.
Firstly, the legislation for R&D tax relief restricts the amount of relief available to SMEs for R&D that has already been funded by other means, such as a grant or subsidy. HMRC increasingly argues that if R&D activities are part of a project to deliver goods or services that are being paid for by a customer, any expenditure on that project should also be treated as subsidised and the relief should be restricted.
Secondly, HMRC restrict the amount of relief available to SMEs where the R&D expenditure is incurred by a researcher in carrying on activities which are contracted out it.
Traditionally, if the researcher could demonstrate that the technical and financial risk of the R&D vested with it, the fact that a customer had approached and asked for a solution could largely be ignored. More recently, however, HMRC has taken to challenging whether expenditure by the researcher in those circumstances is qualifying expenditure.
Two notable recent First Tier Tribunal cases in this area include Hadee Engineering Ltd and, more recently, Quinn (London) Limited. The first case was won by HMRC and the second case was won by the taxpayer.
The more recent case, which found in favour of the taxpayer, involves a construction company with a heritage restoration division. Most of the R&D projects are carried out in order for them to deliver heritage construction work and compliance projects to its customers.
As is the case for many construction engineering companies, Quinn was proud of its reputation for tackling particularly complex projects. Its investment in R&D was essential and a key way for it to maintain its reputation in its field. The new materials, processes and techniques they developed helped them maintain their competitive edge.
HMRC took the view that because the customer paid for the work that was delivered, the price the customer paid covered the R&D costs incurred by Quinn. As a result, the R&D costs were subsidised and SME relief should therefore be denied. On the face of it, HMRC has a point. HMRC argued that where a taxpayer contracts with a customer before or at the time of the R&D activity then the R&D is being subsidised indirectly by the customer.
The taxpayer argued that the payments received were a commercial return for the product itself and did not amount to a subsidy that directly or indirectly meets the R&D expenditure. The taxpayer successfully argued that the payments are for the value of the products or services exchanged for a commercial price.
The first-tier tribunal ruling found in favour of the taxpayer and agreed that in order for expenditure to have been met (i.e. subsidised), the third party (the customer in this case) must either directly meet the payment to the creditor or indirectly reimburse the taxpayer, and the payments must have a clear and direct link to the R&D expenditure.
Although this was a first-tier tribunal case and therefore does not form a legally binding precedent, the judgement in this case cannot be underestimated in terms of its significance. It is no purpose of the legislation to deny relief where arrangements are in place to exploit the fruits of research and development. That would be at odds with a relief which is clearly directed to encouraging R&D in a commercial context.
Tax legislation which denies relief in circumstances where a contract is in place to sell the outcome of R&D would be an absurd one, and therefore not one which can properly be adopted.
Practical Advice
In the unlikely event that there is a clear, contractual agreement that covers all the points relevant to the R&D legislation, there is always going to be an element of subjectivity and ambiguity. It is therefore essential to review all paperwork, question the facts and apply a judgement. All R&D tax relief claims carry some form of risk and any agents that say otherwise should be treated with caution.
Ideally the researcher and customer should enter into a written contract. The contract should identify the nature of what is being contracted for in terms of a solution. In that respect, it should be clear that a failure to provide a solution has the consequence that the researcher will not be paid. It should also identify that the researcher has autonomy in deciding how a solution is reached. Finally, it should provide that any intellectual property developed should vest in the researcher.
The terms of the contract will not, however, be the end of the matter. It will also be necessary to have regard to what happens in practice. HMRC would be entitled to argue that notwithstanding what the contract provides for the reality is that activities have been contracted out. As such, the contract should properly reflect what is intended to be the agreement between the parties.
Nevertheless, in the case of ambiguities, the contract will be relevant as setting out the intentions of the parties. As such, simply by having a written contract and addressing the above matters in advance a researcher can substantially improve the strength of a claim for R&D tax relief. It is important that any documentation accurately reflects what the customer is paying for, be it time, a bespoke product or an off the shelf product.
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