INSPIRED comments on Draft R&D Legislation – Finance Bill 2023-24
We have set out below our comments and suggestions in respect of the proposed new section 1042C CTA 2009 (Qualifying Expenditure: general) included within the draft legislation for a merged research and development (R&D) scheme (“the Merged Scheme”).
Our comments are specifically in relation to:
Condition A: Treatment of expenditure in relation to activities that have been contracted, and
Condition B: Treatment of expenditure that has been subsidised.
Both condition A and B are applied in the draft legislation in determining whether a company’s R&D expenditure is eligible for the Merged Scheme. If either condition is not met, the company will not be eligible to claim R&D credit for the associated R&D activity.
INSPIRED’s recommendations
Condition A
We anticipate that the application of the draft legislation would cause widespread uncertainty for many claimants in determining whether their R&D activities are still eligible for relief. This would make it very difficult for the UK’s Merged Scheme to compete internationally with R&D regimes in other countries.
To prevent the legislation from automatically denying tax relief for companies carrying out R&D activities alongside commercial projects, we would suggest that:
1.Where a customer has contracted out works to a contractor for the provision of a tangible fixed asset in the customer’s hands, the Merged Scheme should allow the main contractor to be eligible for R&D relief,
2.Where the customer has contracted for the supply of a consumable item, the Merged Scheme should allow the supplier to be eligible where R&D was required to develop the item,
3.A specialist contractor should be eligible to claim under the Merged Scheme, where they undertake non-commissioned R&D work during a contracted out project, to fulfil the original contract, and
4.In scenarios where there could be more than one claimant (e.g., in 3 above, and subcontractors to the main contractor in 1 and 2 above, each subcontractor should be responsible for agreeing, under their subcontractor arrangement, or via subsequent formal election (similar to s.198 CAA 2001 election for Capital Allowances), whether they have any right to claim R&D relief under the Merged Scheme.
These measures would ensure that no ‘double claims’ are made within R&D projects, without unfairly impacting subcontractors that develop separate IP to that of the customer in connection with contracted out activities.
Setting out the rights to make R&D claims within commercial agreements (or via a subsequent joint election) would provide clarity to all parties to a contract, of their entitlement to claim under the Merged Scheme.
We have detailed three scenarios which will provide further explanations as to why these recommendations are appropriate.
Condition B
Alongside the recommendations made in relation to “Condition A”,
5. It is our view that the legislation at “Condition B” should either be:
- Amended to allow subsidised activity (as per the existing RDEC regime), or
- Amended to clarify that the definition of ‘indirectly’ subsidised R&D is limited to those instances where grants or similar funding is received.
The definition of indirect subsidies in the Merged Scheme should not restrict claims just because the claimant has the prospect of exploiting the R&D for commercial gain; for example, to be paid for the contract in which R&D was required to complete successfully. Any restriction for ‘customer funded’ expenditure should be dealt with under Condition A.
INSPIRED’s further commentary and examples
Condition A: Treatment of expenditure in relation to activities that have been contracted.
As outlined in the draft legislation:
“…(2) Condition A is that the activities in the course of which the expenditure is incurred are not contracted out to the company by another person in the course of a chargeable trade carried on by that person…”
In addition, this is explained in the Explanatory Notes as:
“…To qualify for relief expenditure must not be linked to activities that have been contracted out to the company…”
Anticipated issues
Whilst it is understandable that the intention is to ensure that no double claims are made (i.e., both a customer and contractor claiming expenditure on the same R&D activity), this would have a perhaps unintended substantial impact on the Merged Scheme, given that it is not clear how the legislation intends to define what constitutes R&D expenditure “linked” to contracted out activities.
This is already a problem area within the existing SME scheme, where companies that are undertaking R&D to fulfil customer contracts might be regarded as ineligible for SME relief, albeit they have the fallback option of instead claiming RDEC. The draft legislation essentially amplifies this problem area as it brings current RDEC claimants within scope, and now, if a company is regarded as not meeting condition A, there is no fallback; there is simply no claim to be made.
We have set out three hypothetical scenarios, outlining how each would be impacted by the draft legislation:
Background to Scenarios
- CarCo (“CC”) is a car manufacturer and aims to push boundaries within the field of electric vehicle (“EV”) technology. CC aims to enhance its EV offerings and contribute to the global shift towards greener transportation.
- BatCo (“BC”) is a battery manufacturer and brings its expertise in battery technologies to the project, aiming to expand its influence in the automotive sector.
Scenario 1 – Supply of Asset
CC contracts BC for the provision of EV battery assembly machinery
In this scenario, CC (the customer) has ‘contracted out’ works to BC (the main contractor) to provide CC with a fully functioning and automated EV battery assembly line (the finished product). R&D activities will be necessary to deliver the finished product. BC may subcontract certain parts of these works if required.
CC will capitalise this machinery line as a tangible fixed asset, given its expected long-term use in the trade.
When this scenario is applied to the draft legislation:
- BC would fail to meet Condition A, as the works have been ‘contracted out’,
- Any subcontractor to BC would also fail to meet Condition A for the same reason, and
- CC’s capital expenditure is not eligible for R&D (i.e., as it is capital in nature).
Therefore, no claim can be made by any party under the Merged Scheme, under a supply of asset contract, even though significant R&D activities may have been undertaken.
This scenario will arise across many other industries including construction, for example, where a property investor has contracted out for the provision of a high rise building in London consisting of an architecturally advanced design, to be constructed using new modular construction techniques. Again, neither the investor, main contractor nor any subcontractor would be eligible to claim for associated R&D work.
Recommendation 1
Where the customer has contracted for the provision of a tangible fixed asset, the Merged Scheme should allow the main contractor to be eligible for R&D relief.
An exclusion should be added to Condition A that provides where the customer has contracted out works on the provision of a tangible fixed asset, the main contractor should be eligible to claim any associated qualifying R&D expenditure in delivering their customer with the finished product.
Scenario 2 – Supply of Components / Items
CC contracts BC for the provision of EV batteries
In this scenario, CC (the customer) has ‘contracted out’ works to BC (the supplier) to provide CC with fully functioning EV batteries (the finished components / items). BC will only be provided with the specifications of each vehicle in CC’s new EV fleet, and will be responsible for all work, including any R&D necessary to supply the finished product.
CC have agreed to pay £20m for the provision of a specified number of batteries; the first £500k of batteries would be used by CC within prototypes (product development).
In the aim of delivering the larger £20m project, BC will need to spend an initial approx. £2m on batteries (component development), which is not reimbursed by CC. BC’s supply cost of batteries under the CC contract will be over and above the initial £2m component development investment.
CC will incorporate these EV batteries into each vehicle in the new CC EV fleet.
When this scenario is applied to the draft legislation:
- BC would fail to meet Condition A, as the works have been ‘contracted out’, and
- CC’s consumable expenditure on the EV batteries (for the most part1) is not eligible for R&D.
1CC is acquiring £20m of consumable items from BC under the contract. The consumable cost would only be eligible where the consumable item has been used up or transformed during an R&D activity, i.e., limited to the £500k incorporated into prototypes.
For CC to include the cost of these batteries within their R&D claim, they would need to be used up during the overall CC R&D project of the vehicle itself, which is a separate activity from the development of the batteries, carried out by BC.
Therefore, no claim can be made on the development of the battery technology by any party under the Merged Scheme under a supply of goods contract, even though significant R&D activities may have been undertaken.
This scenario will arise across many other industries where neither the customer, the supplier nor any subcontractor to the supplier would be eligible to claim for associated R&D works carried out directly on the development of the consumable items. This provides no incentive to carry out the R&D work within the UK, and it is likely that the company would instead carry this out in another jurisdiction with more favourable R&D incentives.
This would unfairly impact UK manufacturers of components, as their costs of standard supply of components are separate from the costs of development, but under the draft legislation all of the supplier expenditure is potentially treated as if they are incurred within their customer’s (entirely separate) overall R&D project or activity.
Recommendation 2
Where the customer has contracted for the provision of a consumable item, the Merged Scheme should allow the supplier to be eligible for R&D.
An exclusion should be added to Condition A that provides where the customer has contracted for the provision of finished components / items, the supplier should be eligible to claim any associated qualifying R&D expenditure in delivering their customer with the finished components / items.
As the customer is acquiring the finished item, they have no eligibility to the R&D carried out on it.
Scenario 3 – Supply of Services
CC contracts BC for specialist testing of EV batteries
In this scenario, CC (the customer) has ‘contracted out’ works to BC (the specialist contractor) to carry out testing works on EV batteries. BC will be provided with CC’s pre-manufactured EV batteries, and BC will be responsible for supplying testing services.
CC had previously completed an R&D project on these batteries and now requires testing for routine purposes on an ongoing basis.
However, BC subsequently needs to develop new techniques and equipment to carry out the EV battery testing, and to fulfil the contract, given the significant advancements made to these EV batteries in CC’s previous R&D project. Once the testing process is developed, BC will use it on other projects and CC will have no rights over this IP.
When this scenario is applied to the draft legislation:
- BC would fail to meet Condition A, as the works have been ‘contracted out’, and
- CC’s expenditure on ‘routine testing’ is not eligible for R&D.
No claim can be made here by any party under the Merged Scheme, even though significant R&D activities may have been undertaken to extend the capability of EV battery testing.
Recommendation 3
A specialist contractor should be eligible to claim under the Merged Scheme, where they have undertaken non-commissioned works during a contracted out project, extending knowledge and capability within their field.
Whilst it would be difficult to include an exclusion to allow the contractor to claim without full visibility of the customer’s wider activities, we consider that this can be dealt with via a joint election. In this regard, please see further details in Recommendation 4.
Potential for Double Claims
Using the above three scenarios, there could potentially be scope for double claims. We would see these as follows:
In Scenario 1, there is no double claim between the customer and the contractor, as the customer is acquiring a tangible fixed asset. However, to the extent that the contractor then engages a subcontractor, there is a potential for a double claim between the contractor and subcontractor.
In Scenario 2, there is no double claim between the customer and the supplier of the consumables. The customer might have a limited R&D claim on the costs incurred on development materials but these will be subject to the R&D rules around consumables and will relate to a different R&D project; as such we do not consider this to be a double claim. However, to the extent that the supplier then engages a subcontractor, there is a potential for a double claim between the supplier and subcontractor.
In Scenario 3 as outlined above, there is no double claim as the customer has no entitlement to claim. However, there will be other scenarios that are less clear cut and it will not always be possible to know whether the contracted work is part of a wider R&D project of the customer. In addition, if the contractor then engages a subcontractor, there is a potential for a double claim between the contractor and subcontractor.
Recommendation 4
The Merged Scheme should require each subcontractor to be responsible for agreeing under their subcontract, (or via subsequent election), whether they have any right to claim under the Merged Scheme.
An exclusion should be added to Condition A that provides where the subcontractor has identified and agreed in writing the extent of their expenditure attributable to R&D under a contract, they should be the eligible party to claim that amount under the Merged Scheme.
Any expenditure identified under this exclusion should be removed from the main contractor’s claim.
Where the subcontractor is unable to evidence that they meet this exclusion, default claim eligibility should be with the main contractor, provided that they have undertaken qualifying R&D activity.
Condition B: Treatment of expenditure that has been subsidised.
As outlined in the draft legislation:
“[…Condition B is that the expenditure is not subsidised…]”
The definition of ‘subsidised’ as per s1138 CTA 2009 is:
“…a company’s expenditure is treated as subsidised to the extent that…the expenditure is otherwise met directly or indirectly by a person other than the company…”
In addition, this is expanded in the explanatory note as:
“…[The subsidy provision is in square brackets because it is still under consideration]…”
“…The Government would like further discussions to understand how the subsidy rules would apply in a potential merged scheme…”
Anticipated issue(s)
We are concerned that without further guidance on the proposed definition of subsidised expenditure, debate will continue between R&D claimants and HMRC, similar to Quinn (London) Ltd v HMRC [2021]. In this case:
- Quinn had carried out construction projects which generated new technological knowledge and capability which could be exploited in future commercial work.
- HMRC contended that Quinn was not entitled to the enhanced R&D relief it had claimed in respect of the claimed expenditure, on the basis the claimed expenditure was “subsidised” within the meaning of section 1138(1)(c), CTA 2009.
- In HMRC’s view, it followed that a customer had indirectly “met” the claimed expenditure by paying Quinn for its services.
The FTT stated that if HMRC’s approach were to be adopted, the circumstances in which a SME could claim enhanced R&D relief would be confined to those where it has no prospect of exploiting the R&D for commercial gain.
If HMRC intends to follow the same approach as above in relation to indirectly subsidised R&D activity, it will cause a substantial number of rejected claims to be appealed by R&D claimants following the precedent set by the Quinn case.
Recommendation 5
Our view is that the draft legislation at “Condition B” should either be:
-Amended to allow subsidised activity, or
-Amended to clarify that the definition of indirectly subsidised R&D is limited to those instances where grants or similar funding is received.
The definition of indirect subsidies in the Merged Scheme should not restrict claims just because the claimant has the prospect of exploiting the R&D for commercial gain, for example, to be paid for the contract in which R&D was required to complete successfully.