Contracted out R&D vs externally provided workers: understanding the key differences

With the increased HMRC enquiry activity continuing to apply increased scrutiny to R&D claims, it is vital that costs included in an R&D claim are categorised correctly. Getting it right the first time around can help to maximise your R&D claim and avoid increasing the risk of an enquiry.

Contracted out R&D

In 2024, HMRC introduced a new legislative definition of when R&D is contracted out. This definition applies to both the new (merged) RDEC scheme and the ERIS scheme. Under the definition, a person (the customer) is treated as contracting out R&D when all of the following conditions are met:

A. The person has entered into a contract under which activities are to be carried out for them, whether directly by the contracting party or through a sub‑contractor

B. The activities carried out to fulfil the contractual obligations owed to the person include qualifying R&D

C. Considering the terms of the contract and the surrounding circumstances, it is reasonable to conclude that the person ‘intended or contemplated when entering into the contract that R&D of that sort would be undertaken in order to meet those obligations’.

Essentially, for a contractor relationship to exist, a contractor must have been engaged for services or activities to be carried out on behalf of the company (the contract can be written, verbal or implied). Those activities must involve qualifying R&D as per the DSIT guidelines. The company must also have intended or contemplated that the R&D would take place at the point the contractor was engaged. Ideally, there should be evidence in the contracts that outlines the specific activities to take place and prescribes the R&D to be undertaken.

The surrounding circumstances as referred to in condition (c) above include intellectual property (IP) ownership, financial risk associated with the work, the degree of autonomy involved in carrying out the work, the means by which the R&D is ultimately to be exploited, the decision-making process, the experience and seniority of decision takers and the nature of the parties. This not an exhaustive list. Each case should be assessed based on the individual circumstances of the claim to determine whether there are contractor costs to be claimed.

Externally provided workers (EPW)

A person is an externally provided worker in relation to the claimant company for R&D purposes if the following conditions are satisfied:

A. The worker is an individual (not a company)

B. The worker is not a director or employee of the company

C. The worker personally provides, or is under an obligation personally to provide, services to the company

D. The worker is subject to supervision, direction or control by the company as to the way those services are provided

E. The worker’s services are supplied to the company through a staff provider (whether or not he or she is a director or employee of the staff provider or staff controller or any other person)

F. The worker provides, or is under an obligation to provide, those services personally to the company under the terms of a contract between the worker and a person other than the company (the staff controller)

G. The provision of those services does not constitute the carrying on of activities contracted out by the company

EPW summary

In summary, EPWs operate like employees of the claimant company for the period they are engaged, but are provided by a third-party staff provider, such as an agency or personal service company. It is this staff provider who invoices for the provision of the EPW. Where the staff provider operates PAYE in relation to the EPW in question, there is no need to review the terms of the contract between the staff provider and EPW in detail as conditions (c) to (g) above are covered off.

There is also a relevant interaction with the off-payroll working rules (IR35) with regards to claiming costs for EPWs. As the individual must personally provide the services, and must be under the supervision, direction and control of the company to be an EPW, it is virtually impossible for an individual to be eligible as an EPW and outside of IR35. Therefore, if there is a circumstance where EPW costs are being claimed for an individual deemed to be outside of the scope of IR35, we would strongly recommend a thorough review is completed as this is very unlikely to be compliant.

R&D expenditure – Contracted out R&D vs expenditure on EPWs

When categorising the costs for inclusion in your R&D claim, it is important to consider whether third-party costs indicate that there is a contractor relationship or externally provided workers.

Generally, a contractor relationship will be one where the third party is engaged to deliver an activity or service under a specific scope of work or with specific deliverables, but the manner in which that is delivered is up to the third party and there is a degree of autonomy.

Where an EPW relationship exists on the other hand, the staff controller would have provided individuals who are personally required to work under the supervision, direction and control of the company with limited autonomy, and are usually charged out on a time-spent basis.

On the one hand, where the contracted out R&D or expenditure on EPW costs relate to unconnected parties, then the claimable amount of the cost paid to the contractor or staff provider in relation to the R&D undertaken is restricted to 65% of the total.

On the other hand, where the contracted out R&D or expenditure on EPW costs relate to connected parties, the claimable amount is the lower of the amount paid in relation to the R&D, and the relevant expenditure of the contractor (costs incurred by the contractor which fall into qualifying cost categories for R&D) or staff provider (costs which qualify for R&D as staff costs).

Contractor chains

Where the customer engages a contractor for R&D and that work is subsequently subcontracted out by the contractor, the customer is still eligible to claim for the contractor costs. This is because the subcontractor has been engaged in order to fulfil the initial contract to the customer, who intended or contemplated the R&D at the point of contract. The rules apply both up and down the chain. Therefore, it is important to consider the nature of the engagement and the contracts in place to determine who can claim for any R&D undertaken both when work is contracted out and when work is contracted to the company in question. In general, checking the position as per the contracts is key to avoid two companies making a claim for the same R&D costs.

Irrelievable clients

If a company carries out R&D contracted out to it by a third-party, it can still claim for the work if the third-party is an ‘irrelievable client’. An irrelievable client is an ineligible company (a charity, higher education institute, scientific research organisation or health service body). It also includes ‘any person not acting in the course of a trade, profession or vocation within the charge to tax in relation to the contracting out of the R&D by that person’ such as a company based overseas.