One of the most generous aspects of the SME R&D tax relief claim is that companies can claim for subcontractor costs and externally provided workers (EPWs), commonly known as agency workers. However, claimant companies, especially SMEs, often find themselves dealing with ‘connected party’ rules.
There are a number of ways that two businesses may be regarded as connected parties. The most common way is that the claimant company either owns or is owned by another company. Another time connected parties rules apply is when there is a family relationship, such as businesses involving parents, siblings and children. In this article, we will give a brief overview of what subcontractors and EPWs mean, and we will discuss how the connected party rules may impact your claim.
Difference between subcontractors and EPWs
When it comes to undertaking innovation research and development, companies will often outsource work to other businesses that may have either the expertise or the equipment necessary to progress with a particular aspect of the project. Whatever the reason may be, for the purposes of R&D tax relief, it is important to ascertain the nature of the relationship between the claimant business and the subcontractors or EPWs in order to ensure that the costs are eligible to be claimed. But before we dive into that topic, let’s discuss the difference between the two types of worker.
|Subcontractor relationship||Externally provided worker relationship|
|– Typically undertake work on their own terms as experts in the field.|
– Have their own methods of working and work towards deliverables.
– The task that is subcontracted out is the responsibility of the business and not a particular individual.
– Work with a high level of autonomy, as long as projects or tasks meet deadlines, the subcontractor is free to manage themselves.
– Subcontractors tend not to take on the economic risk of the project. For example, say a discovery project goes ahead, subcontractors are paid to get the project done even if it ends up being not commercially viable for the claimant company.
|– A specific person is brought into the claimant business as an additional resource but is not on the business’s payroll, instead they are paid via a third party, such as a staffing agency.|
– The individual usually works at the premises of the business in question alongside the team undertaking the R&D, relying on the equipment provided by the business.
– EPWs are often paid for a particular amount of time (e.g. hourly, daily or monthly rates).
Dealing with subcontractor and EPW costs within the R&D tax relief claim
Unlike staff costs, where you can claim 100% of the staff costs that are relevant to the R&D project, for subcontractors and EPW you can only claim 65% of the relevant costs, unless they are deemed to be ‘connected’, which we will discuss in more detail in the section below. For these cost categories, the legislation reduces the claimable amount to 65% of the costs, so as to exclude any profit margin the third-party may be making on their services. We presume that the intention is to encourage businesses to carry out R&D work in-house rather than subcontracting it.
If you’re inputting information about your subcontractors and EPWs into Novel, the system’s auto financial apportionment function will apportion the costs to meet HMRC requirements automatically.
For example, we highlighted above that only 65% of subcontractor costs are eligible for R&D tax relief. Let’s imagine that we paid Enterprise Z £100,000 (ex VAT) for their services and they spent 100% of their time working on our R&D project.
When we go into Novel, we will insert the price as £100,000 and the apportionment as 100%. Novel will automatically apportion the financial information you add. In the financial overview section, you will see the relevant expenditures for your R&D claim, which is £65,000 or 65% of the costs incurred, as demonstrated in Image 1 and 2. Therefore, the system will allow you to see and understand your Total R&D expenditure alongside what you are eligible to claim as tax relief.
However, the 65% restriction does not apply when you are connected to your subcontractor or EPW. This is why you see there is a little tick box in Image 1 to establish whether the costs you are including are from a ‘connected party’.
What changes when subcontractors and EPWs are deemed a ‘connected party’?
For example, Business Seed owns Enterprise Z and enlists them to create a prototype for a bespoke commercial building design. This situation would be classed as a connected party because Business Seed owns Enterprise Z.
When you are dealing with subcontractors or EPW R&D costs of a connected party, you may be able to claim more or less than 65% depending on what actual costs were incurred by the service providers. The claiming company can only claim R&D tax relief on the lower of:
- The payment it makes to the subcontractor or EPW
- The costs incurred by subcontractor or staff provider
For part 1, payment amounts should be easily ascertained by the claimant company from its own accounting records. Part 2 requires access to the subcontractor/EPW’s accounting records. To ascertain the costs incurred by the subcontractor/EPW (known as the “relevant expenditure”), the claimant company will need to calculate the sum of the following:
- Staff costs (including gross salaries and wages, bonuses, employer’s national insurance contributions and pension contributions)
- Consumable items
- Software costs
- Clinical trial volunteers
Let’s take our previous example to outline the above. Business Seed paid £100k to Enterprise Z for their bespoke building mockups, but Enterprise Z’s costs for delivering the mockups were only £75k. Assuming that the full £75k was relevant expenditure, then Business Seed can claim the full £75k as R&D relief as it’s the lower of the two. Where it is established that the parties are connected, no 65% apportionment is required.
Therefore, to account for the ‘connected party’ rules within Novel, we’ve included a ‘connected’ tick box, which effectively will tell Novel not to apply the 65% apportionment. Instead, you will need to ensure that the costs are based on the categories listed above rather than invoice values including any markup.
If the parties are unconnected but you’re privy to the actual costs incurred in providing the R&D work, it’s worthwhile exploring whether electing to be connected is a worthwhile step to take. For example, if you’re engaging with a subcontractor who is open about their profit margin, which is, say, 20%, this is less than the unconnected restriction (35%) and it’s therefore beneficial to make an election, assuming both parties are happy. This will maximise the value of your claim.
For example, what if Business Seed decided to go another way and not enlist Enterprise Z for their mockups but instead use Cheap Designs Ltd, who also charge £100k for their service. However, their profit margin is much lower than Enterprise Z, notably their costs were £90k to deliver the design. As the profit margin was only 10% of the initial cost and is less than the unconnected restriction (35%), it would be more beneficial for Business Seed to elect to be considered as being ‘connected’ to Cheap Designs Ltd, as this would yield a bigger benefit.
In Novel, this would look like Img 3. By checking the ‘Connected?’ tick box, you will be able to edit the ‘Relevant Expenditure’ field to match what was the actual cost of the work as opposed to having the automatic 65% apportionment.
A word of caution: although choosing to be treated as elected companies may be beneficial for you, make sure to stipulate the time scale of how long you wish to be treated as ‘connected’. If you don’t do this, for the purposes of R&D tax relief, you will be treated as ‘connected parties’ for all payments under the same contract or arrangement. We suggest that the timescale you chose corresponds to your accounting periods and is supported by a contract with a predetermined end point.
Do your next R&D tax relief claim with Novel
The world of R&D tax relief can be daunting, which is why we created Novel. Full of educational pieces and intuitive features, Novel will help you generate HMRC-compliant R&D tax relief claims, quickly and efficiently in-house. Also, if you need any help along the way, you can reach out to our team of qualified R&D tax experts who will guide you along the way.