Subcontracted and Subsidised Expenditure
HM Revenue & Customs (HMRC) has rolled out significant updates to its R&D Tax Credit guidance, specifically addressing subcontracted R&D work and subsidised R&D expenditure. These changes, published in late February 2025, aim to clarify how businesses can claim tax relief when projects involve external funding or contracted work. In this blog post, we break down the latest HMRC updates (found in HMRC’s internal manual sections CIRD81650 and CIRD84250) and explain what they mean for SMEs, accountants, and financial professionals. We’ll cover what counts as subsidised R&D, how subcontracted R&D is now interpreted, the impact on R&D tax relief claims, and steps businesses should take in response.
Historically, HMRC took a strict stance on R&D projects that had any outside funding or were done on behalf of another company – often denying SME R&D tax relief in such cases. However, recent First-Tier Tax Tribunal cases (such as Collins Construction Ltd and Stage One Creative Services Ltd) challenged HMRC’s interpretations. The tribunals found that HMRC’s “blanket” approach was too rigid, especially where the R&D work was not explicitly paid for or required under a contract. HMRC opted not to appeal these decisions and instead updated its guidance in February 2025 to reflect a more nuanced, case-by-case approach
What’s new? The revised HMRC internal manuals (sections CIRD81650 on subsidised expenditure and CIRD84250 on subcontracted R&D) now clarify definitions and provide examples following those tribunal rulings. The goal is to ensure genuine R&D undertaken by SMEs isn’t unfairly excluded from relief simply due to the way projects are funded or contracted. Let’s delve into the specifics of the two key areas: subsidised R&D expenditure and subcontracted R&D activities.
In the context of R&D tax credits, “subsidised expenditure” refers to R&D project costs that are met (funded) by someone other than the company itself which, under the SME R&D relief scheme, does not qualify. HMRC’s updated guidance in CIRD81650 defines what counts as a subsidy:
Notified State Aid Grants
If an R&D project has received any funding classified as notified State Aid, then no expenditure on that project can qualify for SME R&D tax relief. In practice, this means certain government grants (e.g. some COVID-19 support loans or EU state aid grants) automatically disqualify the entire project from the more generous SME scheme.
Other Grants or Subsidies
If the company received a grant or subsidy that is not a notified State Aid, the R&D expenditure is considered “subsidised” only to the extent of that subsidy amount. In other words, part of the project’s cost may still qualify for SME relief once you subtract the subsidised portion. The subsidised portion could instead be claimed under the Large Company scheme or RDEC (Research and Development Expenditure Credit) if eligible. This hybrid approach is important – it means an SME might split an R&D claim, with the unsubsidised costs under the SME scheme and the subsidised costs claimed at the lower RDEC rate.
Indirect Funding (Client Payments)
Crucially, HMRC confirms that “subsidy” isn’t limited to official grants. If any other party – whether a customer, contractor, or other third party – funds the R&D costs directly or indirectly then those costs are considered subsidised to the extent of that contribution. For example, if a client pays you for a project and part of that payment covers R&D work you did, HMRC may view that portion as externally met. This was a central argument in recent tribunal cases, and HMRC now concedes that each scenario must be examined to see if there’s a direct link between the payment and the R&D.
HMRC’s updated manual provides practical examples of what is or isn’t deemed “subsidised” in light of these clarifications:
What HMRC considers Subsidised
Situations where funding is specifically tied to the R&D. For instance, if a company receives money and provides nothing in return (or less than a commercial value) except the R&D outcome, that funding is effectively a subsidy for the R&D. Similarly, if there’s a clear link between funds provided and the R&D project spend – even through connected parties or structured arrangements – HMRC will treat it as subsidised expenditure. The guidance emphasizes looking at the facts: if it looks like the company’s R&D was financially covered by someone else’s money, it likely falls under “subsidised expenditure”.
What is Not Subsidised
HMRC also outlines cases that do not count as subsidised. For example, if a company performs R&D on its own account and later sells the resulting product or service, the revenue from those sales isn’t considered to have “met” the R&D costs. Normal commercial revenue after the R&D is fine – it doesn’t retroactively become a subsidy. Likewise, general commercial loans or investments are not treated as subsidising the R&D, since they’re not earmarked to reimburse specific R&D costs. Crucially, if a company receives payment under a contract but the R&D activities were not explicitly contracted or required by that other party, those payments aren’t automatically viewed as subsidising R&D. The rationale is that the R&D was done for the company’s own purposes, even if it occurred during a contracted job.
A real-world example: HMRC’s guidance describes a scenario where Company A (an SME construction firm) was hired by Company B to replace a roof; the contract was for a standard job (no R&D requirement in the agreement). During the work, Company A decided on its own to attempt an R&D approach by innovating a new fitting technique. Company B paid the agreed contract price, which ended up covering the costs of the R&D along with the regular work. According to HMRC, Company A’s R&D was not “subsidised” by Company B’s payment, because the payment was just for the roof installation as per contract, not specifically to reimburse R&D costs. The R&D was incidental and not something Company B explicitly funded or asked for. This example illustrates that incidental R&D, even if done during a customer project, can still qualify for SME relief – it wasn’t disqualified as subsidised, since the client’s money wasn’t a targeted R&D subsidy.
It’s worth noting that if an SME’s only barrier to claiming under the SME scheme is that the project was subsidised, they may still claim R&D relief under the RDEC (large company) scheme for those costs. This has been the case for years, but the updated guidance reinforces hybrid claims. Also, State Aid notifications still trump everything – if the funding was a notified State Aid (for example, certain Innovate UK grants or COVID state aid loans), the project cannot get SME relief at all. In such cases, the RDEC is the only possible route if conditions allow.
It’s worth noting that if an SME’s only barrier to claiming under the SME scheme is that the project was subsidised, they may still claim R&D relief under the RDEC (large company) scheme for those costs. This has been the case for years, but the updated guidance reinforces hybrid claims. Also, State Aid notifications still trump everything – if the funding was a notified State Aid (for example, certain Innovate UK grants or COVID state aid loans), the project cannot get SME relief at all. In such cases, the RDEC is the only possible route if conditions allow.
Navigating Changes to R&D Relief? Let’s Optimise Your Claims.
The second big area of clarification is what counts as subcontracted R&D under the tax credit rules. Under the SME scheme rules, if an SME is performing R&D “as a subcontractor” (i.e. activities contracted to it by another company), that expenditure does not qualify for the SME R&D tax relief deduction. This rule exists to prevent two parties claiming relief on the same R&D and to ensure the incentive primarily rewards the ultimate innovator (usually the client who commissioned the work). However, the crux of the matter is defining when R&D is considered “contracted out” to the SME vs. when the SME is actually doing the R&D on its own behalf.
HMRC’s updated guidance (CIRD84250) now stresses a case-by-case factual assessment. There is no single test – instead, HMRC will look at various factors to judge whether the SME’s R&D was an integral part of a contract with a customer (thus subcontracted) or merely incidental or independent (thus not subcontracted). Key factors and scenarios include:
Incidental vs Required R&D:
The most important consideration is whether the R&D was explicitly required by the customer or contract. If the principal (customer) clearly needed R&D to be done as part of delivering the contracted product/service, then the R&D is likely “contracted out” to the SME. For example, if a contract or project specification implicitly or explicitly says the solution must involve some innovation or development beyond the current state-of-art, any R&D done to meet that requirement is probably subcontracted R&D. Conversely, if the R&D happened to be done by the SME on its own initiative (not mandated by the client) – essentially incidental to the contract – then it’s not treated as subcontracted. HMRC even notes that just because a contract doesn’t mention R&D, it doesn’t automatically mean R&D wasn’t contracted; and likewise a clause claiming “R&D belongs to the client” isn’t conclusive by itself. They will look at the surrounding circumstances: Was the customer aware that R&D might be needed? Did they ask for something novel? If the client was aware and expected R&D, that leans toward subcontracted R&D. If the client simply ordered a product/service and the supplier chose to do R&D unprompted, that looks incidental (not subcontracted).
Financial Risk & Payment Terms:
HMRC also looks at who bears the financial risk of the R&D. R&D projects are uncertain by nature; if the contract is structured so that the SME gets paid regardless of R&D success or failure, then the SME isn’t taking on much risk, which is characteristic of contracted-out R&D. For example, a contract might guarantee payment for effort, even if the research doesn’t achieve the desired result. That would indicate the work was commissioned (contracted) by the client, since the client essentially underwrites the risk. Conversely, if the SME is compensated exclusively upon successful delivery (such as receiving a fixed price upon completion, without additional compensation for extended research and development time), the SME assumes the risk. This arrangement suggests that the R&D is conducted on the SME's own account rather than being contracted, as the SME bears the financial burden should the research prove unsuccessful. In the updated examples, a company performed R&D during a fixed-price contract and would receive no compensation if they failed to deliver, supporting the position that the R&D was not customer-contracted, as the SME had a significant financial stake in the outcome.
Degree of Autonomy and Control:
Another factor is how much control or direction the client (principal) exerted over the work. If the SME had a high degree of autonomy in deciding how to carry out the project (including any R&D methods), this independence suggests the R&D was not directly contracted out but rather undertaken at the SME’s discretion. On the other hand, if the client was closely involved – setting specific R&D objectives, requiring progress updates, or guiding technical aspects – it points to the R&D being part of the contracted deliverable. For instance, a principal who effectively says “I need you to research and develop X for me, and here are the exact parameters” is clearly contracting out R&D. The updated guidance implies that greater client involvement = more likely a subcontracted R&D scenario.
Intellectual Property (IP) Ownership:
Who ends up owning the intellectual property resulting from the R&D can also be a clue, though HMRC notes this is a weaker factor than the above. If the client retains all results/IP rights exclusively, it might suggest they commissioned the R&D. If the SME retains the IP or at least the know-how, it suggests the R&D was for the SME’s benefit. However, the guidance cautions that an SME always retains the “know-how” it gains from doing R&D, so simply keeping knowledge isn’t a definitive sign of independence. But if, for example, the contract explicitly states any patentable invention belongs to the client and the SME cannot use it elsewhere, that would weigh towards a subcontracted arrangement.
HMRC’s manual CIRD84250 provides illustrative examples to show how these factors combine in practice:
Example 1 (Not Subcontracted):
A construction company (Company A) is hired for a routine job (building a roof) with no requirement to do R&D. Company A independently decides to attempt an innovative method (R&D) during the job. The client just wanted a standard roof and had no input into the R&D. Company A had full autonomy in doing the research, and if the experiment failed, Company A would have borne the cost (no guaranteed payment). This R&D was incidental and not contracted out by the client. Company A can claim SME R&D relief on that work (since it wasn’t done for someone else’s R&D project). This scenario mirrors the earlier subsidised example – reinforcing that incidental R&D remains eligible for relief.
Example 2 (Subcontracted R&D):
An engineering SME (Company C) contracts with a food manufacturer (Company D) to design a new high-speed machine, with specs which push beyond existing technology. The contract doesn’t explicitly mention “R&D”, but both parties understood that achieving these specs required research and development by Company C. Company C does the R&D, builds the machine, and delivers it under a fixed-price contract. Here, even though Company C had some freedom in how to do it, the R&D was necessary to fulfil Company D’s request and was implicitly part of the deal. HMRC concludes this was R&D contracted out to Company C. The project’s nature (client-needed innovation) made the R&D an integral contracted activity, so Company C cannot claim SME relief on that expenditure. (Company C might instead claim under RDEC if eligible.)
Example 3 (Not Subcontracted – Collaborative Scenario):
A tech company (Company E) sells a product and a key customer (Company F) requests an improvement (50% energy efficiency boost) and promises to place a big order if achieved. Company E undertakes R&D to improve its product, and Company F will buy units only if the goal is met – there’s no guarantee, and no direct funding from F for the R&D itself. In fact, Company E exceeds the target and even raises the price per unit (which the customer accepts) and keeps the resulting IP (patents a new part). This scenario might be influenced by a customer’s request, but Company F did not contract Company E to do R&D – it was Company E’s choice to pursue it (with the hope of a sale). The risk was all on Company E (no one reimbursed their costs if they failed) and Company E retained control and IP. HMRC deems this not subcontracted – Company E’s R&D is on its own account and can qualify for relief.
These examples highlight the newly nuanced approach: it’s the substance of the arrangement that matters, not just the contract wording. Going forward, HMRC caseworkers will examine factors like project requirements, correspondence, and conduct to decide if R&D was contracted out. Simply having a clause about R&D in a contract (or not having one) is not decisive on its own.
Impact on Businesses Claiming R&D Tax Relief
HMRC’s updated stance on subcontracted and subsidised R&D expenditure has several implications for companies and their advisors:
More (Potential) Claim Opportunities
SMEs that previously assumed they couldn’t claim R&D tax credits because a project had some external funding or was done for a client may have new opportunities. The guidance makes clear that not all external involvement kills a claim. For instance, if you did unfunded R&D during a client project (incidental innovation) or received a non-State Aid grant that only covered part of your costs, you might still claim at least a portion under the SME scheme. Even the portion that was funded might be eligible under RDEC. This is a fairer outcome for companies that innovate while delivering work to customers.
Greater Scrutiny and Documentation Needs
On the flip side, claims will face more detailed scrutiny on these points. HMRC officers are now instructed to assess each claim in detail, looking at contracts, emails, meeting notes, and financial arrangements to determine if an R&D project was truly independent or was paid for by someone else. Businesses should be prepared to provide evidence that supports their position. For example, if you claim R&D relief for a project done alongside a customer contract, you should have clear documentation (contracts, correspondence) showing whether the customer expected that R&D or not. HMRC notes that companies should be able to explain the nature of the advance in knowledge sought and the role of any subcontractor if claiming subcontracted costs. If you paid a third-party for part of the R&D, you’ll need to show how you directed that work and that it was part of your R&D project. Essentially, robust record-keeping and contemporaneous evidence are more important than ever to substantiate that your claim fits the updated rules.
Possibility to Revisit Past Claims
The new guidance was prompted by tribunal wins for taxpayers. If your company had an R&D claim denied in the past solely because HMRC viewed it as subcontracted or subsidised, it might be worth revisiting with an advisor. While HMRC hasn’t announced any automatic reversals, the more flexible interpretation could support a challenge or an appeal for recent claim rejections, especially if still within amendment windows. At the very least, future claims can be prepared differently to highlight these factors and avoid incorrect denials.
SME vs RDEC Claims
Even with the changes, remember that the SME scheme and large company scheme (RDEC) are distinct. If you determine that an R&D project was subcontracted to you (your company was the subcontractor) or it received a disqualifying subsidy, you cannot claim the enhanced SME deduction/credit on that project. However, you may claim an RDEC credit (13% taxable credit, equivalent to ~10% net benefit) for that expenditure if you’re an SME, since RDEC is open to any size company in such situations. The guidance reiterates this pathway: SMEs not eligible under SME rules can fall back on RDEC for those costs when conditions are met. Keep in mind that from April 2024 onward, the government is merging R&D schemes, and some restrictions on subsidised projects will be lifted under the new rules
But for now (under the pre-2024 regimes), understanding these nuances ensures you claim under the right scheme.
To navigate these updates, here are some key points and action steps for companies involved in R&D tax relief claims:
Understand the Definitions:
Make sure you clearly distinguish whether your R&D project was subsidised, subcontracted, both, or neither. Use HMRC’s criteria as a checklist – was there external funding specifically for the R&D? Was the R&D done to fulfil a contract requirement for a customer? The answers determine which scheme (SME or RDEC) you can claim under, and how much of your spend is eligible.
Gather Supporting Documentation:
Given the greater emphasis on facts, gather all relevant evidence before claiming. This includes contracts (and all contract clauses or appendices), any emails or letters with clients about project scope, minutes from meetings where project expectations were discussed, and financial records of any grants or contributions. The documentation should demonstrate the nature of the R&D work and funding. For example, if the R&D was incidental, maybe have a project report indicating you did extra work not required by the client. If you received a grant, have the grant award letter to show whether it was notified state aid or not. If you engaged a subcontractor for part of your own R&D, keep the contract and instructions you gave them.
Review Contracts Carefully:
When entering new projects that involve R&D, consider how contracts are worded. While you cannot simply wordsmith away reality, a well-drafted contract can clarify whether R&D is part of the deliverable or not. If you want to preserve your ability to claim SME relief, be cautious about contracts that put all innovation risk on the client or explicitly make you do R&D for them. Conversely, if you’re fine claiming RDEC, it may be less of an issue. The key is that the contract and actual project practice align – inconsistencies will be probed by HMRC.
Monitor HMRC Communications:
These updates are part of a changing R&D tax landscape in the UK. Further guidance and possibly legislative changes (like the upcoming merged R&D scheme for 2024/25) are on the horizon. Stay informed through HMRC updates, professional body newsletters, or blogs (like this one!). Being aware of the latest rules will help you optimise claims and remain compliant.
Consider Professional Advice:
If there’s any doubt about how these rules apply to your situation, seek expert guidance sooner rather than later. The nuances of subcontract vs subsidised can be tricky, especially if large sums are at stake. A qualified R&D tax credit advisor or tax accountant can review your projects and contracts to determine the best approach. They can help structure your claim so that it clearly fits HMRC’s criteria, maximising your eligible relief while avoiding red flags. Given that HMRC is increasing scrutiny on R&D claims (to tackle abuse and ensure accuracy), having an expert involved can provide peace of mind and save you from costly mistakes or missed opportunities.
HMRC’s 2025 updates on subcontracted and subsidised R&D expenditure represent a positive move towards clarity and fairness in R&D tax credits. By acknowledging recent tribunal decisions, HMRC is allowing a more flexible interpretation that can benefit genuine innovators – particularly small and medium-sized businesses working on customer projects or with partial funding. However, with more nuance comes the need for careful documentation and understanding of the rules.
Link to detailed HMRC Guidance:
Subsidised Expenditure: CIRD81650 – R&D tax relief: conditions to be satisfied: subsidies (SME scheme only) – HMRC internal manual – GOV.UK
Subcontracted Expenditure: CIRD84250 – R&D tax relief: categories of qualifying expenditure: subcontracted activities – meaning of subcontracted – HMRC internal manual – GOV.UK
If your business is engaged in R&D, it’s crucial to assess how these changes affect your tax relief claims. Are you properly identifying which projects qualify under the SME scheme versus RDEC? Do you have the evidence to back up your claim if HMRC asks for justification on whether work was contracted out or subsidised? Now is a great time to review your recent and upcoming R&D projects with these questions in mind.
Need help? Navigating R&D tax relief can be complex, but you don’t have to do it alone. Reach out to Innovation Tax to ensure you’re claiming correctly and maximising your eligible relief. An expert can provide tailored advice, help you document your R&D activities appropriately, and even assist with HMRC enquiries should they arise. With potentially tens of thousands of pounds in tax savings on the line, getting it right is key.
Take action now – review your projects, update your claim approach in line with HMRC’s latest guidance, and seek professional support to make the most of your R&D tax credits. By staying informed and prepared, your business can confidently innovate knowing you’re getting the full benefit of the government’s R&D incentives.