Back in September 2021, we looked at HMRC’s change in approach with regards to client-led R&D and the impacts that this could have on genuine SME claims.  A recent HMRC case shows the outcome may not be as bleak as originally anticipated.

Previously it appeared that HMRC were changing their approach with regards to client-led R&D, with an active move towards reclassifying any expenditure incurred on enhancing the company’s knowledge prior to fulfilling a customer’s order as “subsidised” or “subcontracted”.  HMRC’s revised argument being that the customer is paying for a service, including any company investment in R&D, and therefore it should be treated as fully subsidised.

By reclassifying this element of R&D as subsidised or subcontracted the company would fall within the RDEC scheme, with only R&D carried out to develop a new product or service qualifying for the more generous SME scheme.

A recent case, heard at the First-tier Tribunal (FTT) in October 2021 Quinn (London) Limited v HMRC, addresses this area.

Quinn is a construction company which is involved in high level projects, where other building companies are unable to complete certain elements.  As part of this service, they often undertake R&D to provide a solution to the customers building dilemmas.

Quinn made a claim for R&D tax relief under the SME scheme, however HMRC rejected this claim on the basis that the company was not entitled to R&D relief if the costs were otherwise met directly or indirectly by a person, other than the taxpayer.  HMRC argued that this was reinforced by the fact that the R&D expenditure Quinn incurred was as a result of solving a specific issue for the customer.  If the company were successful in solving such issue an invoice would be sent to the client, thereby meaning the end customer was paying for the R&D.

HMRC argued that where the taxpayer contracts with a client before or at the time of the R&D activity then the R&D is being subsidised indirectly by the client.  

Quinn argued that the payments received were a commercial return for the product itself and did not amount to a subsidy for the R&D expenditure, either directly or indirectly. 

In a welcome turn of events, the FTT ruled in favor of the company.  The FTT agreed that for expenditure to have been met, the customer must either directly meet the payment to the creditor or indirectly reimburse the company.  Furthermore, the payments would have to have a clear and direct link to the R&D expenditure.

The FTT stated that the law should be used to challenge expenditure which is paid for by way of a grant or as a result of state aid assistance.

The decision reached in Quinn appears to be in direct contrast, to the Hadee Engineering Co v HMRC case back in 2020, whereby the FTT agreed with HMRC and rejected six out of seven projects within the company’s SME R&D claim. 

In this case, HMRC were successful in arguing that the expenditure incurred was subsidised, however upon a closer look, the facts of this case are very different to that of Quinn.  For example, the company overstated salaries, had incomplete records to support the claim and the competent professionals were not able to provide insight into the technical complexities of the development work undertaken.

Hadee can also be distinguished from Quinn as Hadee Engineering invoiced their customers and were paid specifically for hours spent during the design and development process.  This showed that there was a direct link between the R&D and the amounts paid by the customers, resulting in the R&D being subsidised.

Whilst the judgement reached in Quinn does not set legal precedence it does provide some clarity on how the subsidised condition should apply and is welcome news to SMEs who contract with clients to deliver products or services where the R&D is required to produce said products or services.

The Chartered Institute of Taxation has approached HMRC for further clarity on the subsidised expenditure and contracted out R&D when HMRC conduct the next steps of their ongoing review of the R&D tax relief schemes so hopefully we will have a much clearer definition in the not to distance future.