Subcontractors for R&D Tax Credits

What HMRC Accepts

A subcontractor under the R&D rules is a third party engaged by the claimant to carry out a portion of the qualifying R&D on an outcome basis. The defining test is that the subcontractor takes the brief and decides how to deliver it, bearing the delivery risk, rather than providing time under the claimant's supervision.

Typical subcontractors in R&D claims include specialist engineering firms hired for a discrete technical deliverable, contract research organisations engaged to run a specific research package, prototype fabricators commissioned to build a one-off unit to given specifications, and university research groups running a funded collaboration.

Where the parties are unconnected, the claimable subcontractor cost is 65% of the portion of the payment that relates to qualifying R&D activity. Where the parties are connected within the meaning of sections 1122 and 1123 of the Corporation Tax Act 2010, a different calculation applies based on the subcontractor's own relevant expenditure.

Apportionment

Subcontractor apportionment usually has one main dimension: the fraction of the subcontractor's work that qualifies as R&D activity. For an outcome that is entirely within R&D scope (for example, building a prototype to specification), the apportionment is 100%. For a mixed engagement covering some R&D work and some routine service delivery, the payment is split accordingly.

Evidence for subcontractor apportionment typically rests on the statement of work, delivery notes, invoices broken down by milestone or work package, and documentation of what the subcontractor actually did.

What Is Included

• Payments to unconnected subcontractors for qualifying R&D activity, at 65% of the qualifying portion.
• Payments to qualifying bodies (universities, research charities, specified research organisations) at 65%, with specific protections under the merged scheme.
• Payments to connected subcontractors at the calculated relevant-expenditure figure.
• Irrecoverable VAT forming part of the subcontractor payment.

What Is NOT Included

• The 35% residual above the 65% cap for unconnected subcontractors.
• Payments for non-R&D work delivered by the subcontractor.
• Payments to overseas subcontractors where the work is performed outside the UK, for periods beginning on or after 1 April 2024 (outside the narrow exception).
• Payments that are really for externally provided worker services (day-rate time-based arrangements under the claimant's direction) — these are EPWs, not subcontractors.
• Costs borne by the subcontractor that it did not recharge to the claimant.

Merged Scheme Changes

Under the old SME scheme, payments to overseas subcontractors engaged on qualifying R&D were eligible. Under the merged scheme, they generally are not. This change has removed significant claim value for companies that used offshore development teams, contract manufacturing in lower-cost jurisdictions, or international specialist partners.

The 65% cap is unchanged. The connected-party rules are unchanged. The treatment of qualifying body subcontractors is broadly preserved under the merged scheme. The primary change is the UK provision rule.

The UK Provision Exception

The statute provides a narrow exception to the UK provision requirement. Overseas subcontractor cost remains claimable where all of the following apply:

1. The conditions necessary for the R&D work are not present in the UK.
2. The conditions are present in the overseas location.
3. It would be wholly unreasonable to replicate the overseas conditions in the UK.
4. The decision to use the overseas provider was not made for reasons of cost or availability of workers.

The exception is intended to cover specific scenarios such as climate or geographical conditions (for example, deep-water marine testing in specific sea conditions), regulatory environments that cannot be replicated (certain clinical trial approvals), and environmental conditions that the UK simply does not provide. Routine offshore software development does not qualify; neither does cost-driven use of lower-priced overseas engineers.

Where a claimant believes the exception applies, specialist advice is essential. The documentation needed to support the exception claim is substantial.

Common Enquiry Risks

• Using subcontractor treatment for what is really an EPW engagement. HMRC scrutinises the direction-of-control question carefully.
• Claiming 100% instead of 65% for unconnected subcontractor cost. A consistent error.
• Claiming overseas subcontractor cost post-April 2024 without testing the exception. The largest current quantum adjustment area.
• Overstating the R&D-qualifying portion of mixed engagements. Splits need to be evidenced in the contract and invoicing.
• Mis-applying the connected-party rules. Groups often miss this and apply 65% when the cost-based calculation should apply.
• Failing to track the split calculation for straddling periods. Subcontractor invoices before and after the split date follow different rules.

Worked Example (Indicative)

A medical device company engages a UK-based contract research organisation to run a specific pre-clinical research package in the year to 31 March 2026. The statement of work describes a novel test protocol developed to resolve a genuine technical uncertainty. Total payment to the CRO: £180,000. The CRO is unconnected to the claimant.

The whole engagement is within R&D scope (100% qualifying portion). Claimable subcontractor cost: £180,000 x 100% x 65% = £117,000.

At the 20% merged scheme credit rate, this contributes £23,400 gross credit. Net benefit after corporation tax at 25% is approximately £17,550. Under ERIS at 27%, gross credit would be £31,590. Figures are indicative.

Qualifying Bodies: Universities and Research Organisations

The Corporation Tax Act 2009 recognises a class of qualifying bodies whose subcontracting treatment has historically been favourable. Qualifying bodies include:

• UK universities listed in the HMRC schedules.
• Charities engaged in scientific research.
• Health service bodies.
• Scientific research organisations specifically recognised by HMRC.

Under the merged scheme, payments to qualifying bodies for R&D activity remain claimable at 65% on the same basis as unconnected-party subcontractor payments. The qualifying body route is particularly relevant for companies collaborating with academic partners on Innovate UK projects or similar grant-funded research.

Where the qualifying body is based in the UK, the UK provision rule is automatically satisfied. Where the collaboration involves an overseas academic partner, the position is more nuanced and typically requires specialist review.

Subcontractors, IR35, and Personal Service Companies

A contractor operating through their own personal service company (PSC) can be classified in several different ways depending on the facts. Three patterns recur.

Direct engagement outside IR35. The claimant engages the PSC directly; the PSC and worker sit outside IR35. The PSC delivers an output under its own direction. This is typically a subcontractor arrangement, with the 65% cap applied to the claimant's payment to the PSC.

Direct engagement inside IR35. The claimant engages the PSC directly but the arrangement falls inside IR35 (the worker is a deemed employee for tax purposes). The claimant operates PAYE on a deemed payment. The R&D treatment here depends on facts but typically tracks the deemed-PAYE cost rather than the 65% subcontractor rule.

Engagement through a staffing agency. The claimant engages an agency, which engages the PSC. This is the classic EPW structure, with the agency as the staff provider.

The correct R&D classification follows the economic reality, not the label on the invoice. A specialist adviser will map each arrangement against the facts and choose the treatment with the strongest evidence base.

Documentation Supporting a Subcontractor Claim

HMRC expects subcontractor claims to be backed by an evidence pack that typically contains:

• The signed subcontract, including statement of work, deliverables, and payment terms.
• Invoices from the subcontractor showing work performed, milestones reached, and location of work (to support the UK provision rule).
• A breakdown of the subcontractor's contribution to qualifying R&D activity versus any non-qualifying work.
• Correspondence establishing the subcontractor's independence of direction (emails confirming the brief, deliverable reviews, acceptance notices).
• Where the UK provision exception is claimed: documentation of the geographical, environmental, regulatory, or social reasons that prevent UK delivery, and evidence that cost was not the driver.
• For connected-party subcontractors: the subcontractor's own cost records attributable to the R&D work.

When the UK Provision Exception Realistically Applies

The UK provision exception is narrow and fact-specific. Four scenarios illustrate the kind of case where it can apply, and the kind of case where it cannot.

Applies: deep-sea trial conditions. A marine technology company needs to trial an underwater sensor in abyssal conditions. The UK does not have coastline with the required depth profile, and the nearest suitable location is off an overseas coast. The overseas subcontractor cost for deploying the trial is likely within the exception.

Applies: regulatory environment. A biotech needs a specific clinical trial approval that a particular overseas regulator uniquely provides (for example, an orphan indication with a registry not present in the UK). The overseas subcontractor cost for the approval and trial activity may qualify for the exception.

Does not apply: offshore software development. A software company hires an Indian development team because engineer day rates are lower. Cost is the explicit driver. The UK has the same technical capability. The exception does not apply.

Does not apply: overseas manufacturing to established tolerances. A hardware company manufactures prototypes in China because of quicker lead times and supply chain proximity. Neither cost nor unique capability is the sole driver. The exception does not apply.

Specialist advice is essential when evaluating the exception. The documentation burden is substantial, and HMRC scrutinises exception claims carefully.

Connected-Party Subcontractor Mechanics

Where the subcontractor is a connected party, the 65% cap is replaced by a rule that looks to the subcontractor's own qualifying expenditure on the R&D work. The claim is limited to the lower of the payment made or the subcontractor's relevant expenditure attributable to the activity.

The rule is designed to stop a parent company paying a subsidiary above cost to inflate the R&D claim. In practice, most connected-party subcontractor claims end up close to the subsidiary's underlying R&D cost base, which is often less than 65% of a marked-up intercompany charge.

The mechanics require cost-side data sharing between the claimant and the subcontractor. For wholly owned subsidiaries, this is straightforward. For group structures involving joint ventures or partial ownership, the data-sharing burden can be significant.

A specialist adviser will also review the transfer pricing position on intra-group subcontracting. The R&D claim mechanics sit alongside, and interact with, the arm's length principle applied to connected-party transactions.

Pre-2024 Contracts and Transitional Cases

A subcontractor arrangement entered into before 1 April 2024 that continues to deliver work after that date is treated on a cost-incurred basis. Expenditure incurred under the contract before the split date follows the old rules (no UK provision requirement for SME claimants). Expenditure incurred after the split date follows the new rules (UK provision required).

This transitional treatment can preserve a share of historic offshore subcontractor spend for claims covering straddling periods. A specialist adviser will identify which invoices fall on which side of the split date and apply the correct rules accordingly.

Renewed or extended contracts deserve special attention: an extension signed after 1 April 2024 may be treated as a new contract for the purposes of the UK provision rule, even if the underlying relationship predates the merged scheme.

Related Cost Categories

• Externally provided workers — time-based engagements under the claimant's direction.
• Staffing costs — for in-house employees.
• Eligible Expenses pillar guide — full category framework.