Everything small businesses should know about the Merged R&D scheme

The UK is implementing one of the most significant overhauls to its research and development (R&D) tax rules in over a decade. The introduction of the merged R&D scheme is designed to simplify the existing R&D tax incentive framework while enhancing accessibility and clarity for businesses.

Understanding the Merged R&D Scheme

At its core, the merged scheme consolidates the two primary UK R&D schemes: the SME scheme and the RDEC (Research and Development Expenditure Credit) scheme, creating a single, above the line credit structure that largely mirrors the RDEC rules.

This new approach is complemented by the continuation of the Enhanced R&D Intensive Scheme (ERIS), which targets SMEs meeting stringent R&D intensity requirements.

The merged scheme applies to accounting periods commencing on or after 1 April 2024. The updated relief rates are available here and provide a clear guide for businesses planning their R&D expenditure and claiming tax relief.

Why the Merged Scheme Matters for Businesses

Going forward, most companies claiming R&D tax relief will operate under the RDEC framework. While the legacy SME rules will persist for Enhanced R&D Intensive Scheme ERIS, businesses must note that eligibility is now more restrictive and based on updated R&D intensity thresholds. This means fewer companies may qualify under the traditional SME scheme unless they meet these new, higher intensity requirements.

Here are the key change in the new R&D tax credits:

• Most companies will follow RDEC rules for claiming R&D tax relief.
• ERIS will continue under SME rules but with stricter eligibility, based on R&D intensity.
• Contracted-out and contracted-by rules have changed, potentially reversing previous entitlements.
• Non-UK costs are generally excluded, with narrow exceptions.

The revised rules can, in certain circumstances, revoke previous entitlements, particularly in complex contracting situations. Additionally, non UK costs are generally excluded from R&D claims, with only a narrow set of exceptions.

Overseas R&D Costs

Under the merged scheme, R&D activity must either occur physically in the UK or be undertaken by individuals on UK payroll for the costs to be eligible for R&D relief. There are exceptions, known as ‘Qualifying Overseas Expenses’ (QOE), but these are limited to very specific circumstances.

To qualify as a QOE, the overseas expenditure must satisfy three conditions:

1. The necessary conditions for the R&D to occur (geographical, environmental, social, legal, and regulatory) are not available in the UK.
2. The required conditions are present at the overseas location where the R&D is performed.
3. Replicating those conditions in the UK would be wholly unreasonable.

HMRC requires clear, independent evidence to demonstrate that replicating conditions in the UK is unreasonable. This could include correspondence with relevant regulatory authorities or similar documentation. Importantly, relocating R&D overseas solely for cost efficiency or access to skilled workers does not qualify as a valid reason. Certain expenses, such as group company secondments to the UK, may still be eligible.

It is worth noting that these overseas restrictions apply specifically to outsourcing costs. Other expenditure, such as importing consumables or staff costs linked to overseas branches, may still qualify.

Contracted-Out R&D Under the Merged Scheme

The rules governing contracted-out R&D have been extensively revised. Understanding the changes is easier when framed in terms of upstream and downstream supplies within a supply chain.

1.The Old Rules

Prior to 1 April 2024, companies claiming RDEC could only claim costs for subcontracted R&D if the work was outsourced to a limited number of qualifying bodies, such as universities, not-for-profits, or eligible individuals/partnerships. SMEs, in contrast, could claim 65% of the costs for most downstream subcontractor payments, irrespective of the subcontractor’s identity.

Upstream, RDEC claims could only include qualifying projects if the upstream customer was large or outside the UK corporation tax scope. This also applied to SMEs claiming RDEC because they did not meet the original SME scheme criteria due to subsidised or subcontracted R&D.

SME claimants had to consider upstream supplies where these represented subsidised or contracted out R&D (governed by RDEC rules). There were no significant downstream restrictions beyond the 65% cost limit.

2. The New Rules

From 1 April 2024, the merged scheme simplifies the upstream and downstream distinction but enforces stricter claiming rules. HMRC has made it clear that only one party in a contract can claim the R&D relief for the same underlying activities.

3. Upstream Considerations

Under the new framework, the company that decides to commission the R&D activities is generally the one entitled to claim RDEC. There are four exceptions:

1. The customer is ineligible (e.g., charities, universities, state sector organizations, or non-UK corporates).
2. By election within a UK group structure.
3. Where it was always “contemplated and intended” that the subcontractor would perform the R&D.
4. Where no supply chain exists, meaning the work is purely in house and unrelated to a customer contract.

4. Downstream Considerations

1. Companies can claim for contracting out costs, even if the subcontractor further outsources the work.
2. If R&D is directed by a customer, the customer usually retains the claim, not the subcontractor.

5. New Complications

The concept of activities being “contemplated and intended” by the subcontractor introduces potential confusion. HMRC has issued guidance to clarify this, but in practice, the ultimate customer in the supply chain often controls who can claim R&D relief.

As a result, all companies within a supply chain need to review their upstream and downstream contracts carefully. If HMRC determines that a customer, rather than a supplier, owns the claim, the RDEC entitlement could shift up the chain, impacting accounting disclosures, profitability and valuations.

These effects can cascade throughout the entire supply chain, leaving companies lower in the chain potentially unable to claim any RDEC. Moreover, claiming RDEC incorrectly can result in HMRC denying the claim for the company, even if the statutory claim period has lapsed for the correct party.

6. Other Considerations

For accounting periods starting on or after 1 April 2024, transitional rules may apply where overlapping periods create timing conflicts. In such cases, the old rules typically take precedence, often benefiting subcontractors.

Additionally, with the changes to contracted out R&D rules, the previous provisions regarding subsidised expenditure have been removed. This expands eligibility for companies with grant funded or subsidised R&D projects, which were previously restricted.

Claiming R&D Relief Under the Merged Scheme

The merged scheme introduces multiple rates of tax benefit and credit depending on whether a company is profit making or loss making. Eligibility and rates can also vary depending on the company’s accounting period, especially for periods spanning 1 April 2023 or 2024.

The SME category still exists but now requires careful consideration within the context of the Enhanced R&D Intensive Scheme (ERIS), which operates alongside the merged RDEC scheme.

Although the revised subcontractor rules attempt to clarify entitlement, real world implementation can create complexity and uncertainty. Businesses must carefully assess contracts to determine which entity is entitled to claim R&D relief and ensure compliance with HMRC guidance.

How We Can Help

Our team of experts provides comprehensive support in reviewing existing and proposed contracts for R&D activities, ensuring clarity on who can claim relief under the merged scheme.

Contact us today to discuss your circumstances and secure the right support for your R&D claims.

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