When preparing your R&D tax credits claim, one classification mistake can cost your company thousands in lost relief. With HMRC scrutiny increasing, understanding the difference between subcontractors and externally provided workers (EPWs) has never been more critical.
Get this wrong, and you could undervalue your claim or worse, trigger a compliance check. Get it right, and you'll increase your relief while staying fully compliant.
What is a Subcontractor?
A subcontractor is a third-party company you've contracted to carry out specific activities as part of your R&D project. They're engaged to deliver a particular outcome or service.
For example, a manufacturing company developing new machinery might subcontract specialised component testing to an external lab. The lab is responsible for delivering test results according to agreed specifications. They work independently to achieve the contracted outcome.
Key characteristics of subcontractors:
- They're separate companies, not individuals
- They deliver a specific outcome or service
- They work with relative autonomy
- They're usually responsible for their own project management
What are Externally Provided Workers (EPWs)?
EPWs are fundamentally different. They're staff augmentation, considered additional workers who operate under your company's direct supervision and control.
Also known as agency workers, EPWs are common in software development projects. You might bring in additional developers or engineers to scale your team whilst maintaining full project control. These workers integrate into your team structure, follow your processes, and work under your day-to-day direction.
Key characteristics of EPWs:
- They work under your supervision
- You direct their day-to-day activities
- They integrate into your team structure
- You maintain project control
The Control Test: How to Distinguish Between the Two
The critical question isn't what you call them—it's who controls the work. Ask yourself:
Who makes day-to-day decisions about the work? If your project manager is directing the work, assigning tasks, and making daily decisions, you're likely dealing with an EPW. If the third party manages their own workflow to deliver an agreed outcome, they're a subcontractor.
Who provides supervision and direction? EPWs work under your supervision. Subcontractors work independently, perhaps with milestone reviews or progress updates, but without ongoing direction from your team.
Who bears the responsibility for the outcome? If the contractor is responsible for delivering a specific result and has contracted to do so, they're a subcontractor. If your company remains responsible for the work output and the contractor is simply providing labour, they're an EPW.
Examples of Subcontractors vs EPWs
There are many ways you can include subcontractors or agency staff in your claim, but they will differ depending on the sector.
IT Sector: You hire a software development agency to build a complete authentication system for your platform. They design, develop, and deliver the finished system. That's subcontracting. If instead you bring in three developers from an agency who join your daily stand-ups, work in your repositories, and follow your sprint planning, those are EPWs.
Manufacturing: You contract a specialist firm to conduct heat resistance testing on new materials you're developing. They use their facilities and expertise to deliver test data. That's subcontracting. If you hire skilled technicians on a short-term basis from an agency to operate your equipment under your production manager's direction, those are EPWs.
Professional Services: You engage a consultancy to analyse market data and deliver a feasibility report. They work independently and deliver findings. That's subcontracting. If you bring in temporary analysts who work alongside your team using your methodologies, those are EPWs.
Cost Treatment Under Different R&D Schemes
How you classify workers directly impacts what you can claim and how much.
SME Scheme
The SME Scheme is only available to SMEs (as the name might imply) but you can only claim through it for accounting periods beginning before 1 April 2024.
Under the SME scheme, you could claim subcontracted costs, provided the R&D formed part of the contracting agreement, and for EPWs.
Both these categories were limited to 65% of the cost for unconnected parties (to account for the mark up). Connected companies can be fully claimed, assuming they were priced at arm’s length.
RDEC Scheme
Large companies faced stricter limitations under the RDEC scheme. Like the SME scheme, it is only available to eligible companies with accounting periods beginning before 1 April 2024.
You can only claim subcontracted costs when the contractor was an individual, a partnership of individuals, or a qualifying body (charities, universities, scientific research organisations, or health service bodies).
You can claim for work subcontracted to other SMEs or large companies. In these cases, the expenditure became "irrelievable" for you, but the contractor could claim for the work instead, using the RDEC scheme.
EPWs, however, could be claimed under RDEC.
The New Merged Scheme
The Merged Scheme, which applies to accounting periods beginning on or after 1 April 2024, brings significant changes, particularly for large companies.
Large companies can now claim subcontracted costs. This opens up substantially larger claims for established businesses with significant contractor relationships.
However, there's a critical new test: the "intended or contemplated" R&D requirement. The company initiating the R&D gets relief from that expenditure. If you intended or contemplated that R&D would be carried out by your contractor at the point of contract, you can claim for that work.
This shift affects SMEs too. If you previously claimed for R&D work contracted to you by large companies, you likely can't include those projects anymore, as the contracting party now claims them instead.
The 65% Rule: Connected vs Unconnected Parties
Not all contractor costs are treated equally. Whether the contractor is connected to your company dramatically affects your claim amount.
Unconnected Parties
For unconnected third parties, you can only claim 65% of the relevant costs. This accounts for the commercial markup built into third-party invoices.
Here's how it works: If 100% of an invoice is for R&D work, you claim 65%. If only 50% of the work is R&D, you claim 32.5% (half of 65%).
Why only 65%? HMRC recognises that third-party invoices include profit margins and overheads. The 65% figure is designed to reflect the actual cost of the R&D work, excluding commercial markup.
Connected Parties
The rules change completely for connected parties. You must undertake a "look through test”, examining the actual costs incurred by the connected party and claiming only eligible R&D expenditure at cost value, without markup.
You're connected if:
- The same person has control of both companies
- Connected people have control of the companies (spouses, civil partners, relatives)
- You're partners in a partnership
- You've made a joint election to be treated as connected
You and your contractor can elect to be treated as connected by writing to HMRC within two years from the end of the accounting period when the contract was entered. This allows you to claim full costs instead of the reduced 65%.
Director Restrictions
One absolute rule: Payments to contractors who are also directors of your company cannot be included in R&D claims.
Directors' costs can only be claimed through payroll:
- Salaries
- Bonuses
- Pension contributions
- Class 1 National Insurance paid by the company
We've seen companies attempt to claim directors as subcontractors or include directors' dividends. These don't qualify and will trigger compliance issues if included.
Determining Who Can Claim: The Intent Test
With all the changes to subcontracting rules, HMRC needed to clarify who could claim. The key question is: who intended the R&D to happen?
Clear Communication is Key
For you to claim subcontracted R&D, you must have "intended or contemplated" that R&D would be undertaken at the point of contract. This means clearly conveying:
- The advance in science or technology you're seeking
- The uncertainties that need to be addressed
- How the work fits into your R&D project
You can communicate this formally in contracts, in project discussions, or through internal documents. However, high-level contract wording isn't enough. A clause stating "Company A intends for R&D to be carried out by Company B" without describing the actual work proves nothing.
When the Contractor Can Claim
If you didn't intend or contemplate R&D at the point of contract, the contractor may claim instead.
HMRC provides this example:
Company B is contracted to provide a product or service which isn't R&D, such as constructing a building or developing a software product. From the contract and negotiations, it's clear the customer, Company A, had no understanding or intention that any R&D should take place. If Company B undertakes R&D in delivering that product or service, it could claim relief even though it's undertaking R&D on an activity contracted out to it.
This follows recent First-Tier Tax Tribunal decisions supporting contractors' claims when they initiated R&D to fulfil contractual obligations without the contracting party's knowledge or intent.
Surrounding circumstances matter too:
- IP ownership: Who retains intellectual property rights?
- Financial risk: Who bears the risk if the R&D fails?
- Autonomy: How much control does the contractor have over methodology?
- Decision-making: Did the motivation for R&D flow from your strategy or the contractor's tactical decisions?
Special Cases: Ineligible Companies
If the contracting party can't claim R&D tax relief (perhaps they're a charity, university, or government department) the contractor can claim regardless of who intended the R&D.
This prevents R&D work from going unclaimed when the natural claimant is ineligible. There's no risk of "double dipping" because the contracting party isn't making a claim anyway.
For more information on working out which company has the right to claim, check out our full blog here.
Navigating Transitional Provisions (2024 Rule Changes)
The shift between schemes creates complexity for companies claiming in different accounting periods. HMRC released specific guidance to ensure only one company claims any single expense.
The general principle: Rules favour companies who could claim under the old SME or RDEC schemes but can't under the Merged Scheme.
Example 1: SME (Old Rules) Contracting SME (New Rules)
Company A (an SME) contracts Company B (an unconnected SME) for work that's part of its R&D project but isn't explicitly agreed as R&D under HMRC’s new requirements. Company A's accounting period runs from 1 January 2024 (SME scheme) and Company B's runs from 1 April 2024 (Merged Scheme).
- Company A has a claim under old rules (subcontracted costs) but not under new rules (no specified R&D details)
- Company B has a claim under new rules (R&D it initiated) but not under old rules (can't claim work fulfilling a contract)
Result: Company A can claim. Company B cannot.
Example 2: Large Company (RDEC) Contracting SME (Merged Scheme)
Company C (a large company) contracts Company D (an SME) with clear R&D intentions communicated. Company C's accounting period runs from 1 March 2024 (RDEC) and Company D's runs from 1 April 2024 (Merged Scheme).
- Company C can't claim under RDEC (can't claim subcontracted costs to another company)
- Company D usually couldn't claim (intention was with Company C) but can claim this period since Company C is treated as ineligible
Result: Company D can claim. Company C cannot.
Example 3: SME (New Rules) Contracting SME (Old Rules)
Company E (an SME) contracts Company F (an unconnected SME) to deliver a product involving R&D. Company E's accounting period runs from 1 April 2024 (Merged Scheme) and Company F's runs from 1 March 2024 (SME scheme).
- Company E can claim under new rules (its contractor is unable to claim)
- Company F can't claim under old rules (did R&D to fulfil a contract)
Result: Company E can claim. Company F cannot.
Can You Pro-Rate Between Schemes?
No, you cannot pro-rate between the SME scheme/RDEC scheme and the Merged Scheme. Claims must be made entirely under one scheme or the other.
For companies with accounting periods beginning before 1 April 2024, the entire claim falls under the SME or RDEC scheme, even if the accounting period crosses 1 April 2024. You can't apply Merged Scheme rules to any portion of the period.
For example, a large company with an accounting period from 1 March 2024 can't claim any subcontracted costs, even though eleven of twelve months fall after 1 April 2024.
You can shorten or lengthen your accounting period to align with the rule change. Consider the broader implications, but for companies with substantial subcontracted costs, adjusting your period to fall entirely under the Merged Scheme could significantly increase your claim.
The PAYE/NIC Cap Issue
SMEs face an additional constraint: the PAYE/NIC cap on payable tax credits.
This cap limits the tax credit you can receive to £20,000 plus 300% of your total PAYE and National Insurance Contributions for the period.
The formula is: £20,000 + (3 × Total PAYE/NIC)
This particularly affects companies with low payroll costs relative to their R&D spend, often businesses with high subcontracting or EPW costs.
You're exempt from the cap if:
- Your employees are creating or managing intellectual property, and
- You don't spend more than 15% of your R&D expenditure on connected contractors or EPWs
If you're close to the 15% threshold, consider whether certain contractor relationships could be structured differently. Managing this percentage could unlock substantially more relief.
International Contractors: The UK-Only Rule
From accounting periods starting on or after 1 April 2024, only R&D activities physically performed in the UK by contractors can be claimed. This reflects the government's focus on benefiting UK-based innovation.
If your contractor performs R&D work overseas, you can't claim those costs, with very limited exceptions.
This applies regardless of:
- Where the contractor company is based
- Whether costs are lower overseas
- Worker availability in other countries
Cost savings and worker availability explicitly don't qualify as exceptions.
For more details on claiming for overseas work, including staff, contractors or EPWs, read our full blog here.
Preparing for HMRC Compliance Checks
With HMRC's Mandatory Random Enquiry Programme, any claim faces potential investigation regardless of quality. Strong documentation makes checks straightforward; weak documentation makes them expensive and time-consuming.
You’ll need to keep the following information on hand in the event of a compliance check:
- Contracting agreements: Don't rely on purchase orders. Your agreements should specify the R&D work being undertaken, the uncertainties being addressed, and the intended outcomes. Include technical detail, not just commercial terms.
- IP ownership documentation: Clear records of who owns intellectual property created during the project support your position on who initiated and controlled the R&D.
- Financial risk records: Document who bears the financial risk if the R&D fails or takes longer than expected. This helps demonstrate the true nature of the relationship.
- Decision-making documentation: Email trails, meeting notes, and internal memos showing who decided to pursue specific R&D approaches and why. This proves where the R&D originated.
- Time allocation records: For EPWs especially, maintain records showing how their time was spent and who directed their work. Timesheets with R&D codes integrated into your existing systems work well.
Key Takeaways
The distinction between subcontractors and EPWs significantly impacts your R&D claim amount and compliance risk.
For large companies, the Merged Scheme opens up new claiming opportunities. For SMEs, particularly those doing contracted R&D work, the rules have tightened. Understanding where you stand requires careful analysis of your contracts, working relationships, and documentation. Under the new Merged Scheme, the critical question is who intended the R&D to happen.
If you're preparing an R&D claim involving contractors or EPWs, proper classification and documentation from the project's outset will save you significant time and stress later. Whether you're unsure about your contractor relationships or want to ensure your documentation meets HMRC's standards, we're here to help.
To discuss your specific situation or get clarity on your contractor arrangements, get in touch with our experts.
