If you subcontract parts of your research and development work to third parties, you can still claim R&D tax credits on those costs. But the rules are different from when you use in-house staff. HMRC restricts the proportion of subcontractor costs you can include in your claim, and the restriction depends on whether the subcontractor is connected to your company.
Many business owners assume subcontractor costs are treated the same as direct employee costs. They are not. Get the classification wrong and you risk a full HMRC enquiry, repayment demands, and penalties. Get it right and you can claim legitimate relief on significant R&D spend.
This article covers how to claim R&D tax credits for subcontracted work under the current merged R&D scheme (from 1 April 2024) and the pre-April 2024 rules where relevant. We also cover the connected party rules, the 65% cap, and what records you need.
What Qualifies as Subcontracted R&D Work
Subcontracted R&D means you engage another party to carry out R&D activities on your behalf. You remain the company that is seeking to resolve the scientific or technological uncertainty. The subcontractor performs some or all of the work.
Common examples include:
- A software consultancy in Manchester's Northern Quarter building a prototype algorithm for your fintech product
- A specialist engineering firm in Birmingham's Jewellery Quarter developing a new manufacturing process for your hardware company
- A materials science lab in Bristol's Harbourside testing new composite formulations for your construction business
- A freelance data scientist in Shoreditch building a machine learning model for your SaaS platform
HMRC distinguishes between two categories of subcontractor: connected and unconnected. The rules for each are different.
The 65% Cap on Unconnected Subcontractor Costs
If your subcontractor is not connected to your company (meaning they are an independent third party with no ownership or control links), you can include only 65% of the relevant costs in your R&D claim.
This applies to the merged R&D scheme for accounting periods starting on or after 1 April 2024. It also applied to the old SME scheme before that date.
Here is how it works with real numbers. Say a 4-employee software consultancy in Leeds turns over £420,000. They subcontract a specialist AI developer (unconnected) for £80,000 of work on a new recommendation engine. The qualifying R&D subcontractor cost is 65% of £80,000, which is £52,000. The remaining £28,000 is not claimable.
The 65% cap exists because HMRC assumes the subcontractor has their own overheads and profit margin built into their fees. The cap strips out that element, leaving only the direct R&D activity cost.
There is no cap on connected subcontractor costs. But the rules are stricter in other ways.
Connected Subcontractors: No Cap but Different Rules
A connected subcontractor is one where your company controls them, they control you, or both are under common control. For a limited company, control usually means holding more than 50% of the shares or voting rights.
If your subcontractor is connected, you can include 100% of the qualifying costs you pay them. But the subcontractor cannot also claim R&D relief on the same work. HMRC prevents double counting.
This is common in group structures. A parent company might subcontract R&D work to a wholly owned subsidiary. The subsidiary performs the work and charges the parent. The parent claims R&D tax credits on the full amount paid. The subsidiary does not claim anything for that work.
The connected party rules also apply to individuals who are connected to your company. For example, a director who provides R&D services through their own personal service company. If the director controls both companies, the 100% rule applies. If they are unconnected, the 65% cap applies.
What Costs Qualify Under Subcontracted R&D
Not every cost in a subcontractor's invoice qualifies. HMRC looks at the substance of the work, not the label on the invoice.
Qualifying costs include:
- Direct staff costs of the subcontractor's employees working on the R&D project (salary, employer NI, pension contributions)
- Consumable items used directly in the R&D work (materials, software licenses for the project)
- Subcontracted costs paid to third parties by the subcontractor (but subject to the same 65% cap further down the chain)
Non-qualifying costs include:
- General overheads and admin costs
- Profit margin built into the subcontractor's fee
- Capital expenditure (though capital allowances may be available separately)
- Costs that are not directly attributable to the R&D project
For unconnected subcontractors, the 65% cap is designed to automatically exclude the non-qualifying elements. You do not need to itemise the subcontractor's internal cost breakdown. You simply take 65% of the total relevant payment.
For connected subcontractors, you need to identify the actual qualifying costs incurred by the subcontractor. You cannot claim on the full invoice amount if it includes profit, overheads, or non-R&D costs.
How to Claim R&D Tax Credits for Subcontractor Costs
The claim process follows the same general route as any R&D tax credit claim. You include the qualifying costs in your corporation tax return (CT600) and submit a separate R&D claim report.
For accounting periods starting on or after 1 April 2024, the merged R&D scheme applies. You claim under either the enhanced R&D Intensive Scheme (ERIS) if you are an R&D-intensive loss-making SME, or the standard merged scheme for all other companies.
The key steps are:
- Identify the R&D projects that meet HMRC's definition: work to resolve scientific or technological uncertainty, not routine development or improvement.
- Separate subcontractor costs from in-house costs. Track them separately in your accounting records.
- Determine connected or unconnected status for each subcontractor. Document the relationship.
- Calculate qualifying costs using the correct percentage (65% for unconnected, 100% of actual qualifying costs for connected).
- Prepare the R&D claim report with detailed narratives of each project, the technical uncertainties, and the costs incurred.
- Submit the claim with your CT600 within the normal filing deadline (12 months after the end of the accounting period for the merged scheme).
As ICAEW qualified accountants, we strongly recommend using specialist R&D software or working with an adviser who understands the subcontractor rules. HMRC has increased scrutiny of R&D claims, and subcontractor costs are a common trigger for enquiries.
Common Mistakes with Subcontracted R&D Claims
Here are the errors we see most often from UK business owners who attempt to claim without proper advice:
Claiming 100% of unconnected subcontractor costs. This is the most common mistake. The 65% cap applies regardless of how detailed the invoice is. Even if the subcontractor itemises their staff costs, you still apply the cap.
Claiming on connected subcontractor costs without identifying actual qualifying costs. You cannot simply take the full invoice amount. You must identify the subcontractor's direct R&D staff costs, consumables, and qualifying subcontracted costs (with their own 65% cap).
Including costs that are not R&D. Just because a subcontractor works on a project does not mean all their costs qualify. Routine testing, standard software development, or non-technical work does not count.
Failing to document the connected party relationship. HMRC will ask. If you claim 100% of connected subcontractor costs and cannot demonstrate the control relationship, your claim will be rejected.
Double counting. If the subcontractor also claims R&D relief on the same work, both claims will be rejected. Ensure your subcontractor confirms they are not claiming.
Record Keeping Requirements
HMRC expects you to maintain contemporaneous records of your R&D activity. For subcontractor costs, you need:
- Contracts or engagement letters with each subcontractor
- Invoices showing the work performed and costs incurred
- Technical documentation of the R&D projects (design documents, test results, meeting notes, emails)
- Evidence of the subcontractor's connected or unconnected status
- Project time records if the subcontractor charges on a time basis
If you use accounting software like Xero or FreeAgent, tag subcontractor costs to a specific R&D project code. This makes extracting the data for your claim much easier.
Example: Subcontracted R&D Claim for a Bristol Engineering Firm
A structural engineering company in Bristol's Harbourside employs 12 staff and turns over £1.2 million. They develop a new lightweight composite material for bridge construction. They subcontract specialist testing to an unconnected lab in Sheffield for £45,000. They also subcontract design work to a connected subsidiary company for £60,000.
For the unconnected lab: qualifying cost is 65% of £45,000 = £29,250.
For the connected subsidiary: the subsidiary's actual qualifying costs (staff, consumables, subcontracted costs) total £42,000. The parent claims £42,000 (not £60,000).
Total subcontracted R&D qualifying costs: £29,250 + £42,000 = £71,250. This is added to the company's in-house R&D costs (staff, consumables, software) to calculate the total R&D claim.
Under the merged scheme, the company would receive a payable credit (if loss-making) or a reduction in corporation tax (if profitable). The exact benefit depends on the company's tax position.
What Happens If HMRC Opens an Enquiry
HMRC has increased the number of R&D enquiries significantly since 2023. Subcontractor costs are a frequent focus because the rules are misunderstood.
If HMRC opens an enquiry into your claim, they will ask for:
- Detailed project narratives for each R&D project
- Breakdown of costs by category (staff, consumables, subcontractors)
- Evidence of the subcontractor relationship (connected or unconnected)
- Supporting invoices and contracts
- Technical evidence that the work involved scientific or technological uncertainty
If your claim is incorrect, HMRC can withdraw the relief, charge interest, and impose penalties. In serious cases, they can open a criminal investigation for fraudulent claims.
The best defence is a well-documented claim prepared by someone who understands the rules. If you are unsure about any aspect of your subcontractor costs, speak to an adviser before submitting the claim.
For more detail on the overall R&D claim process, see our R&D tax credits guide.