HMRC tribunal ruling: landmark decision on client-led R&D tax relief

In a landmark decision, the First-Tier Tax Tribunal (FTT) in Stage One Services v HMRC overruled what many deem a restrictive interpretation of the SME R&D Tax Relief scheme by HMRC, particularly around the concepts of ‘contracted-out’ and ‘subsidised expenditure’. The ruling clarifies that businesses can claim R&D Tax Relief for client-led projects, provided specific criteria are met. This decision builds on key precedents in Quinn v HMRC, providing crucial insights into the evolving landscape of R&D Tax Relief.

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The case in focus: Stage One Services v HMRC

Stage One Services—an engineering, construction, and automation solutions provider for the creative industry—submitted a claim for SME R&D Tax Relief for the 2019 accounting period. HMRC rejected this claim on two fronts:

1. Contracted Out Condition: HMRC claimed that R&D was effectively ‘contracted out’ because it was linked to specific client projects.
2. Subsidised expenditure- HMRC argued that the R&D costs were subsidised by the client, even though there was no explicit subsidy agreement.

Additionally, HMRC opened a discovery assessment for the 2017 and 2018 accounting periods, alleging under-declared tax for those years. There was no disagreement regarding the fulfilment of the other conditions required for R&D Tax Relief in all the years in question.

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The ‘Subsidy’ condition

Stage One Services’ argument

Stage One Services based their argument on the FTT’s decision in Quinn v HMRC, arguing that the R&D expenditure was not subsidised because the contracts were for delivering a specific end product or service in exchange for an agreed price. Whilst this price might fluctuate, it often fell short of covering the full costs of completing the contract, particularly the costs associated with R&D. Crucially, Stage One Services assumed full responsibility for the designs and any challenges that arose. At the time of signing contracts, they did not know whether R&D would be required, or if it was, the scope or cost of such R&D. Furthermore, the company had not agreed to conduct R&D specifically and did not seek reimbursement for those expenses.

To illustrate their point, Stage One Services offered a compelling analogy:

The client wanted the “picture on the jigsaw box, but has no interest in putting the puzzle together.” The clients did not instruct Stage One Services as to the order in which the pieces should go together and Stage One Services is not rewarded for the way in which the puzzle is solved. Stage One Services is simply “rewarded for delivering a completed puzzle that matches the picture on the box.”

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HMRC’s position

HMRC, on the other hand, argued that the FTT’s decision in Quinn v HMRC had “erred in law.” They specifically took issue with the Tribunal’s prior interpretation of Section 1138 (1), which defines when a company’s expenditure is considered subsidised. In Quinn v HMRC, Judge Morgan ruled that there must be a “clear link” between the funding provided and its intended use for it to be deemed subsidised. In contrast, HMRC argued that requiring an explicit reference to R&D within a contract could create a loophole of sorts, enabling taxpayers to circumvent the rules and claim substantial relief unjustly.

Referring to Judge Morgan’s view in Quinn v HMRC, where the Tribunal stated that adopting HMRC’s approach would limit SME claims for enhanced R&D relief to cases where there is no potential for commercial gain from the R&D, HMRC explained that their stance does, in fact, allow for such commercial exploitation.

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HMRC elaborated on their position, stating:

“If, for example, a taxpayer undertakes R&D in January and then in April is able to exploit the expenditure in the context of a commercial contract with a customer, that would qualify for relief on HMRC’s analysis. There is, in HMRC’s submission, a clear distinction between a trader who incurs R&D in the course of carrying out a contract […] and the example above where it could not be said that the expenditure incurred in January is ‘met’ by the sums received from the contract in April.”

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The Tribunal’s ruling

After careful consideration, the Tribunal rejected HMRC’s argument, endorsing the reasoning from Quinn v HMRC and confirming that Stage One Services’ R&D expenditure was not subsidised.

The Tribunal expressed that they were “somewhat bemused by the argument that Judge Morgan’s logic was flawed.” Moreover, the Tribunal concluded that HMRC’s interpretation was “very narrow” and inconsistent with both the plain meaning and grammar of the legislation. They reinforced Judge Morgan’s view that, under HMRC’s approach, the only R&D qualifying for relief would be standalone projects without client involvement- an unreasonably restrictive outcome.

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The ‘Contracted out’ condition

Stage One Services’ argument:

Stage One Services based their argument on the FTT’s decision in Quinn v HMRC, arguing that the R&D expenditure was not subsidised because the contracts were for delivering a specific end product or service in exchange for an agreed price. Whilst this price might fluctuate, it often fell short of covering the full costs of completing the contract, particularly the costs associated with R&D. Crucially, Stage One Services assumed full responsibility for the designs and any challenges that arose. At the time of signing contracts, they did not know whether R&D would be required, or if it was, the scope or cost of such R&D. Furthermore, the company had not agreed to conduct R&D specifically and did not seek reimbursement for those expenses.

To illustrate their point, Stage One Services offered a compelling analogy:

The client wanted the “picture on the jigsaw box, but has no interest in putting the puzzle together.” The clients did not instruct Stage One Services as to the order in which the pieces should go together and Stage One Services is not rewarded for the way in which the puzzle is solved. Stage One Services is simply “rewarded for delivering a completed puzzle that matches the picture on the box.”

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HMRC’s position:

HMRC, on the other hand, argued that the FTT’s decision in Quinn v HMRC had “erred in law.” They specifically took issue with the Tribunal’s prior interpretation of Section 1138 (1), which defines when a company’s expenditure is considered subsidised. In Quinn v HMRC, Judge Morgan ruled that there must be a “clear link” between the funding provided and its intended use for it to be deemed subsidised. In contrast, HMRC argued that requiring an explicit reference to R&D within a contract could create a loophole of sorts, enabling taxpayers to circumvent the rules and claim substantial relief unjustly.

Referring to Judge Morgan’s view in Quinn v HMRC, where the Tribunal stated that adopting HMRC’s approach would limit SME claims for enhanced R&D relief to cases where there is no potential for commercial gain from the R&D, HMRC explained that their stance does, in fact, allow for such commercial exploitation.

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HMRC elaborated on their position, stating:

“If, for example, a taxpayer undertakes R&D in January and then in April is able to exploit the expenditure in the context of a commercial contract with a customer, that would qualify for relief on HMRC’s analysis. There is, in HMRC’s submission, a clear distinction between a trader who incurs R&D in the course of carrying out a contract […] and the example above where it could not be said that the expenditure incurred in January is ‘met’ by the sums received from the contract in April.”

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The Tribunal’s ruling

After careful consideration, the Tribunal rejected HMRC’s argument, endorsing the reasoning from Quinn v HMRC and confirming that Stage One Services’ R&D expenditure was not subsidised.

The Tribunal expressed that they were “somewhat bemused by the argument that Judge Morgan’s logic was flawed.” Moreover, the Tribunal concluded that HMRC’s interpretation was “very narrow” and inconsistent with both the plain meaning and grammar of the legislation. They reinforced Judge Morgan’s view that, under HMRC’s approach, the only R&D qualifying for relief would be standalone projects without client involvement- an unreasonably restrictive outcome.

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The discovery assessment

A discovery assessment allows HMRC to look at earlier financial periods outside the normal scope of enquiry. To do this, they need to demonstrate that the original submission suffered from inaccurate information – such that an officiating caseworker could have reasonably discovered the deficiency at the point of submission. The Discovery Assessment into the 2017 and 2018 claims examined two separate but intertwined issues:

• Whether HMRC could have reasonably discovered the under-declaration of tax when the R&D claims were made.
• Whether Stage One Services’ returns were filed in accordance with practices generally prevailing during the relevant period

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Were the tax returns in line with practices generally prevailing?

HMRC maintained that the SME R&D Tax Relief scheme has always been intended for free-standing, self-initiated R&D. They argued that their stance on the issue was consistent over time, even as guidance evolved. According to HMRC, the revised interpretations clarified existing policies rather than introducing new ones.

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Stage One Services’ Position on changes in guidance

Stage One Services contested this, arguing that HMRC’s published guidance had undergone significant changes. They identified a “radical change” in November 2021, after the relevant accounting periods in question. For instance, the earlier version of CIRD84250 stated, “a contract to provide services rather than undertake a specific part of the activities is not subcontracted R&D.” This version emphasised autonomy, intellectual property ownership, and financial risk as key factors.  

By contrast, the revised CIRD84250 removed the passage quoted above and introduced the following: “any activities carried out in order to fulfil the terms of a contract are considered to have been contracted to the Company.”  Stage One Services argued that these revisions reflected a significant shift in HMRC’s interpretation.

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Subsidy condition and prevailing practices

Similarly, regarding the subsidy condition, Stage One Services pointed to earlier guidance (including a 2013 RDCC meeting minutes) indicating “that there needed to be a clear and direct link between the payment received and the qualifying expenditure.” This condition was redefined in the post-November 2021 version of CIRD81650 to include the following, “payment received for undertaking a contract will be considered to meet expenditure incurred in undertaking that contract.”

Stage One Services emphasised that their claims, therefore, aligned with the practices generally prevailing when submitted. They argued that before 2020, HMRC rarely raised concerns about the contracted-out condition in SME R&D Tax Relief compliance checks. They contended that case-specific facts, such as autonomy and intellectual property rights ownership, were critical to assessing eligibility.

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HMRC’s supporting evidence

In response, HMRC referred to a 2022 article in the Tax Journal which analysed Hadee Engineering v HMRC. This case centred on the denial of SME R&D Tax Relief due to insufficient evidence supporting qualifying activities. HMRC argued that the writer had not expressed surprise at the outcome of this case, thereby demonstrating their position was consistent.

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Tribunal’s interpretation of shifts in guidance

However, the Tribunal noted that the Tax Journal article also discussed Quinn v HMRC. The article highlighted a shift in HMRC’s guidance, specifically that the earlier focus on autonomy, intellectual property rights, and financial risk was replaced with an emphasis on the contractual relationship. The article suggested that under the new interpretation, contractually driven R&D activities were likely to be classified as subcontracted. The Tribunal interpreted this as an indication of a shift in HMRC’s approach, acknowledging that the article inferred a change in how R&D activities were evaluated.

On the contracted-out condition, the Tribunal found that:

• Earlier guidance considered autonomy, intellectual property ownership, and financial risk as crucial to determining eligibility.
• The revised guidance narrowed the focus to contractual terms, suggesting a significant departure from past practice.

On the subsidy condition, the Tribunal noted:

• The older guidance required a “clear and direct link” between payments and qualifying R&D expenditure but left this concept vaguely defined.
• The revised guidance explicitly tied payments under contract to qualifying expenditures, representing a notable change.

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Ultimately, the Tribunal determined that Stage One Services had submitted their claims in accordance with practices generally prevailing at the time. They ruled that the revisions in HMRC’s guidance represented significant changes that post-dated the accounting periods in question.

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Could HMRC reasonably have discovered the issue?

HMRC argued that Stage One Services’ R&D reports lacked sufficient contractual details to satisfy the requirements for claiming R&D Tax Relief. In particular, HMRC found that the reports should have included more granular information on the terms of the contracts under which the R&D was carried out. However, the Tribunal was not convinced by this argument. In fact, the Tribunal found that the level of detail provided in the R&D reports should have been sufficient for any hypothetical officer to conclude that the expenditures were both subcontracted and subsidised.

The Tribunal noted that HMRC’s guidance on best practices did not require explicit mention of the legal conditions such as the Contracted Out and Subsidy Conditions. As such, Stage One Services had submitted their R&D reports in accordance with the practices generally prevailing at the time, and thus the disclosure in those reports was deemed adequate, despite the post-facto revisions to guidance.

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Final thoughts: the impact of Stage One Services v HMRC

The Stage One Services v HMRC ruling represents a pivotal moment in the evolving landscape of R&D Tax Relief, particularly for businesses engaged in client-led projects. It confirms that R&D conducted on behalf of clients can qualify for tax relief if legislative criteria are met.

By rejecting HMRC’s narrow stance that client-driven projects automatically fall under ‘contracted-out’ or ‘subsidised’ conditions, the Tribunal reinforces the notion that R&D claims should be assessed based on the nature of the work undertaken, not merely on the presence of a contractual relationship.

The judgement also revealed an important aspect of HMRC’s strategy. Whilst HMRC did not appeal the Quinn v HMRC decision, they admitted during the proceedings that this was a tactical choice. They sought to bring forward a stronger case addressing both the subsidy and contracted-out condition simultaneously. However, this decision clearly backfired as the Tribunal heavily endorsed the reasoning in Quinn v HMRC, further entrenching its principles in tax jurisprudence.

Most recently, HMRC has announced that they will not appeal the decision in Stage One Creative Services. Additionally, they have indicated that updated guidance on their stance regarding subcontracted and subsidised R&D will be issued in February 2025.

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