Tribunal allows taxpayer's appeal in R&D relief claim

In Stage one Creative Services Ltd v HMRC [2024] UKFTT 1059 (TC), the First-tier Tribunal (FTT) allowed the taxpayer's appeal against HMRC's decision to refuse research and development (R&D) relief claims on the basis that the relevant projects were not "subsidised" or "contracted out".

Background

Stage One Creative Services Ltd (SOCS) provides bespoke engineering, construction and automation solutions for live events and installations. Clients contact SOCS with an idea of what they want to achieve creatively, and SOCS provides a technical solution that allows them to achieve that objective. Many of the projects are novel and therefore R&D will often form part of that process.

As an illustrative example, SOCS was approached by a theatre company (Franco) that asked it to produce a "Pearl & Straw Platform with Automation". Franco were not concerned with how the solution was developed and created as long as it met its aesthetic expectations. SOCS was tasked with designing, manufacturing and installing a scenic design comprising an automated pearl that was flown through the theatre and opened on a straw platform to reveal a performer within it.

SOCS often claimed relief for expenditure on R&D under the SME relief scheme (R&D relief) pursuant to Chapter 2, Part 13, Corporation Tax Act 2009 (CTA 2009). These claims were both in the context of specific contracts but also for purely internal purposes aimed at improving aspects of its own systems to improve its client offering.

SOCS made claims for R&D relief in accounting periods ending 31 December 2017, 2018, and 2019. HMRC challenged those claims and issued discovery assessments in relation to 2017 and 2018, and a closure notice in relation to 2019.

There were three main issues to be determined:

1. Was the relevant expenditure "subsidised"?

HMRC argued that the expenditure did not qualify for R&D relief because it was "subsidised", for the purposes of section 1138(1), CTA 2009. HMRC's position was that SOCS was not entitled to relief because the expenditure was actually met by the client's payments under the relevant contract.

SOCS contended that the R&D was not subsidised by its clients because there was no "clear and direct" link between the payments received from its clients and the expenditure. Its clients were not paying for the R&D and SOCS retained the intellectual property generated while working on the relevant projects.

2. Was the relevant expenditure "contracted out"?

HMRC argued that the expenditure did not qualify for R&D relief because it was "contracted out" to SOCS by its clients within the meaning of section 1052(5), CTA 2009 (the intention of this provision is to prevent two companies claiming relief for the same expenditure).

SOCS contended that the R&D activity was not what was contracted out. Its clients were not required to reimburse SOCS for R&D expenditure and R&D was not even mentioned in the contracts. Since SOCS retained the intellectual property, it would not have been possible for the clients to claim R&D relief and therefore the threat of double relief did not arise. 

3. Were HMRC's discovery assessments valid?

SOCS argued, amongst other things, that HMRC's discovery assessments were invalid because its returns were prepared in accordance with the practice generally prevailing at the time.

HMRC's Corporate Intangibles Research and Development Manual (CIRD) changed on 30 November 2021. Before the change, the CIRD simply stated that whether a payment "subsidised" relevant expenditure was to be determined by the "underlying facts". After the change, the CIRD specified that there will automatically be a clear and direct link between a payment received under a contract and expenditure incurred in undertaking that contract.

HMRC argued that this was simply a clarification of its previous position, but SOCS argued that HMRC had changed its position, and its returns had been prepared in accordance with the practice generally prevailing before 30 November 2021.

FTT decision

The appeals were allowed.

The FTT found in favour of SOCS on all three issues.

In relation to the first issue, the FTT said that HMRC's approach would result in no R&D relief being available for expenditure incurred in the course of undertaking a contract, which cannot have been the intention of Parliament.

In relation to the second issue, the FTT agreed with SOCS that the R&D was an incidental part of the project and could not be considered to be contracted out.

With regard to the third issue, the FTT found that it was understood by both HMRC and taxpayers before 30 November 2021 that there needed to be a "clear and direct" link between the payment and the relevant expenditure, in order for it to be considered "subsidised". HMRC was incorrect to claim that payments under a contract would automatically be linked to expenditure incurred pursuant to that contract, and SOCS prepared its returns in accordance with the practice generally prevailing.

Comment

The FTT's decision provides helpful clarification to taxpayers who undertake R&D as part of the process of meeting their contractual obligations. The decision is also a reminder that HMRC's guidance simply reflects HMRC's own interpretation of the relevant legislation and will not necessarily represent the correct interpretation of the legislation under consideration.

The decision can be viewed here.