Understanding the Impact of ‘Connected-Party’ Subcontractors & Externally Provided Workers on SMEs

Date: April 13, 2021

Effectively claiming for the Research & Development (R&D) tax relief can be a harrowing ordeal for business owners across the nation. Countless continue to place their full faith in their R&D tax specialist, such as Catax, to maximise this generous benefit. Therefore, it is of the utmost we make good on our promise without fear or favour of the outcome.

This applies particularly when faced with claiming for eligible expenditure on connected-party subcontractors or externally provided workers (EPWs).

This article serves to shed some light on this seldom visited piece of the ruling.

What are ‘connected-party’ subcontractors or EPWs in an R&D claim?

Whilst there exist numerous ways in which a company may be classified as connected, the general underlying theme is control and ownership, be it officially via shares or through lineal family relationships (children, siblings, and parents).

For example, a typical scenario would involve business owners Jack and Jill, who are developing a bespoke software solution (the R&D project) and hire a software developing company (the subcontractor), which they, too, control. The hired software developing company would be classed as a connected-party, due to the common ownership present, and the expenditure would need to undergo a special set of rules to determine the amount eligible for R&D tax relief.

Another common example would be if the software developing company was under the control of their son Jacob. This, too, would trigger a situation where the subcontractor would be viewed as a connected-party.

Whenever a subcontractor or EPW provider is exclusively or mutually controlled by those in control of the R&D claimant, there is an excellent chance you have just uncovered a connected-party situation.

Why are ‘connected-party’ subcontractors or EPWs treated differently in an R&D claim?

The R&D tax relief for SMEs, as envisioned by HMRC, ensures that only the actual cost associated with the R&D receives the generous uplift; an extra 130% deduction of qualifying costs from a company’s yearly profit.

For unconnected subcontractors and EPWs, a notional 35% ‘profit margin element’ of the R&D relevant expenditure is removed from the claim with the remainder being fair game. This “fair” treatment becomes difficult to assume when both the R&D claimant and the subcontractor or EPW provider are controlled by the very same individual or group of individuals.

Calculating the qualifying expenditure for R&D tax relief.

For the reason above, HMRC has set out a specific set of guidance when calculating payments made to a connected-party subcontractor or EPW provider, as follows.

The company can only claim R&D tax relief on the lower of:
• the payment that it makes to the subcontractor (or EPW provider), and
• the relevant expenditure of the subcontractor,

Defining relevant expenditure; it is neither capital nor subsidised and is incurred in carrying on the subcontracted activities, and must be on:

• staffing costs
• externally provided workers
• consumable items
• software costs
• subjects of clinical trials

Important to note that staffing costs are made up of gross salaries and wages, bonuses, qualifying reimbursed expenses, employer national insurance contributions, employer pension fund contributions, but not dividends or benefits in kind.


Let us assume the following in the example with Jack and Jill and their connected software developing company:

During the accounting period in which R&D activity had taken place, a sum of £100k, net VAT, had been paid to the connected company for software development, which was entirely related to the development of the bespoke software solution. However, relevant expenditures incurred by the connected-party subcontractor was £50k.

– Jack and Jill can claim £50k for R&D tax relief, as this is the lower of the two.
– Note, the 65% cap typically found when dealing with unconnected subcontractors or EPWs does not apply when dealing with connected-party subcontractors or EPW providers.

One more thing…

Noteworthy to mention that a company and their subcontractor or EPW provider may jointly elect to be treated as though they are connected even though they are not. Whilst such an election may aid in the pursuit of maximising an R&D claim, it is important to bear that this election is irrevocable, applies to all payments made between the parties, and necessitates financial transparency between both companies. Entering such an agreement should only be considered with rigorous understanding of HMRC’s ‘relevant expenditures’ for subcontractors, which your R&D tax specialist should be able to assist with.

An R&D claim may be impacted in a plethora of ways, and yet this article only covers one subpoint of the categories of qualifying expenditures on R&D. Please feel free to get in touch and let us help make the most from uncovering your R&D tax relief.

Khaled Fatheldin, R&D Tax Analyst at Catax Group

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