Barriers to commercial lending and mainstream innovation funding, combined with rigorous certification requirements that must be met before deployment, mean that defence businesses often require patient, long-term capital to sustain development before generating any revenue.

The UK R&D tax relief regime can provide essential support for those in the sector, but recent reforms to the scheme have materially who can claim, which costs qualify, and how claim ownership works in practice. Read our article here for more information on the R&D tax credits scheme.

The scheme underwent significant reform for accounting periods beginning on or after 1 April 2024, and those reforms have materially changed how and when people can claim.

How the subsidised expenditure rules when working on Ministry of Defence (MOD) contracts and government-funded projects

For defence contractors, the merged scheme introduces a number of complexities that require careful analysis before a claim is prepared. Under the merged scheme, a company may claim relief on qualifying R&D expenditure at an effective rate of 20 pence per pound spent (or at the enhanced rate of 26 pence per pound for loss-making SMEs that qualify as “intensity” companies).

One material change is that the merged scheme allows a claimant to include expenditure that has been met, directly or indirectly, by an MOD contract or support through entities such as Defence Science and Technology Laboratory (DSTL). The merged scheme does not automatically exclude R&D expenditure simply because the project has received government funding. This is a significant improvement for many defence contractors compared with the pre-April 2024 rules.

Whilst the legislation does not itself preclude a claim where support has been received, the terms of the grant or contract may do so in practice. Some public sector funders, such as MOD, can include provisions in their non-competitive contracts that require a contractor to account for, or repay, any tax benefit that flows from government-funded activity. These provisions vary considerably in their drafting and effect.

Where such a term exists, a business that claims R&D relief on defence-related expenditure may find that some or all of the tax credit is recouped by the funder, either through a price adjustment mechanism or a specific clawback clause. The commercial benefit of making the claim may therefore be substantially reduced or eliminated, but the contractor might be contractually obliged to make such a claim.

Funded R&D and supply chain structures

The merged scheme draws a distinction between R&D that is “contracted out” to a subcontractor, and R&D that is funded by a third party. Where a company funds R&D and subcontracts the activity, the funder is entitled to claim. Where a company carries out the R&D as a subcontractor for a funded project, the position is more nuanced and depends on the specific contractual arrangements.

The merged scheme generally allows the company paying for the work (i.e. the contractor) to claim on costs it incurs in carrying out contracted R&D, provided it initiates the R&D and bears the financial risk of the activity. However, where the subcontractor initiated the R&D work independently, in order to deliver the product or service to the contractor, there is still the ability for this entity to claim. The rules to determine who claims in this situation are complex and require care to ensure there is no double claiming taking place.

In the defence sector, it is common for a prime contractor to hold the principal contract with the MOD and to engage a network of subcontractors to carry out specialist development work. When making an R&D claim under the merged scheme, the claimant company will have to determine who in the contracting chain initiated the R&D. This can be complicated when the prime contractor will be the entity that receives the government funding but may or may not be involved in the development activity themselves. The businesses performing the qualifying R&D may be SMEs or specialist technology companies with limited awareness of the entitlement to claim, so it can create confusion and complexity around who should be making the R&D claim.

Both the contractor and its subcontractors may have valid claims in respect of the same project, but each must be assessed independently. Duplication of claims on the same expenditure is not permitted. Businesses at every level of the supply chain should consider their own qualifying expenditure separately and seek advice before concluding that a claim is unavailable.

Overseas costs: development, testing, and trials

For accounting periods beginning on or after 1 April 2024, the merged scheme restricts relief on the costs of externally provided workers and subcontractors who perform R&D activities outside the UK. This restriction is set out in the Finance Act 2023 and is intended to ensure that the relief incentivises UK-based activity. The general rule is that overseas subcontractors and externally provided worker costs do not qualify unless one of two exemptions applies: the relevant conditions are not met in the UK, or there is a specific geographic, environmental, or social reason for the activity taking place overseas.

For defence sector claimants this restriction can cause significant complications. Development and qualification testing often takes place in overseas ranges, facilities, or environments. Internal development costs incurred overseas, for example the costs of a software development team based in another jurisdiction, are unlikely to qualify under the merged scheme. However, for testing, the exemptions might allow a claim. For example, high-altitude testing, tropical, or arctic environment trials, or testing at allied nations’ restricted facilities may be passable. In such cases there is a reasonable argument that the there is no domestic equivalent to overseas location, so the exemption applies.

The exemptions are, however, narrowly drafted, and their application to specific fact patterns requires careful analysis. HMRC is expected to scrutinise claims that rely on the overseas exemption, and the burden of demonstrating that the relevant conditions were not available in the UK rests with the claimant. A clear distinction should be maintained between overseas development costs (which will generally not qualify) and overseas testing or trials costs where a geographic necessity argument can be substantiated. This distinction should be documented at the time the activity takes place, not retrospectively.

First-in-class prototypes and IP ownership

The R&D tax relief legislation does not permit a claim in respect of prototype costs where the ownership of the item is transferred to a third party. The default position is that consumable expenditure related to the supply of goods is not qualifying. Therefore, if a contract is in place where the ownership of the prototype is transferred from the claimant company to someone else this activity is like to be considered to be the supply of goods. This restriction is making a distinction between items where it is intended to be retained, sold, or transferred rather than destroyed or consumed in the R&D process.

These rules impact defence projects where the contractor is producing a high-value item and will build a prototype that will be supplied to the funder, sometimes termed the “first-in-class” prototype. Where a single physical prototype is produced purely as part of the R&D process and is not intended for any commercial purpose, its cost may be treated as revenue expenditure and therefore as qualifying R&D. However, if there was a contractual requirement to pass the prototype unit onto the funder for testing or other work, this arrangement could fall within the production of goods restriction. If the production of this prototype is part of the eligible project, all of the labour time to produce this unit can be claimed.

In the defence sector, contracts with the MOD commonly include provisions that automatically transfer ownership of prototypes, deliverables, and associated intellectual property to the MOD. This transfer can occur through a contract and will be triggered by delivery or at defined contract milestones. Where a prototype transfers to the MOD, it may be difficult to demonstrate that the item was produced “for the purposes of R&D” in the sense contemplated by the legislation.

This is a fact-specific analysis. The mere fact that a prototype is delivered to the MOD or a prime contractor does not automatically preclude a claim, but it does require careful review of the contract terms, the nature of the deliverable, and the extent to which the prototype was integral to the claimant’s own R&D process. Contract terms governing IP ownership and prototype transfer should be reviewed as part of the R&D claim scoping process. Where there is genuine uncertainty as to whether a prototype cost qualifies, this should be discussed with a specialist.

Security classifications and preparing a defensible claim

Some defence R&D projects involve technologies, capabilities, or operational contexts that are subject to security classifications under the Government Security Classifications policy or equivalent frameworks. This creates a particular difficulty when preparing an R&D tax relief claim, because HMRC requires a sufficient technical narrative to understand the nature of the qualifying activities and to verify that the work meets the definition of R&D for tax purposes.

A claimant cannot simply assert that work is classified and decline to provide any supporting information. Equally, it would be inappropriate, and potentially a breach of the relevant security protocols, to include classified technical details in a standard HMRC submission or correspondence. This can raise problems for a business in this position looking to make a defensible R&D claim.

HMRC has experience of handling sensitive information in the context of tax enquiries and has protocols for doing so, but these are not invoked automatically: they must be raised proactively by the claimant or its adviser.

Therefore, technical narrative supporting a classified claim should be drafted at the highest level of generality that is consistent with demonstrating the qualifying criteria, without disclosing classified details. Experienced advisers can help you work through the eligibility assessment approach without discussing classified material. In some cases, it may be appropriate to discuss the project in more detail with a security-cleared HMRC inspector, but this has to be agreed and planned with HMRC in advance.

At the outset of any claim involving classified work, identify which aspects of the project are subject to classification restrictions and agree with the relevant contracting authority what information can be disclosed. Engage advisers who are familiar with the security protocols applicable to your contracts.

How we can help

We have extensive experience advising businesses in the defence, aerospace, and security sectors on R&D tax relief claims. Our team works closely with you to understand the technical and contractual context of your projects, to identify qualifying expenditure accurately and to prepare claims that are robust in the event of an HMRC enquiry. Fill in the form below and one of our team will be in touch.