R&D tax incentives - qualifying overseas expenditure in life sciences sector

In this blog, Richard Turner, Senior Managing Director at FTI Consulting, discusses the new legislation for qualifying overseas expenditure and guidance and its practical application to the life sciences sector. 

At FTI Consulting, working closely with the BIA’s Finance and Treasury Committee and HMRC, we have devoted a great deal of time interpreting the new legislation for qualifying overseas expenditure and guidance to its practical application resulting in our development of in-depth application guidance which we are using with our clients. 

As we talk to more and more companies on this topic, we remain surprised and concerned by the number still holding the view that use of overseas suppliers with result in a loss of tax credits. This is not the case.

UK R&D incentives remain internationally competitive, and the merged R&D Expenditure Credit (“RDEC”) regime now enables all companies to claim for contracted-out R&D, with an enhanced incentive for R&D intensive loss‑making companies. The exception was designed with life sciences in mind – acknowledging complex supply chains, extensive outsourcing and the reality that clinical development cannot be confined to the UK.

Key principles at a glance

• Section 1138A permits overseas expenditure on contracted‑out R&D where three conditions are met: (1) the conditions necessary for the R&D are not present in the UK; (2) the conditions are present where the R&D occurs; and (3) it would be wholly unreasonable to replicate those conditions in the UK.
• “Conditions” include geographical, environmental, social, and legal/regulatory factors but explicitly exclude cost and the availability of workers.
• The restriction is determined by where the R&D activity is undertaken (not the contracting party) and claimants must know and evidence where the work occurred.
• The limitation applies only to contracted‑out R&D and contractors.  Consumables, software, data licences, cloud computing services and payments to clinical trial volunteers are excluded from the overseas restriction.

What this means for drug development

In life sciences, valid overseas “conditions” commonly include patient availability, specific regulatory requirements, UK hospital or trial-site capacity constraints, and the absence of specialist manufacturing capability or capacity.  Activities placed overseas purely for lower cost or where equivalent UK resources exist (specifically people not facilities) and can be accessed in time are not eligible.

For clinical trials, site‑based activity in the UK or overseas is generally eligible, except where UK trial sites could have been stood up in the same timeframe without compromising outcomes (see HMRC manuals CIRD152000 Example 6).  Phase 1 one trials are often harder to justify outside the UK because healthy volunteers can be recruited more readily domestically, whereas later‑stage patient recruitment and timely UK site activation are more challenging and have worsened in recent years.

CRO central (non‑site) costs require careful consideration.  Claimants must know where each activity occurred and whether it could have been undertaken in the UK.  If a CRO could have provided services via a UK team but chose not to, those costs should be excluded because availability of workers is a prohibited condition (CIRD151100 Example 4).

For clinical manufacture, replicating facilities in the UK typically cannot be achieved quickly, so time‑critical overseas manufacture can often qualify (CIRD152000 Example 1) provided that there is appropriate evidence to support this. In mixed supplies, only the service element is in scope for the overseas rules and materials.

Compliance, evidence and practical takeaways

• Base case: only UK activities are eligible unless the exception under Section 1138A applies.
• Eligibility must be justified not assumed.
• Relatively high levels of overseas activities should be within scope of the exception, and it is therefore likely that HMRC will want to understand the basis for eligibility.
• Companies must know where R&D occurs and it is advisable to include contractual provisions to cater for this.
• People services (i.e. consulting) will be much harder to support unless tied to specific physical infrastructure or regulatory/legal requirements. Intra‑group recharges from overseas affiliates are most likely to be ineligible.
• Time pressure can be used to tackle the ‘wholly unreasonable” hurdle but is fact‑specific: one week is unlikely to qualify whereas18–24 months is likely to be excessive. Six months may be reasonable in many cases but it would be helpful to quantify the impact.  However, time pressure cannot be used to justify people services as this would be excluded under the prohibited condition for the availability of workers.
• It is recognised there will be an increase in the compliance burden placed upon companies to track and evidence the decision process to support the inclusion of overseas expenditure.

A positive path forward

The rules aim to give UK suppliers an edge, onshore more capability and encourage overseas providers to invest in the UK. The long-term benefits for UK life sciences can hopefully exceed the monetary value of the reduced incentives. With robust procurement records, clear visibility of where work happens, and evidence aligned to Section 1138A’s conditions, significant levels of overseas activity (especially clinical trials and clinical manufacturing) should continue to be eligible under the UK’s incentive regimes.