You ran a development project for a client. You subcontracted a specialist developer for six weeks. The work was genuinely innovative: building a new machine learning model to automate content tagging across video assets. You spent £42,000 on the subcontractor. You are preparing your R&D tax credit claim and expecting to include the full amount.
Then your accountant tells you only 65% of that payment, £27,300, counts as qualifying R&D expenditure. The other £14,700 does not qualify at all.
This is the subcontractor 65% restriction, and it trips up more agency founders than almost any other R&D rule. Not because the rule is complicated, but because it is widely described wrongly. You will see it called an aggregate cap, a proportion limit, or a ceiling you can raise by adding more in-house cost. It is none of those things. It is a flat haircut applied to each payment you make to an outside party for R&D.
Here is exactly how it works, how it feeds into a claim under the current merged scheme, and what it means for the way agencies resource their projects.
What the 65% Rule Actually Is
When your company pays a third party to carry out qualifying R&D on its behalf, you cannot include the whole payment in your claim. You include 65% of each unconnected payment. The remaining 35% is disallowed. That is the rule, in full.
It applies to two categories of outside spend:
- Contracted-out (subcontracted) R&D. You pay another business or freelancer to undertake R&D work for you.
- Externally provided workers (EPWs). You pay a staff provider (typically an agency) for workers who carry out R&D under your direction.
Both are restricted to 65% of the payment where the other party is unconnected to you. This restriction has been part of UK R&D relief since its inception and it carries straight through into the merged R&D expenditure credit scheme that now applies.
The crucial point, and the one most articles get wrong, is that this is not an aggregate test. There is no calculation where you total your qualifying spend and check that subcontractor costs sit below 65% of it. There is no ceiling that rises when you add staff or consumables. Each subcontractor payment is included at 65%, on its own, every time. If you have one subcontractor payment or twenty, each is haircut individually and the results are added together.
If you have read that the 65% rule is a proportion cap on your total claim, unlearn it. It will cause you to over-claim on subcontractor-light projects and mis-plan on subcontractor-heavy ones.
How the 65% Restriction Works in Practice
Let us run two examples. You run a 15-person digital agency in Bristol Harbourside. You take on a project to build an AI-driven content personalisation engine for a retailer. The work involves genuine technological uncertainty: no off-the-shelf solution handles the specific dataset and integration requirements.
Example one: a balanced project
Your R&D costs before the restriction:
- Direct staff costs (your employed developers and project lead): £48,000
- Subcontractor cost (an unconnected UK data science contractor): £62,000
- Software licences and cloud compute: £12,000
Apply the 65% restriction to the subcontractor payment only. £62,000 × 65% = £40,300. Your employees' staff costs qualify in full, and so do your software and cloud costs. Your qualifying expenditure is therefore £48,000 + £40,300 + £12,000 = £100,300. Not the £122,000 headline figure, because £21,700 of the subcontractor payment never qualifies.
Under the merged scheme that £100,300 attracts a 20% expenditure credit of £20,060. After corporation tax on the credit, the net benefit is about £15,045 for a company paying the 25% main rate, or roughly £16,249 for a loss-making company (a net rate of about 16.2%).
Example two: a subcontractor-heavy project
Now flip the resourcing. Your in-house involvement is light and one external specialist does most of the build:
- Direct staff costs (employees): £18,000
- Subcontractor cost (one unconnected contractor): £85,000
- Consumables and data costs: £5,000
The £85,000 is restricted to £55,250 (65%). Your qualifying expenditure is £18,000 + £55,250 + £5,000 = £78,250. The 35% you cannot claim on that payment, £29,750, is worth roughly £4,463 in net benefit at the main rate that simply never lands.
Notice there is nothing to "restructure" after the fact. The £29,750 is lost the moment the work is contracted out to an unconnected party. Adding more consumables or software to the claim does not recover it, because there is no aggregate cap for those costs to lift. The only lever is whether the R&D is done by your own people or by someone else's.
Which Scheme You Are Actually In Now
Before you calculate any benefit, be clear about which scheme applies, because the old figures are still quoted everywhere and they are wrong for current claims.
For accounting periods beginning on or after 1 April 2024, a single merged R&D expenditure credit scheme replaced the separate SME and RDEC regimes. Under it, companies of all sizes claim a 20% taxable above-the-line credit on qualifying R&D expenditure. The credit is itself taxable, so the net cash benefit is about 15% for a company paying the 25% main rate, and about 16.2% for a loss-making company (where the notional tax is charged at the 19% small-profits rate).
There is one alternative. A loss-making, R&D-intensive SME (where qualifying R&D is at least 30% of total expenditure) can instead claim under Enhanced R&D Intensive Support (ERIS), which gives an 86% additional deduction and a payable credit worth 14.5% of the surrenderable loss. ERIS is a separate route with its own rules, not the default.
You will still see the old SME headline of an "186% enhanced deduction" and a "14.5% payable credit". Those applied to accounting periods beginning 1 April 2023 to 31 March 2024, and to a shrinking pool of even older periods before that. They do not apply to current claims and you should not size a benefit against them.
What has not changed across all of this is the 65% restriction on unconnected third-party R&D. It sat in the old SME rules, it sits in the merged scheme, and it applies to the examples above regardless of which period you are in.
Who Is Caught: Subcontractors, EPWs and Employees
The 65% restriction turns on who you are paying, not on job titles. Three categories matter, and getting them wrong is the most common error agency founders make.
Subcontractors
A subcontractor is an external business or individual you pay to carry out R&D activities. You set the brief and the outcome; they decide how the work is done. Most freelancers, specialist studios and independent developers you engage for project work fall here. Payments to an unconnected subcontractor are included at 65%.
Externally provided workers (EPWs)
An EPW is a worker supplied by a third-party staff provider (an agency) who then works under your supervision, direction and control. You pay the agency; the agency pays the worker. A common myth is that EPWs escape the 65% restriction because they feel like part of your team. They do not. Payments to an unconnected staff provider for EPWs are also restricted to 65%. The EPW category matters for eligibility (it lets agency-supplied labour qualify at all), but it does not lift the haircut.
Your own employees
The only R&D labour that qualifies at 100% is your own employees: people on your payroll whose salary, employer National Insurance and pension contributions you pay directly. This is the single most important structural fact in the whole area. Employee staff costs are not restricted; unconnected subcontractor and EPW payments are. Consumables, software and data used in the R&D also qualify in full.
Connected Subcontractors: A Different Rule Entirely
If you contract R&D to a connected party (for example a sister company under common control, or a company you also own), the 65% restriction does not apply. A different, and generally stricter, test replaces it.
For connected parties the qualifying amount is the lower of the payment you made and the connected subcontractor's actual relevant cost of doing the work. In other words, you cannot claim on a marked-up intra-group invoice; you claim on what it genuinely cost the connected company, capped at what you actually paid.
There is no "65% plus a profit mark-up" rule for connected parties, despite what you may have read. The mechanism is the lower-of test, full stop. This makes group structures with a separate development entity workable but tightly evidenced: you need the connected company's real cost records, not just the invoice, and HMRC will ask for them.
Overseas Subcontractors: Now Largely Excluded
The merged scheme also narrowed where the work can be done. For accounting periods beginning on or after 1 April 2024, payments for contracted-out R&D and for EPWs generally only qualify where the work is carried out in the UK, or where the worker's earnings are subject to UK PAYE and National Insurance.
There are narrow exceptions where the conditions genuinely cannot be replicated in the UK (geography, regulatory or environmental factors). Cost and availability of labour do not count as exceptions. For agencies that lean on offshore development teams, this is the bigger issue than the 65% haircut: much of that spend does not qualify at all, before you even reach the restriction.
Why This Matters More for Agencies
Agencies are structurally more exposed to the 65% restriction than, say, a manufacturer. Most agencies run a lean core team and scale delivery with freelancers, specialist studios and offshore developers. On a typical build, one or two employees oversee the work while external contractors do the heavy lifting.
Every pound of that external R&D labour is included at 65% if the party is unconnected and UK-based, and at nil if the work is done overseas without an exception. A web agency building a custom platform, a creative agency prototyping an AR experience, or a PR agency building a proprietary monitoring tool is likely to be subcontracting the very skills that make the project innovative. That is fine commercially. It just means the claim is smaller than the headline spend, and planning matters.
What You Can Actually Do About It
Because there is no cap to raise, the levers are narrower and more honest than the "add more in-house cost to lift the ceiling" advice you will see elsewhere. Here is what genuinely moves the number.
1. Employ the people doing your core, repeatable R&D
If you have a consistent pipeline of qualifying work, an employee beats a contractor on relief because their cost qualifies in full. Pay a contractor £80,000 a year and only £52,000 qualifies. Employ someone on £70,000 with about £10,500 of employer NI and pension on top, and the full £80,500 qualifies. Comparable gross cost, materially larger claim, and you keep the capability in-house.
2. Keep genuinely innovative work onshore
Given the overseas restriction, R&D done outside the UK by unconnected parties will usually not qualify at all. Where the innovative element can reasonably be done in the UK, keeping it here is often the difference between a claimable cost and a non-claimable one.
3. Separate qualifying R&D from routine subcontractor work
Not every subcontractor cost on an R&D project is R&D. Routine integration, standard UI build and non-innovative testing are not qualifying expenditure and should be excluded entirely, before any 65% calculation. Getting this split right protects the claim from challenge and keeps the qualifying figure defensible.
4. Evidence connected-party costs properly
If you use a connected development company, keep its actual cost records, not just intra-group invoices. The lower-of test needs the real cost to work, and without it HMRC can disallow the lot.
What HMRC Looks For in Agency R&D Claims
HMRC has increased its scrutiny of R&D claims across the board, and agency claims are a particular focus. Third-party costs are one of the first things a compliance officer checks. When HMRC reviews your claim they will want to see:
- A clear narrative of the technological uncertainty you faced and how you resolved it
- Timesheets or project records showing which people worked on the R&D and for how long
- Contracts with subcontractors and staff providers showing scope, terms and where the work was done
- Evidence that your company was the decision-maker: that it decided to undertake the R&D and bore the financial risk
- A cost breakdown by category (employee staff, subcontractor, EPW, consumables, software), with the 65% restriction correctly applied to the third-party lines
Under the merged scheme, entitlement usually follows the decision-maker: the company that decided to carry out the R&D and took the risk is the one that claims, not necessarily whoever physically did the work. If a client contracted you to solve a defined problem and took the risk, the claim may sit with them, not you. Your contracts decide this, so read them before you claim.
Working exclusively with agency founders, we see HMRC open more enquiries into agency R&D claims than almost any other sector. Mishandled third-party costs are rarely the only issue, but they are often the trigger.
Common Mistakes Agency Founders Make
The same errors come up again and again. Here are the ones to avoid.
Mistake 1: Treating the 65% rule as an aggregate cap. It is not a proportion test across your total spend and there is no ceiling to raise. Each unconnected subcontractor and EPW payment is included at 65%, individually. Modelling it as a cap will systematically misstate the claim.
Mistake 2: Assuming EPWs escape the restriction. Payments to an unconnected staff provider for externally provided workers are restricted to 65% too. Only your own employees qualify at 100%.
Mistake 3: Claiming overseas contractor costs. For periods beginning on or after 1 April 2024, R&D contracted out to unconnected parties doing the work outside the UK generally does not qualify at all. Check where the work was performed before you include it.
Mistake 4: Marking up connected-party invoices. For connected subcontractors you claim the lower of the payment and their actual cost. An intra-group invoice with a margin baked in will be cut back to real cost, or disallowed if you cannot evidence it.
Mistake 5: Using the old SME figures. The 186% deduction and 10% or 14.5% payable credit belong to periods beginning 1 April 2023 to 31 March 2024 and earlier. Current claims use the merged scheme's 20% credit, netting about 15% or 16.2%. Sizing a benefit on the old rates overstates it badly.
What to Do Next
If you are preparing an R&D claim and you use subcontractors, first map your qualifying costs by category: employee staff, subcontractor, EPW, consumables and software. Strip out non-R&D work. Then apply the 65% restriction to each unconnected subcontractor and EPW payment, check that the work was done in the UK, and use the lower-of test for anything connected.
The strategic question is not how to raise a cap that does not exist. It is which R&D belongs in-house as employed effort (qualifying in full) and which is genuinely specialist enough to buy in at 65%. For a consistent R&D pipeline, employing the core capability usually wins on both relief and control.
If your resourcing model has changed in the last year, or you are planning a new R&D project, ask your accountant before you commit. A small change to who does the work, and where, can move the claim by thousands.
We help agency founders across the UK, from Soho to Manchester Northern Quarter to Bristol Harbourside, structure their R&D claims to maximise relief within the rules. If you want to run through your numbers, get in touch.
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