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 claim relief on the full amount.

Then your accountant tells you HMRC caps subcontractor costs at 65% of your total qualifying R&D expenditure.

This is the subcontractor R&D 65 percent rule, and it catches more agency founders than almost any other R&D rule. It is not a deduction limit. It is a proportion limit. And it changes how you structure your projects if you want to maximise your claim.

Here is exactly how it works, what qualifies, and what to do about it.

What Is the 65% Rule for Subcontractor Costs in R&D Claims?

The 65% rule applies to companies claiming under the SME R&D tax relief scheme. It states that the total qualifying expenditure on subcontracted R&D (paid to external parties) cannot exceed 65% of the total qualifying R&D expenditure for the project.

Total qualifying expenditure includes:

  • Staff costs (salaries, employer NI, pension contributions) for directly employed R&D staff
  • Subcontractor costs (payments to external individuals or companies for R&D work)
  • Consumables and software used directly in R&D
  • Externally provided workers (EPWs), staff provided by an external agency but under your supervision
  • Clinical trial costs (rarely relevant for agencies)

If your subcontractor costs exceed 65% of that total, HMRC restricts the qualifying amount to 65%. The excess is simply not eligible for relief.

This is not a penalty. It is a structural rule designed to prevent companies from routing most of their R&D through subcontractors to inflate claims. HMRC expects the company making the claim to be the principal in the R&D, meaning you direct, control, and take the financial risk on the project.

How the 65% Rule Works in Practice

Let us run through a real example. You run a 15-person digital agency in Bristol Harbourside. You take on a project to build a new AI-driven content personalisation engine for a retailer. The work involves genuine technological uncertainty: no off-the-shelf solution exists for the specific dataset and integration requirements.

Your qualifying R&D costs for the project look like this:

  • Direct staff costs (your in-house developers and project lead): £48,000
  • Subcontractor costs (a specialist data science contractor): £62,000
  • Software licences and cloud compute costs: £12,000
  • Total qualifying expenditure: £122,000

Now apply the 65% rule. HMRC says subcontractor costs cannot exceed 65% of £122,000, which is £79,300. Your subcontractor costs are £62,000, so you are under the cap. You claim relief on the full £122,000.

But what if the numbers looked different? Suppose your in-house staff costs were only £18,000, subcontractor costs were £85,000, and consumables were £5,000. Total: £108,000. The 65% cap is £70,200. Your subcontractor costs are £85,000, so only £70,200 qualifies. You lose relief on £14,800 of subcontractor spend.

At the SME enhanced deduction rate of 186% and 19% corporation tax, that lost relief is worth roughly £525. Not a disaster, but it adds up across multiple projects and years.

Who Counts as a Subcontractor for R&D Purposes?

HMRC draws a distinction between three categories of external worker. Getting this wrong is the most common error agency founders make.

Subcontractors

A subcontractor is an external individual or company you pay to carry out R&D activities. They are not under your day-to-day supervision or control. They decide how and when to do the work. You provide the brief and the outcome, but not the direction.

Most freelancers, specialist agencies, and independent developers you engage for project work fall into this category. Their costs are subject to the 65% cap.

Externally Provided Workers (EPWs)

An EPW is a worker provided by a third-party agency but under your supervision, direction, and control. You tell them what to do, when to do it, and how to do it. They work on your premises (or remotely under your direction). You pay the agency, and the agency pays the worker.

EPW costs are not subject to the 65% cap. They are treated more like direct staff costs. But the conditions are strict: you must have the right to supervise and control the worker, and the worker must be providing their own services (not the agency's).

If you use a recruiter to place a contractor who then works under your project manager's direction, that is likely an EPW arrangement. If you hire a specialist agency to deliver a module of work with their own project manager, that is a subcontractor.

Connected Parties

If you subcontract R&D work to a connected party (for example, a separate company you also control), the rules tighten further. The connected subcontractor can only include its direct costs plus a 65% profit mark-up. No overheads. No indirect costs. And the 65% cap still applies at your level.

This makes holding company structures with separate trading entities tricky. If your agency subcontracts R&D to a sister company, HMRC will scrutinise the arrangement closely.

Why the 65% Rule Matters More for Agencies Than Other Businesses

Agencies are structurally more likely to hit the 65% cap than, say, a manufacturing company. Here is why.

Most agencies operate with a lean core team and scale up with freelancers and subcontractors. A typical project might have one or two in-house developers overseeing the work and a team of external contractors doing the heavy lifting. That means subcontractor costs can easily exceed 65% of total qualifying spend.

If you are a web design agency building a custom platform, a creative agency developing a new AR experience, or a PR agency building a proprietary media monitoring tool, you are likely subcontracting specialist skills you do not keep in-house. That is fine commercially. But it limits your R&D claim.

The solution is not to stop subcontracting. It is to structure the work so that more of the cost falls under direct staff or EPW categories, or to increase your in-house R&D headcount on qualifying projects.

How to Structure Your Agency to Maximise R&D Claims Within the 65% Rule

There are legitimate ways to reduce the impact of the subcontractor R&D 65 percent rule. These are not loopholes. They are structural choices that reflect genuine R&D activity.

1. Bring More R&D Work In-House

If you have a consistent pipeline of R&D projects, consider hiring a permanent specialist rather than subcontracting. A permanent employee's salary, employer NI, and pension contributions all count as direct staff costs. They are not subject to the 65% cap. And they increase your total qualifying expenditure, which raises the 65% cap for any remaining subcontractor spend.

Run the numbers. If you pay a contractor £80,000 per year, a permanent hire on £70,000 plus £10,500 in employer NI and pension costs gives you £80,500 in qualifying costs. That is comparable. And it pushes your cap higher for future projects.

2. Use EPW Arrangements Where Possible

If you use a recruitment agency to place a contractor who works under your supervision, make sure the contract reflects that. The worker should be on your premises (or working under your direction), using your tools, and reporting to your project manager. The agency should be providing a worker, not a service.

HMRC looks at the reality of the arrangement, not the paperwork. If the contractor works independently, decides their own hours, uses their own equipment, and delivers a finished module, they are a subcontractor regardless of what the contract says.

3. Segregate R&D and Non-R&D Subcontractor Costs

Not every subcontractor cost on an R&D project is automatically an R&D subcontractor cost. If a subcontractor does routine integration work, standard UI development, or non-innovative testing, those costs are not qualifying R&D expenditure at all. They should be excluded from your claim entirely.

This reduces your total qualifying expenditure, which lowers the 65% cap. But it also removes non-qualifying costs from the calculation. The net effect is often neutral or positive, because you are not diluting your claim with non-qualifying spend.

Work with your accountant to split subcontractor costs into qualifying and non-qualifying categories. HMRC expects this level of granularity.

4. Consider the RDEC Scheme for Larger Projects

If your agency is large enough (typically over 500 employees or turnover over €100m), you fall under the RDEC (Research and Development Expenditure Credit) scheme instead of the SME scheme. RDEC does not have a 65% subcontractor cap. Subcontractor costs are restricted to 65% of the total project cost, but the calculation is different and often more generous for subcontractor-heavy projects.

Most agencies are not large enough for RDEC. But if you are part of a group or approaching that threshold, it is worth discussing with your accountant.

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. The subcontractor 65 percent rule is 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 staff worked on R&D and for how long
  • Contracts with subcontractors showing the scope of work and payment terms
  • Evidence that you were the principal in the R&D, directing the work, taking the risk, owning the IP
  • A breakdown of costs by category (staff, subcontractor, consumables, EPW)

If your claim has high subcontractor costs relative to staff costs, expect questions. HMRC wants to know why you could not do the work in-house and whether the subcontractor was genuinely undertaking R&D or just routine development.

As ICAEW qualified accountants working exclusively with agency founders, we see HMRC open more enquiries into agency R&D claims than almost any other sector. The 65% rule is rarely the only issue, but it is often the trigger.

Common Mistakes Agency Founders Make With the 65% Rule

I see the same errors repeatedly. Here are the ones to avoid.

Mistake 1: Including non-R&D subcontractor costs in the calculation. If a subcontractor does standard development work that is not innovative, do not include it. It inflates your total qualifying expenditure but also inflates your subcontractor costs. The cap calculation becomes distorted.

Mistake 2: Treating all external workers as subcontractors. If you supervise and control a contractor, document that. An EPW classification removes the cost from the 65% cap entirely.

Mistake 3: Ignoring the cap until the claim is prepared. By the time your accountant runs the numbers, the project is finished. You cannot go back and restructure. Plan for the cap at the project briefing stage.

Mistake 4: Assuming the 65% rule applies per project. It applies to the total qualifying R&D expenditure across all projects in the accounting period. If you have multiple R&D projects, the cap is calculated on the aggregate. A project with low subcontractor costs can offset a project with high subcontractor costs.

What to Do Next

If you are preparing an R&D tax credit claim and you use subcontractors, the first step is to map out your qualifying costs by category. Identify which costs are staff, which are subcontractor, and which are EPW. Then calculate the 65% cap on your total qualifying expenditure.

If you are over the cap, you have two options: restructure future projects to increase in-house or EPW costs, or accept the restriction and claim what you can.

For most agencies, the best approach is a combination: increase in-house R&D headcount where the work is consistent, use EPW arrangements where you supervise the work, and subcontract only the specialist work you cannot justify keeping in-house.

If your contractor mix has changed in the last 12 months, or you are planning a new R&D project, ask your accountant before you commit to the resourcing model. A small structural change at the start can save thousands in lost relief.

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.