The rule, plainly
HMRC’s manual states the position in one sentence: spend on externally provided workers whose earnings are not subject wholly or in part to UK PAYE, and contractor payments for R&D undertaken overseas, is excluded from qualifying expenditure under both ERIS and the merged scheme, unless the statutory exception in CTA09/S1138A applies.
Notice what the rule tests. For contractors, it is where the R&D is undertaken, not where the contractor is incorporated or invoices from. A UK-registered contractor doing the work through a team abroad is still overseas R&D. For workers, the test is UK PAYE on their earnings, which is a factual payroll question rather than a nationality or residence one.
The exception, and how narrow it is
The exception applies where the conditions necessary for the R&D are not present in the UK, are present where the work is done, and it would be wholly unreasonable to replicate them here. The guidance’s own flavour is geographic, environmental and regulatory: testing that needs a particular ocean depth, a disease population, a climate, or a foreign regulator’s supervised trial.
What expressly does not count is that overseas work is cheaper or that suitable staff are easier to hire abroad. If your justification is cost or workforce, the exception is not for you, and a claim built on it invites exactly the enquiry it will lose.
The Northern Ireland difference
One genuine carve-out exists. A loss-making, R&D-intensive SME with its registered office in Northern Ireland claims under the separate NI ERIS variant, where the overseas restrictions do not apply. In exchange, the additional relief sits under a de minimis aid cap (broadly €300,000 over three years for most businesses, counted with other de minimis aid group-wide). Companies near that boundary should take advice; the trade-off can cut either way.
What to do if this hits your model
- Re-baseline the claim before budgeting. Pre-2024 claim values built on overseas subcontractors will not repeat. Treat history as history.
- Map every arrangement against the two tests. Where is each piece of R&D undertaken, and whose earnings are within UK PAYE? Substance decides, not invoicing.
- Do not contort the facts. Recharacterising an overseas team as something else is the kind of pattern HMRC’s compliance work is built to find, and penalties follow behaviour.
- Weigh the real choices. Onshoring the uncertain core of the work, using the exception only where its conditions are honestly met, or accepting a smaller claim are all legitimate. Pretending is not.
The wider claim mechanics, including how these costs interact with the 65% restrictions, are on subcontractors and agency workers.
Frequently asked questions
Our developers are abroad but employed by our UK company. Are they excluded?
The statutory tests run on where contracted-out R&D is undertaken and whether workers' earnings are within UK PAYE. Directly employed staff on a UK payroll are the core qualifying case; overseas arrangements of any kind need testing against the rules rather than assumption, and this is exactly the area to take advice on.
What is the exception actually for?
Situations where the conditions the R&D needs are not present in the UK and cannot reasonably be replicated here, deep-water testing, particular populations or environments, regulatory requirements. Cost and workforce availability are precisely the factors the rules do not accept.
Does the restriction apply to ERIS too?
Yes, the exclusion applies under both the merged scheme and ERIS, with one carve-out: the separate Northern Ireland ERIS variant disapplies the overseas restrictions in exchange for a de minimis aid cap.
Our pre-2024 claims included overseas subcontractors. Were they wrong?
Not necessarily: earlier periods ran under different rules. What is wrong is using those claim values to predict current ones. Re-baseline before you budget.