Direct vs indirect costs in R&D tax claims: What to include and when

One of the most common challenges in preparing an R&D tax relief claim is how expenditure is classified and assessed. While businesses often refer to costs as “direct” or “indirect”, HMRC does not apply this distinction when determining eligibility. Instead, the key test is whether expenditure:

• Falls within a defined category of qualifying expenditure, and
• Relates directly to qualifying R&D activity

This distinction is important. Costs should not be included or excluded based on internal labels alone. In practice, some costs described internally as “indirect” may still qualify if they meet HMRC’s criteria. Equally, costs described as “direct” may not qualify if they fall outside the statutory categories or do not relate to qualifying activity.

Since the introduction of the merged R&D scheme, the accurate categorisation and clear evidencing of expenditure has become increasingly important during HMRC compliance checks. Claims are now more frequently reviewed with a focus on how costs link to qualifying activity and whether they have been treated in line with the legislation.

This guide explains how to assess expenditure using HMRC’s framework. It focuses on identifying qualifying cost categories, linking costs to underlying R&D activity, and applying apportionment in a way that is reasonable, consistent and capable of withstanding scrutiny.

What does HMRC mean by qualifying expenditure?

HMRC does not primarily assess R&D expenditure using direct and indirect accounting labels. Instead, the legislation focuses on specific categories of qualifying expenditure. These categories determine what costs can be included in an R&D claim. 

Common qualifying costs are: 

• Staffing costs
• Externally provided workers (EPWS)
• Subcontracted R&D
• Consumable items
• Software

Each type of cost has its own qualifying conditions. The principle that they have in common is that the cost must be incurred on qualifying research and development activity. The activity must seek to resolve scientific or technological uncertainty that is not readily deducible by a competent professional working in the field.

This means classification alone is not enough. Expenditure can sit within a valid category and still fail if it does not align with the qualifying R&D criteria. In the same way, a cost that supports R&D in a general sense may not qualify if it does not meet the specific rules of a category. The starting point will always be the activity, and costs will follow from there. 

What are commonly treated as “direct” costs in R&D tax claims?

In practice, direct costs are those that can be clearly linked to qualifying activity. These costs usually arise from individuals or resources actively trying to resolve scientific or technological uncertainty. While this terminology can be useful internally, it is not how HMRC determines whether expenditure qualifies.

Examples of direct costs include: 

• Salaries of engineers or developers working on qualifying R&D projects
• Employer National Insurance and pension contributions for those members of staff
• Consumables used in testing or prototyping
• Software tools used directly in development work

These types of costs are often easier to evidence because the link to qualifying R&D activity is more direct and observable.

However, inclusion is not automatic. Most staff divide their time between qualifying R&D and non-qualifying activities. For example, time spent maintaining existing systems or performing routine business operations does not qualify. As a result, staff costs must be apportioned on a reasonable and supportable basis to reflect only the time spent on qualifying activity. 

The key point is that direct R&D expenditure is easier to evidence within the claim documentation. The link to qualifying activity is more visible and easier to explain in a technical narrative. 

What are some indirect costs in R&D tax claims?

Indirect costs is a broader business term. It typically refers to overheads or shared resources that support operations but are not tied to a single activity in particular. 

Examples of indirect costs include: 

• Utilities 
• HR and finance functions 
• General management oversight 
• IT support infrastructure 

These costs should not be automatically included or excluded because they are described as indirect. HMRC does not assess eligibility by accounting labels. The correct test is whether the cost falls within a qualifying expenditure category and whether the related activity forms part of qualifying R&D, including qualifying indirect activities where relevant.

For example, utilities such as water, fuel and power may qualify as consumable items where they are used in qualifying R&D activity. This can include use in qualifying indirect activities, subject to a reasonable apportionment between R&D and non-R&D use.

Similarly, certain HR, finance, management or IT support activities may qualify where they are specifically undertaken to support the R&D project and fall within the qualifying indirect activities recognised by HMRC. However, general business support, routine administration or company-wide overheads will not qualify simply because the business carries out R&D.

This is an area where many R&D claims drift into risks of compliance. Businesses sometimes include a portion of overheads on the basis that they support R&D. That approach does not align with HMRC guidance. 

Supporting R&D activity alone is not enough. The expenditure must fall within a qualifying category and relate directly to qualifying activity.

How are costs often misclassified?

Certain areas of expenditure documentation regularly cause confusion amongst claimants. They sit close to qualifying research and development activity but require careful treatment. 

Staff time and apportionment

Staff costs are one of the most commonly misapplied areas. HMRC expects staff time to be analysed based on the nature of the activities undertaken, rather than relying on broad assumptions or internal cost classifications.

In practice, staff activities can be split between activities that directly contribute to resolving scientific or technological uncertainty and those that support the R&D project but do not directly resolve that uncertainty.

Direct R&D activities include work such as:

• Designing, creating or adapting software, materials or systems
• Testing and analysis undertaken to resolve scientific or technological uncertainties

Qualifying indirect activities may include:

• Maintenance and support activities required for the R&D environment
• Security, administrative and clerical work undertaken specifically for the R&D project
• Finance, personnel and management activities that directly support the R&D work

A competent professional may spend their time across a range of activities, including designing new solutions, troubleshooting scientific or technological uncertainty, attending internal meetings, and supporting existing systems. Only the time spent on qualifying activity is eligible. The rest must be excluded. 

Apportionment should reflect realistic working patterns. Reasonable estimates can be acceptable where records are limited. The documentation method must be consistent and explainable. The competent professional working on the project should clearly define how the time was allocated for members of staff and what activities were undertaken. 

Subcontractors vs externally provided workers

The distinction between subcontractors and externally provided workers (EPWs) affects how R&D expenditure is treated. 

Subcontracted R&D and externally provided workers (EPWs) are treated differently under the legislation. The distinction depends on the subcontracting agreement and how the work is carried out in practice, including factors such as:

• Supervision
• Direction
• Control  

In general, externally provided workers are individuals supplied to the business who work under its supervision, direction and control. In contrast, subcontractors are typically engaged to deliver a defined piece of work and retain greater autonomy over how that work is performed.

Consumables vs capital expenditure

Consumables are items that are used up or transformed in the R&D process. Examples include materials used in prototypes or test components that are destroyed during the experimental stage of the project. 

Capital expenditure is generally excluded from the R&D tax relief schemes. To claim relief on capital investments, businesses must use separate mechanisms like Research and Development Allowances (RDAs). 

Materials incorporated into prototypes that are consumed or transformed during qualifying R&D activity may qualify, depending on how the asset is used and retained. 

Software costs

Software can qualify as genuine R&D where it is used directly in R&D activity. 

This includes: 

• Development tools
• Simulation software
• Testing platforms 

In practice, software is often used across a range of functions. A licence may support both R&D and routine business operations. In these cases, structured apportionment is required. 

Only the portion used in qualifying research and development activity should be included. This must be based on a reasonable method, such as user access or project allocation. 

How is expenditure apportioned correctly?

Apportionment sits at the centre of an R&D claim. It bridges the gap between qualifying activity and regular business operations. 

The expectation is that apportionment is reasonable and justifiable. This isn’t a fixed formula, it requires judgement supported by clear evidence. 

Common approaches to apportioned expenditure include:

• Time-based allocation for staff costs
• Project-level costing for subcontractors and software
• Usage metrics where available

The method should reflect how the business accurately operates. Overly complex models are not required as simplicity and consistency are often more effective approaches. 

Clear documentation is an important part of a compliant R&D tax relief claim. Assumptions should also be recorded. If there are any changes in methodology, it should be explained. This will create a clear audit trail if HMRC reviews the R&D tax credit claim. 

What are some common HMRC challenges and risk areas?

HMRC enquiries often focus on cost treatment. Several patterns appear consistently. One is the over-allocation of staff time. Claims that attribute a high percentage of time to R&D without clear support are likely to be challenged by HMRC for compliance. 

1. Over-allocation of staff time

Claims that allocate high percentages of time to R&D without supporting evidence are more likely to be challenged.

1. Inclusion of non-qualifying overheads
   Rent, utilities, and administrative salaries are commonly included incorrectly.
2. Incorrect subcontractor categorisation
   Misunderstanding the working relationship can lead to expenditure being treated under the wrong legislative category.
3. Weak documentation
   Where expenditure cannot be linked clearly to qualifying activity, claims become difficult to defend during an enquiry.

These issues can be avoided with specialist advice and guidance. They usually arise from applying internal accounting logic rather than following HMRC criteria.

FAQs on R&D direct and indirect costs

What are direct costs in R&D tax relief?

Direct costs are those that can be clearly linked to the R&D activity. Common examples include staff salaries and consumables used in development work. 

Are overheads included in R&D claims?

Most general overheads do not qualify for R&D tax relief. These costs fall outside HMRC’s categories of qualifying expenditure. 

Examples include:

• Rent & rates
• Commercial & Marketing operations
• Routine travel expenses
• General training and recruitment

How is qualifying expenditure defined under HMRC?

HMRC defines qualifying expenditure through specific categories such as:

• Staff costs
• Subcontractors and EPWs
• Consumable materials
• Software, data and cloud computing

Each cost must clearly link to qualifying R&D activity. 

Do subcontractor costs always qualify?

No, the treatment depends on the nature of the contract and the applicable scheme rules. Control and supervision are key factors in determining eligibility. 

Closing thoughts

The distinction between direct and indirect costs can be helpful internally, but it should not be the deciding factor of how an R&D tax credit claim is prepared for submission. HMRC does not assess expenditure based on accounting labels. It assesses whether costs fall within defined categories and whether they relate directly to qualifying research and development activity. 

The different categories matter because they reduce the risk of an HMRC enquiry and improve the clarity of how expenditure is evidenced. In practice, the strongest R&D tax credit claims start with the technical narrative. Once the qualifying R&D activity is clear, the treatment of expenditure becomes more straightforward and defensible. 

Apportionment remains a key area of an R&D claim. The documentation doesn’t need to be complex, it needs to accurately reflect how the business operates. Consistency, clear reasoning and documented assumptions will hold more value than overly detailed models that are difficult to support. 

Where R&D claims run into difficulty, it is often due to applying internal financial logic rather than HMRC criteria. Aligning the two is not always intuitive, particularly in areas such as staff time, use of software and contractor relationships. 

At Alexander Clifford, our focus is on building R&D tax credit claims that are technically grounded and compliant from the outset. That means linking expenditure to qualifying activity with clear reasoning, not stretching categories to fit commercial expectations. Our aim is not simply to submit a claim. It is to ensure the claim remains technically grounded and capable of withstanding HMRC scrutiny. 

For more information about direct vs indirect costs in an R&D tax relief claim, please get in touch and one of our financial or technical specialists will be in touch to guide you through this process.