Innovate UK cost guidance 2026 – avoid these expensive errors!

Congratulations – you’ve secured Innovate UK funding! Whether it’s a Smart grant, an Innovation Loan or another competitive award, landing that funding letter feels like crossing the finish line.

Except it’s not the finish line. It’s the starting line.

Unsurprisingly, Innovate UK doesn’t pay on trust. They pay on evidence. And if your financial records don’t conform with the Innovate UK cost guidance, you’re not just risking a delay – you’re risking a clawback of tens of thousands of pounds.

Before we look at some of the most common errors, let’s quickly clarify some terminology. While grants require “audits” to release cash, Innovation Loans often require an Independent Accountant’s Report (IAR) as a strict legal covenant to keep your loan facility active.

Common reasons why Innovate UK claims get challenged

Every year, hundreds of UK businesses submit funding claims that get flagged during audit. Not because they’re fraudulent, but because they didn’t understand the rules.

The official Innovate UK Cost Guidance covers labour costs, overheads, capital expenditure, subcontracting and more. Many project managers skim through it once, assume their accountant “has it covered,” and then discover – months later – that they’ve been claiming costs incorrectly.

The result? Delayed payments. Withheld funds. And in the worst cases, repayment demands.

Let’s make sure that doesn’t happen to you.

When do you need an Independent Accountant’s Report (IAR)?

Not every Innovate UK project needs a full audit or report, but most do. Here’s the 2026 threshold breakdown:

Critical point: An IAR must be signed by a Registered Auditor who is independent of your company. Even if your business employs a qualified auditor internally, they cannot sign your own IAR – the auditor must have no financial interest in your company. Many high-street accountants aren’t Registered Auditors at all, which causes last-minute scrambles when companies realise they need specialist support.

Special note for Innovation Loans: If you have an Innovation Loan, the IAR isn’t just about securing your next payment – it’s often a legal covenant in your loan agreement. If the audit fails or costs are disallowed, the loan could be called in early or interest rates could increase.

The labour costs minefield

This is where most claims go wrong. Labour costs typically make up 60-80% of an Innovate UK claim, so even small mistakes have big consequences. There are three main ways businesses get caught out.

1. The dividend trap

Here’s a scenario that happens frequently:

Sarah runs a tech startup. She’s the CEO and holds 80% of the shares. She draws a modest PAYE salary of £25,000 but takes most of her income as dividends – around £60,000 a year. Her company wins a £150,000 Smart grant. Sarah spends 20 hours a week on the project and assumes she can claim for all that time at a commercial rate.

She can’t.

Innovate UK only accepts:

• PAYE salary
• Employer National Insurance contributions
• Employer pension contributions

Dividends – no matter how much you rely on them – are not eligible. Sarah can only claim costs based on her £25,000 salary, not the £85,000 total she earns from the business.

This catches many owner-managers off guard, especially in early-stage businesses where dividend strategies are common for tax efficiency.

2. The 8-hour rule

Even if your team is pulling all-nighters to hit project milestones, Innovate UK always caps your claims at:

• 8 hours per day
• 40 hours per week

If someone works 50 hours per week on your project, you can only claim for 40. If they log 10 hours in a single day, you can only claim 8.

This isn’t negotiable, even if you have timesheets proving longer hours.

3. The non-PAYE cap

For individuals not on a PAYE scheme – such as certain sole traders – the 2026 rate cap is £22 per hour.

Tip: This cap often catches company directors who do technical work but do not run their income through a PAYE scheme. If you are a director-owner drawing most of your income as dividends and only a minimal (or no) salary through PAYE, any time you claim as an internal team member is subject to this £22/hour cap – not a commercial day rate.

Note on external help: The cap applies to your internal team. External freelance specialists or contractors are typically classified as subcontractors. While they aren’t subject to the £22 limit, their costs must still reflect “fair market value” and are usually capped at 30% of your total project budget.

Overheads: the 20% shortcut

Innovate UK allows businesses to claim a share of their overheads (rent, utilities, IT systems, insurance) as project costs. But calculating the exact allocation can be a paperwork nightmare.

The good news? There’s a simpler option.

The 20% flat rate lets you claim 20% of your net labour costs as overheads, with no need to produce detailed cost breakdowns. Net labour costs mean your base PAYE salary costs, excluding bonuses or non-standard benefits (these are defined in the guidance). For most SMEs, this significantly reduces their administrative burden and audit risk.

If your overhead allocation exceeds 20%, you can claim the full amount.  However, you’ll need to provide robust evidence during audit.

Subcontractors: proving fair market value

If your project involves subcontracted work – such as from design agencies, specialist engineers or testing labs – you need to demonstrate that:

1. The work was essential to the project
2. It was procured at fair market value
3. It was delivered by a UK-based supplier (in most cases)

“Fair market value” means you sought competitive quotes and can justify your choice of supplier. A single quote from your founder’s brother-in-law won’t pass muster!

Keep procurement records from day one. If you’re challenged during audit, saying that “we just picked someone we knew” isn’t a valid defence.

VAT: a common mistake

If your company is VAT registered, you must exclude VAT from all cost claims.

This seems straightforward, but it trips up businesses regularly – especially when suppliers’ invoices prominently display VAT-inclusive totals. Your finance team needs to extract the net cost before adding it to your Innovate UK claim.

If VAT-inclusive figures slip through the net, your claim will be reduced during audit.

The 10% retention rule

Innovate UK typically withholds 10% of your total grant until your final IAR is approved.

For a £250,000 project, that’s £25,000 of cash flow sitting in limbo until an auditor signs off your costs.

If your final audit throws up issues – such as disallowed labour costs, missing evidence or incorrect overhead calculations – that 10% gets held even longer. Worse still, you may even be asked to repay costs that have already been drawn down.

This is why getting your bookkeeping right from day one isn’t optional. That final 10% often makes the difference between a project that breaks even and one that loses money.

Real-world example: where it goes wrong

Let’s return to Sarah’s tech startup.

She’s 18 months into her £150,000 Smart Grant project. It’s going well, but her financial records are in a mess. These are the reasons why:

• She’s been claiming dividends as labour costs (this isn’t allowed)
• Her lead developer logged 45 hours in one week, and Sarah claimed for all of them (8-hour per day / 40 hours per week rules broken)
• She claimed £30/hour for a freelance consultant (non-PAYE cap is £22)
• Her subcontractor’s invoices include VAT, which she didn’t strip out

At the final grant audit, the accountant disallows:

• £40,000 in dividend-based labour claims
• £8,000 in overclaimed hours
• £6,000 in excess freelancer costs
• £4,000 in VAT errors

But here’s where it gets worse: when labour costs are disallowed, you also lose the 20% overhead claim attached to them.

Sarah claimed 20% overhead on that £40,000 in dividend-based labour costs – an additional £8,000. That’s gone too.

Total disallowed: £66,000 (not £58,000).

Sarah’s company has already drawn down £135,000 of the £150,000 grant. After the disallowance, she’s only entitled to £84,000. Innovate UK demands repayment of £51,000.

Sarah’s startup doesn’t have £51,000 in cash reserves. The project – and potentially the business – is now in crisis.

As you can see, the Innovate UK cost guidance is a set of rigid rules that must be followed. Ignoring them can jeopardise your entire project’s financial viability.

What if you’ve already made a mistake?

If you’re reading this and realising you’ve been claiming costs incorrectly, don’t panic. But don’t ignore it either.

Innovate UK has a Project Change Request (PCR) process that allows you to notify your Monitoring Officer of changes to your project – including changes to suppliers, cost categories or team members.

If you’ve switched subcontractors, hired different staff or realised your labour cost calculations were wrong, submit a PCR before your audit. Your Monitoring Officer may approve the changes retrospectively, or at least you’ll have a documented trail showing you acted in good faith.

Trying to hide mistakes and hoping the auditor doesn’t notice? That never ends well. Proactive communication through the PCR process is always the better route.

If you’re uncertain whether your situation requires a PCR, talk to a grant audit specialist like THP before your next claim. Catching problems early is infinitely better than discovering them at final audit. By aligning your bookkeeping with the Innovate UK cost guidance from day one, you ensure your project remains a financial success.

How THP can help you with Innovate UK cost guidance

THP Chartered Accountants are Registered Auditors and, crucially, independent of your business. This means we can (and frequently do) legally sign off Independent Accountant’s Reports (IARs). Many high-street accountants can’t, which is why businesses often find themselves searching for a Registered Auditor with grant audit experience at the last minute.

At THP, we have a grant audit team with significant, proven experience. Whether you need a final IAR, support with your first claim audit, or a pre-audit review to spot problems early, we can guide you through the process.

If you would like to look at grant funding possibilities for your company please go to this page, select option 2 on the form, complete your details and download our comprehensive grant writing report. We can then put you in touch with a suitable grant consultant who can look at your particular circumstances and tell you about any relevant opportunities.”

> Learn more about THP’s Grant Audit Service