2024 is here, and with the new year comes the promise of change in the world of defence contracting, with significant reform to the Single Source Contract Regulations 2014 (“SSCR”) on the cards over the coming months. 

The reform is part of the MOD’s periodic review of the statutory regime and follows on from the Command Paper published in April 2022 (see our blog post here). Changes to the primary legislation (the Defence Reform Act 2014) to effect the changes proposed in the Command Paper have already been enacted as part of the Procurement Act 2023, which has now received royal assent (see our previous article here).

Towards the end of last year, the government issued its formal proposals for changes to the SSCR in order to implement the first tranche of secondary legislation reforms, being those deemed the most urgent to deliver the Defence and Security Industrial Strategy. 

Here’s what you need to know about the key changes proposed to the SSCR:

Alternative Pricing Mechanisms

The cornerstone of the current regulatory framework is that contracts must all be priced using the same formula: (CPR x AC) + AC (with CPR being the contract profit rate calculated using the statutorily prescribed process, and AC being the supplier’s allowable costs). However, the reforms will now allow parties to move away from this formula in certain circumstances.

The proposals set out six different scenarios in which parties will no longer have to use the pricing formula, but the one which is likely to be the most broadly applied and which will have the most significant impact on pricing negotiations for single source contracts is “Commercially Priced Items”. These are items which can be priced by reference to market prices; for example, where the contractor provides the same goods or services on the open market or prices have been determined competitively as part of a previous procurement.

Other circumstances which will also allow the pricing formula to be disapplied include where prices are constrained by other regulations or statutes (such as utilities pricing) or where the scope of the contract is unchanged, but the contract is being novated.

Componentisation

Amendments have now been made to the Defence Reform Act to expressly allow parties to a QDC to agree to treat different components of a contract distinctly from other parts in determining the price payable. 

Although this kind of segmentation already regularly happens in practice, the new regulations provide greater clarity around how it should work - they will provide that a part of a contract MUST be a separate component if there is a different pricing method, pricing type or profit calculation, but other than that parties can choose how to split the contract into components, as long as the purpose isn’t to change the way the legislation applies (e.g. to avoid thresholds set elsewhere.) The overall contract price will then be calculated by adding together each component price.

QDC Definition

There are two proposals relating to the QDC definition – both are aimed at widening the definition to broaden the scope of the regime and increase the number of contracts that fall within it.

New contracts vs amended contracts

Under the Defence Reform Act, whether a contract is a new contract or an amendment to an existing contract is significant: new contracts automatically fall under the regime if the relevant criteria apply, but amendments to existing contracts only do so if both parties agree.

The government proposes to change the regulations to say that an amendment to an existing contract will be considered a new contract (and so will be brought under the regime automatically) if:

  • the same outcome could be achieved whether entering into a new contract or an amendment;
  • using a separate contract wouldn’t give rise to unavoidable extra risk or duplication of costs/resource; and
  • there isn’t an existing pricing restriction which would apply to the new requirement which is incompatible with the single source pricing requirements – e.g. where the contract was originally placed competitively and prices for additional scope had been agreed. 

Contracts not wholly for Defence Purposes

The other amendment proposed to the definition of QDC is to ensure that contracts such as cross governmental contracts used by both MOD and other government customers are included in the regime despite not being wholly for defence purposes. As part of the changes to the Defence Reform Act, contracts will be subject to the regime if they are “substantially” for defence purposes.  

The proposals set out a test to determine whether a contract is “substantially” for defence purposes – if the part of the contract which is for defence purposes meets the following value thresholds, the contract will be a QDC:

  • more than 30% of the total expected value of the contract and more than £5m; or
  • more than £25m regardless of total expected contract value.   

Changes to calculation of profit rate – POCO

Changes made to the Defence Reform Act mean that Profit on Cost Once (the mechanism employed to avoid suppliers earning profit at multiple levels when contracting within their group) will no longer be dealt with by an adjustment to the contract profit rate, but instead by an adjustment to the allowable costs of the contractor.

The government’s new proposals provide more detail on how this cost adjustment will be applied:

  • It will only apply to sub-contracts of at least £1m in value.
  • It will apply to contracts between the prime contractor and a “connected party” (and further down the supply chain, between two or more parties who are both connected with the prime contractor). “Connected Party” is defined as a party which:
    • is a group undertaking of the other party; or 
    • has at least 20% beneficial ownership of the other party. 
  • The adjustment will reduce the contractor’s Allowable Costs by an amount equal to the “attributable profit”, which is either all or part of the profit element of the sub-contract, depending on whether all of the output of the sub-contract is required to enable the performance of the prime contract, or only part.

What happens next?

These are not the final draft regulations - the proposals are subject to a consultation (which has now closed), although given that all proposed changes have been discussed “extensively” with key stakeholders, and are the culmination of a long process to date, it seems unlikely that significant changes will be made now.

It is anticipated that the draft regulations reflecting these “Tranche 1” proposals will be introduced to parliament this month, with the intention that they will come into effect on 1 April this year. A second consultation is expected on the “Tranche 2” changes, although there is no commitment to a timeline as yet.

We’ll report in more detail on the changes once the draft regulations are made available.

If you have any questions regarding this article please contact lucy.owens@burges-salmon.com or your usual Burges Salmon contact.