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Design Effort Explicitly Excluded From Commercial Contract Work Qualified As IR&D

Client Alert | 9 min read | 12.13.05

Anyone looking for concrete proof of the proposition that bad facts make bad law should compare the District Court decision in United States v. Newport News Ship building, Inc., 276 F. Supp. 2d 539 (E.D. Va. 2003), to the recent decision of the Court of Federal Claims in ATK Thiokol, Inc. v. United States, No. 99-440C (Nov. 30, 2005).  In Newport News, a federal District Court judge found that a commercial contract to deliver ships implicitly required the contractor to perform the design work necessary to build the ships, disqualifying that effort as independent research and development (IR&D) cost.  In ATK, where there was a factual record demonstrating that the contractor and its commercial customer had specifically negotiated the price of the commercial contract to exclude certain design work, the Court of Federal Claims rejected the “implicit requirement” concept and held that the design work specifically excluded from the commercial contract was not “required” by the contract and did qualify as IR&D.  In the ATK case, the Court also rejected what must be the leading candidate in any contest to identify the most far-fetched accounting argument ever made by the Government, finding that production tooling, equipment, and facilities costs purchased by the contractor to manufacture the commercial products were not direct costs of that commercial product. 

Concurrently, ATK was negotiating with Mitsubishi Heavy Industries to sell the improved version of the motor, specifically adapted for use on a Japanese launch vehicle.  Mitsubishi refused to pay for any nonrecurring costs that would improve the basic motor for the commercial market.  Eventually, the parties agreed that ATK would pay for the development effort and for production equipment and Mitsubishi would pay for the adaptation effort.  ATK classified the development costs for upgrading the motor as IR&D and the adaptation costs as direct costs of the Mitsubishi contract.  The production tooling was capitalized and the depreciation costs were included in ATK's indirect cost pools. 

Under both CAS 420 and the definition of IR&D in FAR 31.205-18, costs may not be claimed as IR&D if the costs are “required in the performance of a contract.”  The Government argued that the “generic” development effort to improve the engine was “required” by ATK's contract with Mitsubishi, so those costs were not allowable as IR&D.  The Government also argued that the production equipment was “required” by the Mitsubishi contract and therefore had to be charged direct to that contract.  ATK argued that the generic development work was properly charged as IR&D because the contract expressly provided that ATK would pay for the generic development effort and associated production equipment and that Mitsubishi would pay for the adaptation effort.  ATK asserted that the fact that the generic design work was “implicitly” required was not sufficient to establish that it was required in the performance of the contract for purposes of FAR 31.205-18.  ATK also argued that because the production equipment items were “tangible capital assets” CAS 404 required the costs of that equipment to be capitalized, and CAS 409 required the depreciation costs of those assets to be treated as indirect costs. 

Both parties moved for summary judgment.  The court's decision addresses two issues:  (1) whether the generic development effort was excluded from the definition of IR&D because it was“implicitly” required in the performance of ATK's contract with Mitsubishi; and (2) whether the costs of production equipment necessary to manufacture the motor were properly capitalized, depreciated, and allocated through ATK's indirect cost pools. 

IR&D Costs

Acknowledging the lengthy debate about the “implicitly required” issue, the court summarized the extensive regulatory history of FAR 31.205-18 and CAS 420.  The court also noted briefly two relatively recent U.S. District Court False Claims Act cases that discussed this issue, United States ex rel.Mayman v. Martin Marietta Corp., 894 F. Supp 218, 222 (D. Md.1995) and United States v. Newport News Shipbuilding, Inc., supra .  The Mayman decision turned on issues that make it largely irrelevant to what is “required” by a contract, but the ATK decision and the Newport News decision present a stark contrast.  Based on an analysis of the "FAR's plain language," the Newport News court concluded that the definition of IR&D excludes the cost of efforts “required in the performance of a contract,” including efforts “which are not explicitly stated in the contract, but are nonetheless required by it.”  The court adopted a “bright line” test, holding that the distinction between IR&D and work required in the performance of a contract is not whether the work is “explicitly” or “implicitly” required, but, rather, whether the work is performed before or after the contract is executed.  The court concluded that the definitional limitation would be meaningless if contractors and their commercial customers could write contracts that “excluded” effort clearly necessary to perform the contract.

The Court of Federal Claims reached the opposite conclusion in the ATK case, relying on CAS 402 and 420.  CAS 402 requires that contractors disclose their cost accounting practices in writing and follow those practices consistently.  Where a cost could be classified as either direct or indirect, the court stated that the treatment of that cost is determined by the contractor's Disclosure Statement.  In Interpretation No. 1 to CAS 402, the CAS Board stated that a contractor is permitted, but is not required, to treat bid and proposal (B&P) costs incurred as the result of specific contract requirements differently from the contractor's other B&P costs.  CAS 420 provides that the costs of technical effort “required in the performance of a contract” must be excluded from both IR&D and B&P.  The court concluded that CAS 420, which was promulgated after the issuance of CAS 402 Interpretation No. 1, must be interpreted in light of that provision, which permits but does not require contractors to treat B&P costs “required in the performance of a contract” as direct costs of that contract.  The court extended the reasoning of Interpretation No. 1, to IR&D costs as well as B&P costs, concluding that the meaning of “required in the performance of a contract” must be the same for both B&P and IR&D costs.  Based on its analysis of the CAS requirements, the court held that whether a cost is “required in the performance of a contract” is determined by the intent of the parties to each individual contract. 

Although less important than the core holding about the meaning of “required” in a contract, another important feature of the case is its application of Interpretation No. 1 of CAS 402 to both IR&D and B&P costs.  Interpretation No. 1 authorizes contractors to treat B&P that is “required” by a contract either as a direct cost or as an indirect cost.  In our experience, the Government has always argued that the interpretation applies only to B&P costs.  The Court justified extending the interpretation to cover IR&D on the ground that there is essentially no difference between IR&D and B&P under the regulations, so there is no reason for the interpretation to apply only to B&P. 

Depreciation

It is hard to understand what led the Government to make the silly [1] arguments advanced in this case about direct charging of manufacturing hardware.  Perhaps, because the Government was arguing that development effort “implicitly” required by the contract had to be charged as a direct cost, the government concluded that logic and consistency required it to argue that all costs “implicitly” required by the same contract should be charged directly to the contract.  Seeing the absurd results that would result from a rigorously consistent application of the Government's “implicitly required” argument probably made it much easier for the judge to conclude that the “implicitly required” argument should be rejected. 

The relevant regulatory requirements for treatment of the capitalized costs at issue could not be clearer.  The production equipment items were tangible capital assets with a value greater than $5000 and a useful life exceeding 2 years.  CAS 404 specifically requires that the cost of such equipment must be capitalized.  CAS 409 requires that the capitalized costs must be depreciated as indirect costs. 

The court agreed with ATK that all of the production equipment items at issue were tangible capital assets that had to be capitalized and depreciated.  The ATK holding on this issue is unassailable.  Most capital equipment has multiple uses.  Even when equipment is unique to one particular product, it is likely to be useful on future contracts for that product.  Because the cost of the capital equipment should be allocated fairly to all the contracts on which it is used over its entire life, the regulations require that equipment be capitalized and depreciated over its useful life.  The Government's approach would mean that the first contract on which capital equipment is used would pay for every dollar of equipment cost and every subsequent contract would get a free ride. 

Where We Go From Here

It is inevitable that the Government will appeal this decision to the Federal Circuit, where there will be a battle between the rationale of the Newport News decision and the rationale of this case.  In Newport News, the Court concluded that the relevant inquiry was whether the design effort at issue was a necessary prerequisite to delivery of the ships required by the contract.  Because delivery of the ships could not be accomplished without completing the design, the Court agreed with the Government that the design effort was implicitly “required” by the contract and therefore did not qualify as allowable IR&D.  In ATK, the Court concluded that what is “required” by a contract depends on the intent of the parties.  Because the evidence demonstrated that the parties clearly did not intend that the generic commercial development effort would be a part of their commercial contract, the Court found that the costs qualified as IR&D, even though the development effort was admittedly a necessary prerequisite to performing the commercial contract.  It seems likely that the result at the Court of Appeals will turn on whether the demonstrated intent of the parties trumps an undeniably implicit “requirement.” 

In the interim, while we are waiting for the case to work its way through the Federal Circuit, contractors will need to make hard decisions about how to charge IR&D costs.  This is an issue on which millions of dollars are likely to depend for some contractors.  Contractors that have accommodated the Government view about “implicitly required” effort will have to decide whether to continue to forego claiming what may be substantial costs while the case is pending a final decision on appeal.  Many contractors accommodated the Government view because history suggested that the Government might treat claims that were inconsistent with the Government view as false claims, as the Government did in Mayman and Newport News, or assert that they were subject to the penalties imposed on contractors for claiming expressly unallowable costs.  With the ATK decision on the books, the risk of false claims allegations and penalties is substantially reduced, so contractors may decide that they have nothing to lose by reclassifying costs in reliance on the decision. 

If the decision stands up on appeal, contractors will want to be very careful to negotiate new contracts, particularly with commercial customers, that are as clear as they can be about what effort is included in the contract and what effort is not included in the contract.  For old contracts, particularly those that involve substantial concurrent development efforts, it may be wise to review the negotiation records in connection with any decision to reclassify costs as IR&D. 

[1] In light of references in recent cases, including the ATK decision, to the use of standard dictionary definitions in Government contract cases, we could not resist consulting Webster's for a definition of silly: “exhibiting or indicative of a lack of common sense or sound judgment.”  That definition certainly fits the Government argument here.

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