Elimination of CAS Exemption for Overseas Contracts and Subcontracts
On August 10, 2011, the Government published a final rule, which eliminated the exemption to compliance with the Cost Accounting Standards ("CAS") for contracts and subcontracts executed and performed entirely outside the United States. Known as the "(b)(14) overseas exemption," the exemption has been in place since 1973, when the underlying authority for CAS – the Defense Production Act – was applicable only to the United States, its territories and possessions, and the District of Columbia.
The rationale provided in the final rule for the elimination of this exemption is as follows:
- The statutory basis for the exemption is gone: The CAS Board ceased to exist under the Defense Production Act in 1980. It was reestablished in 1988 but under a different statute – the Office of Federal Procurement Policy Act – and that statute's applicability is not limited to the United States.
- An accounting basis for the exemption is absent: According to the final rule, the place of contract execution and performance is not relevant to the measurement, assignment, and allocation rules in CAS.
- No hardship will result from elimination of the exemption: The CAS Board states that it does not foresee hardship for federal agencies or contractors with the elimination of the overseas exemption. First, contractors and subcontractors will still have the exemption for contracts and subcontracts with foreign governments/agents/instrumentalities ("foreign government exemption"). Second, contractors and subcontractors performing entirely overseas will be required to comply only with CAS 401 "Consistency in Estimating, Accumulating and Reporting Costs" and 402 "Consistency in Allocating Costs Incurred for the Same Purpose," and these requirements are minimal and not substantively different from what is already required by the Federal Acquisition Regulation ("FAR").
In response to comments voicing concern about foreign concerns' ability to comply with CAS and complete a Disclosure Statement (which is currently available only in English), the rulemakers focused on the benefits expected to be received by taxpayers and pointed out that there are foreign companies unable to take advantage of the overseas exemption that are currently able to comply with the CAS requirements. Other comments raised concern in particular about the effect on foreign subcontractors. The rulemakers recognized that their visibility into foreign subcontractors is limited and stated that if the impact on foreign subcontractors is sufficient, the CAS Board will be able to reconsider the elimination of the overseas exemption for subcontracts.
Overall, we anticipate that the number of companies affected by this rule will be limited, although the impact on some affected companies could be significant. As stated by the Board, the entities that will be affected by this rule, i.e., "foreign concerns," will be subject to two basic CAS standards. In addition, foreign companies owned by foreign governments are completely exempt under the "foreign government exemption" mentioned above. As the rulemakers noted, any foreign entity that will be required to comply with CAS 401 and 402 under this rule would already be covered by FAR provisions that are virtually identical to the substantive requirements of those Standards, although the rulemakers fail to note those foreign entities will, for the first time under this rule, be subject to CAS price adjustment provisions on covered contracts, including fixed-price contracts. The potential for impact will be small for many contractors, but will be significant for some, as described below.
First, the government itself will need to address the coverage issue when awarding prime contracts to foreign concerns. Many foreign concerns are already required to comply with CAS because their contracts involve some performance in the United States, so the new rule will extend coverage only to prime contracts that have no contact at all with this country. The cost and other benefits of the Government's decision to subject itself to the administrative burden of monitoring compliance with CAS in far-flung locations seem dubious, but the change in the rule for prime contracts will have little or no impact on U.S. contractors.
Second, the impact on U.S. prime contractors awarding subcontracts outside the U.S. could be a more significant problem. U.S. primes will need to flow CAS coverage down to newly-covered subcontracts performed entirely outside the United States, unless another exemption applies. For example, many overseas purchases are with entities owned by foreign governments, are for commercial items, are awarded based on adequate price competition, or are awarded to foreign concerns that have not received a $7.5 million "trigger" award, and, accordingly, those subcontracts would be exempt from CAS coverage. In addition, many major subcontracts with foreign concerns are already subject to CAS coverage because they involve at least partial performance inside the United States. The impact of the new rule will also be ameliorated to some extent in countries that have entered into a Memorandum of Understanding (MOU) with the Defense Department concerning procurement and audit issues. The MOUs with the major allies of the United States, where most existing CAS-covered subcontracts are performed, provide for audit of foreign companies by the local national audit agency in that country, so there is already an infrastructure in place to address audit issues.
There will, however, be additional burden for some prime contractors. DCAA's prior comments about this issue are instructive – and alarming. On October 20, 2010, when it issued a Notice of Proposed Rulemaking on the (b)(14) exemption (75 Fed. Reg. 64684), the CAS Board summarized comments it had received in response to an earlier "Request for Information" that it had issued. The CAS Board quoted DCAA, as follows:
DCAA commented that the prime contractor will need to give greater attention to foreign concerns that are performing as subcontractors to U.S. contractors and will no longer be covered by the (b)(14) overseas exemption. DCAA observed that if the (b)(14) overseas exemption is eliminated, the foreign subcontractors would be subject to the (b)(4) foreign concern exemption and must comply with CAS 401 and 402. DCAA noted ‘that these foreign subcontractors' accounting practices are not always adequately defined and that the prime contractor's oversight responsibility for ensuring its foreign subcontractors' CAS compliance is not clearly understood and properly executed.' DCAA recommended that the prime contractor be required to evaluate the CAS compliance of its subcontractor, and to submit the CAS evaluation report on the subcontractor to its Contracting Officer (CO). DCAA also recommended that the Government be provided the right to examine the subcontractor's records for CAS compliance when the prime contractor does not submit the CAS evaluation report on a subcontractor's compliance with CAS to the CO. To mitigate these concerns, DCAA recommends that the Board strengthen the CAS contract clause to ‘* * * clearly require the prime contractor to enforce CAS compliance by its foreign subcontractor.' [Id. at 64689]
While the CAS Board declined to adopt the DCAA recommendation for enhanced oversight requirements for prime contractors, DCAA may press for FAR changes to achieve its recommended result.
Why DCAA, the self-proclaimed guardian of taxpayers' funds, made that recommendation is puzzling. In other comments, as quoted by the CAS Board, DCAA correctly expressed doubt about the cost-effectiveness of the proposed change:
[DCAA] believes that those firms most affected by the elimination of the (b)(14) overseas exemption will be foreign concerns that are subcontractors to U.S. prime contractors. DCAA commented that the cost of administering CAS requirements to certain foreign subcontractors that are currently CAS exempt under the (b)(14) overseas exemption might outweigh the benefit to be derived from making CAS applicable to them. [Id. at 64686]
In light of the DCAA comments, it is difficult to understand the CAS Board's conclusion that the new rule is not covered by the Paper Work Reduction Act "because this rule imposes no additional paperwork burden on offerors" and is exempt from other possible statutory and regulatory limitations on new rules because "the economic impact of this final rule on contractors and subcontractors is expected to be minor." This rule could impose a significant additional paperwork burden, both on U.S. prime contractors and on their foreign subcontractors. The cost of administering this new requirement, particularly in those parts of the world, including the Middle East, where there are no international agreements concerning audits and no existing audit infrastructure, could make the cost of CAS coverage problematic for individual contractors.
Assuming it is even possible for prime contractors to find CAS-compliant subcontractors in countries where the Government is currently spending hundreds of billions of dollars under wartime conditions, the CAS Board promulgation completely ignores the real significance of the new rule. While it is true that the substantive requirements of CAS 401 and 402 are virtually identical to FAR requirements that already apply to foreign subcontractors, FAR does not incorporate the CAS price adjustment rules. Once a fixed-price contract is awarded, there is no FAR provision that permits adjustment of the price of that subcontract to reflect subsequent changes in cost accounting practices or noncompliance with CAS requirements. Moreover, because the definition of "small business" covers only domestic entities, the CAS exemption for small businesses will not be applicable to foreign concerns. Even if the number and value of subcontracts covered by the new rule is modest, as seems likely, the administrative cost of monitoring CAS compliance, including changes in accounting practice, for subcontractors on fixed-price, non-exempt subcontracts in places like Afghanistan and Pakistan will almost certainly be completely disproportionate to any modest benefit that the Government might realize from extending CAS coverage to those subcontracts. In fact, given the administrative problems associated with enforcing the CAS requirements on foreign subcontractors, the likelihood is that compliance will be spotty or non-existent, creating an opportunity for expensive disputes about what is likely to be uneven enforcement efforts by the Government.
It is also important to recognize that although prime contractors are contractually responsible for CAS violations of their subcontractors, as a practical matter prime contractors are completely removed from CAS administration for domestic subcontracts. Virtually all domestic subcontractors with CAS-covered contracts and subcontracts have their own Cognizant Federal Agency Official ("CFAO") or Administrative Contracting Officer ("ACO") for DOD contractors/subcontractors and CAS issues are almost always resolved directly between the CFAO/ACO and the subcontractor, without the participation or even the knowledge of the prime contractors. In the real world, it would be virtually impossible for prime contractors to play any role in that process because they typically are not permitted to have access to the proprietary subcontractor information that would be required to monitor CAS compliance. As a result, most prime contractors do not need and do not maintain any CAS-compliance function for their subcontractors. As the DCAA comments quoted above indicate, if the new rule requires prime contractors to exercise a new oversight role for foreign subcontractors, where compliance issues are likely to be particularly challenging, the administrative effort required from prime contractors could be substantial.
Finally, the new rule will affect U.S. companies with foreign subsidiaries that provide products or services that are incorporated in U.S. government contracts. Those foreign subsidiaries have typically been exempt from CAS coverage when their work was performed entirely outside the United States. Because awards to these subsidiaries typically are not competitive, they will usually not be exempt from CAS coverage unless all individual awards are less than $7.5 million in value or for commercial items, so the subsidiaries may be required to comply with CAS 401 and 402, and with the price adjustment provisions in CAS. For some companies, CAS compliance issues for foreign subsidiaries may be the most difficult problem to address.
In fairness to the CAS Board, when it last addressed this issue on a truly independent basis in 2005-08, it decided not to rescind the exemption. After that decision, Congress sent a clear statutory message to the Board to reconsider. It seems likely that the Board interpreted that message as the moral equivalent of a direction to rescind the exemption. While the rulemakers are probably correct that the new rule will affect a relatively small number of contractors, the impact will be primarily in foreign locations where compliance is virtually impossible and enforcement will be difficult. It seems inconceivable that the benefit, if any, that taxpayers can expect from this new rule will be sufficient to offset the pointless administrative cost and effort that it will generate.
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