Intercompany Transaction Cost Restrictions and Allowability for Government Contractors

As more and more companies are acquiring companies or being acquired, a predominant question that arises is can I do work with my new or existing affiliates. The simple answer is yes, but there are specific requirements in the FAR on how transactions are performed between affiliates. The requirements of intercompany transactions are found in two primary cost principles FAR 31.205-26 – Materials Costs and FAR 31.205-36 Rental Costs.

FAR 31.205-26 (e) states that allowances for services, materials, or supplies transferred by any affiliate, division, subdivision, etc. of the Government contractor that are under common control will be at cost, i.e., profit omitted. Although provisions of FAR do not define common control, it is generally presumed that any Government contractor within an organization, where a parent or corporate entity manages/owns that contractor and other affiliates, will be under “common control” for purposes of cost/price transfers between the contractor and its affiliates.

This same subsection of FAR permits the contractor to price amounts to the Government for items or services transferred from an affiliate at other than cost (at price) when certain conditions exist. For a contractor to obtain reimbursement on a basis at other than cost for items or services transferred by an entity under common control, three fundamental tests must be met:

• Transferring organization must have an established practice of pricing interorganizational transfers of items or services at “other than cost” for commercial work of the contractor, or any affiliate, division, subsidiary, etc. of the Government contractor under a common control.

This requirement means that the transferring organization must be able to demonstrate a historical practice of providing the same items/services to the Government contractor, or other affiliates under a common control, for sales to non-Government customers. Evidential data substantiating such a practice would include sales history information confirming that the same services or supplies had been “sold” at price to affiliates, where the end users of the services/supply were commercial customers. Other information that may justify this practice would include commercial product catalogues that identify these same items or services within that publication.

• There must be an exception to the requirement for cost or pricing data as outlined in FAR 15.403-1(b). Such exceptions would include (1) adequate price competition; (2) items/services meet the FAR definition of “commercial”; (3) catalogue or market price; (4) price set by law or regulation; or, (5) modification to an existing commercial contract (or subcontract).
• If the two tests above are met, the contracting officer must not have determined that the transferred price is unreasonable. If the transferring organization has historically billed/bid such items/services at price to the Government, and the contracting officer has not taken exception to this practice, the contractor receiving these items/services may presume an implicit acceptance to this practice. However, the contractor should be certain that the contracting officer’s previous “acceptance” was not inappropriate, and that the tests above were met in those historical situations.

The idea behind these limitations on intercompany transactions is to avoid doubling up on profit, meaning to pay a contractor profit on top of a material item for which it has already received profit. Contract auditors are very aware of this potential risk and will closely scrutinize any estimates or costs incurred under cost-type contracts for intercompany transactions to ensure that costs are consistent with the FAR limitations.

The second cost principle related to intercompany transactions is FAR 31.205-36 Rental Costs. FAR 31.205-36(b)(3) limits allowable rental or lease costs to actual costs of ownership for related party transactions. Normal costs of ownership are depreciation, taxes, insurance, maintenance, and facilities capital cost of money. We frequently encounter situations where an affiliate is renting or leasing a facility to another affiliate and have the mistaken notion that the “market rates” for similar lease/rental property can be claimed costs under government contracts.

Common control is also a factor regarding FAR 31.205-36. DCAA guidance instructs the auditor to review two specific areas regarding rental costs: (1) the actual decision-making process and (2) the reasonableness of the lease terms. The audit guidance provides a specific example related to joint venture decision making process regarding the determination of control. The audit guidance states that percentage of ownership is only one factor to be considered in evaluating control and that controlling interest could exist even where the controlling individual only owns a small percentage of the company’s equity if that company is performing all the decision making for the joint venture.

Secondly, the audit guidance instructs the auditor to evaluate unreasonable lease terms which may provide evidence of control. The auditor is instructed to compare the lease terms with:

1. The contractor’s other comparable leases that did not involve a related party,
2. Other comparable leases, and
3. Actual advertised prices for the facilities in question or similar facilities.

The audit guidance does state that while showing the lease costs are unreasonable will not itself constitute a determination of common control, but it is an important factor and could demonstrate that the lease costs were unreasonable at the time of the lease decision under the provisions of FAR 31.205-36(b)(1).

Redstone GCI has a team of consultants with extensive experience with assisting Government contractors with establishing intercompany transaction policies, procedures, and practices to be complaint with the FAR cost principles. Our team would be happy to discuss any potential issues or concerns facing your organization as it relates to these compliance areas.