For Immediate Release
January 12, 2004
U.S. Government Contractors
Effectively determining the exemption available for direct and indirect overhead supplies used by Defense Contractors can be a difficult task. The exemption for overhead materials is generally determined by the percentage of government versus commercial contracts and then by whether or not the government contract contains the appropriate federal acquisition regulation (FAR) clauses. Further complicating the process is the fact that the FAR clauses for fixed price contracts and cost reimbursement contracts are different.
In Strayhorn v. Raytheon E-Systems, Inc. the Texas Court of Appeals, January 30, 2003, determined that title to tangible overhead items charged to contracts with the United States Government are exempt from sales tax under title-vesting provisions. The court rejected the Texas Comptroller’s argument that the sale for resale exemption turns on control and use rather than title. The case has been remanded to determine whether Raytheon collected the sales tax from the federal government.
In other states that have litigated whether indirect and direct overhead materials are exempt, government contractors have won the issue. For example, the California Court of Appeals determined in Aerospace Corp v. State Board of Equalization that under the appropriate title clauses the use of overhead materials occurred after title to the materials passed to the federal government. Therefore the overhead materials were exempt sales to the government. In addition to California, the issue has been litigated in Arizona (Motorola Inc. v. Arizona Dept. or Revenue, 1999); Connecticut (United Technologies Corp. v. Groppo, 1996); and Missouri (McDonnell Douglas Corp. v. Director of Revenue, 1997). In each of the states the courts determined that title to the overhead materials passed to the government prior to the defense contractors use.
Florida and Georgia have made statutory changes by amending their laws to phase in exemptions for overhead materials for government contractors. Florida phased the exemption in over five years with 100% of qualifying cost of overhead materials exempt effective July 1, 2003. Georgia phased the exemption in beginning January 1, 1997 through December 31, 1999. The exemption is scheduled for repeal in Georgia after December 31, 2004.
There are two classes of consumable supplies defined as overhead materials, direct overhead materials and indirect overhead materials. Direct overhead materials are supplies consumed in the performance of a contract that are directly identified to a specific contract. In contrast, indirect overhead materials are supplies consumed in the performance of a contract, the cost of which is charged to an overhead expense account and then allocated to various contracts based on generally accepted accounting principles. (Some states have determined that direct overhead materials are exempt from tax while the indirect overhead materials are subject to tax.)
In the Aerospace Corporation case, the court found that an allocation of indirect overhead materials based on direct labor hours incurred on the contract was an acceptable method of allocation. The court further determined that there was not a requirement for the defense contractor to physically identify the materials through a means of a requisitioning system.
Leases
In general, leases of tangible personal property to a defense contractor are subject to sales or use tax. However, leases may be exempt when the leases are to contractors that occupy legal status of agents of the United States and to non-agents cost-plus contractors that act as agents when procuring from General Services Administration pursuant to a letter of authorization. It has been the policy of the Department of Defense not to designate government contractors as legal agents of the United States. Therefore, a lease between a defense contractor and a vendor; generally, does not include the United States as a party to such a lease and either sales or use tax applies to the lease of tangible personal property.
Exceptions to the lease rules may be available for misclassified property. For example software licenses may be determined to be sales rather than leases of property. If the software is “shrink warp” software without the requirement to renew the license at periodic intervals and the purchaser is not required to return CD ROM or diskette once the software is not longer useful the transaction may be classified as a sale rather than a lease.
If you would like additional information on this topic or have any questions, please contact James Privett, Regional Vice President - Sales & Use Tax Group at (615) 373-8373 or (615) 414-1682. E-mail jprivett@thesaltgroup.com
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