Unpaid Royalties Included in Government Contracts

Generally, royalties on a patent or amortization of the cost of purchasing a patent or patent rights necessary for the proper performance of a contract and applicable to contract products or processes are allowable.  There are some exceptions however when royalty costs are unallowable. For example, if the Government has a license or the right to a free use of the patent, the costs are unallowable. Sometimes there are situations where the patent has been adjudicated to be invalid, or  has been administratively determined to be invalid. The Government is not going to pay for royalties on invalid patents of course. Same goes for patents considered to be unenforceable or expired patents.

But what happens when royalty costs have been included in a proposal for a fixed price contract, the Government accepts such costs, but it turns out that the contractor didn't pay or didn't need to pay royalties after all? Well, we can assure you that the Government will want its money back. But a deal's a deal, right? Not so fast. In the case of unpaid royalties, most fixed price contracts include a provision that requires pay back.

Some contracts contain recapture provisions to become effective in the event actual royalty payments are less than those estimated and included in the negotiated prices. Specifically, FAR 52.227-9, Refund of Royalties, establishes procedures for the Government to recover royalties not paid by the contract when the royalties were included in the contractor's fixed price. You might want to check your contract(s) for that clause.

There's another FAR clause that may come into play. FAR 27.202-3 prescribes actions for the contracting officer to take to protect the Government's interests if royalties paid or to be paid to the contractor are excessive, improper, or not consistent with Government rights. This provision states that if, at any time, the contracting officer believes that any royalties paid, or to be paid, under a contract or subcontract are inconsistent with Government rights, excessive, or otherwise improper, the contracting officer shall promptly report the facts to the office having cognizance of patent matters for the contracting activity concerned, and then, if appropriate, demand a refund.

Who's going to find out whether a contractor has negotiated royalties but ultimately didn't have to pay? Contract auditors, for one, when performing defective pricing reviews (i.e. audits of compliance with the Truth in Negotiations Act). These unpaid royalties must be an issue from time to time because contract auditors have been specifically instructed to "... be alert to identify these circumstances and promptly notify the contracting officer."