When a contractor performs Government contracts in foreign countries, whether under Foreign Military Sales (FMS) contracts or for domestic requirements, certain host countries impose taxes on the contractor. FAR 31.205-41(a)(1) specifically addresses the allowability of Federal, state, and local taxes but does not address the allowability of foreign taxes. According to DCAA's Contract Audit Manual (CAM), foreign taxes are analogous to state or local taxes and are therefore considered to be allowable contract costs (see CAM 7-1408a). That's the good news. Now for the not so good news.
Contractors may have to pay some or all of these foreign taxes back to the Government. When a contractor has paid income taxes to a host country, it may be able to claim a foreign tax credit against its Federal income tax. If so, the contractor would be duplicating the recovery of foreign income tax expenditures - first as a contract cost and second as a reduction in its Federal income tax liability.
To preclude this windfall, FAR requires that the contractor repay the amount of the tax credit. For fixed price contracts, the reduction must be paid or credited to the U.S. Government as directed by the contracting officer (see FAR 52.229-6(h)). For cost type contracts, the same procedure applies except in cases where the foreign government is reimbursing the contractor's costs. In that case, FAR 52.229-9 specifically requires the payment to the Treasury and prohibits credit to a contract.