Rental Costs - Part 2

Yesterday we began this two part series on rental costs by emphasizing the need for contractors to document their justification for determining rental costs are reasonable. Generally, rental costs are going to be allowable but the FAR cost principle governing rental costs make a great deal about "reasonableness" and provides a number of attributes that contractors need to document in order to demonstrate cost reasonableness. It is not uncommon for contract auditors to request that information during audits. If you missed Part 1, click here.

"Sales and leasebacks" are specifically called out in this FAR cost principle (FAR 31.205-36). Companies sometimes sell their assets and lease them back. One common reason for this practice is to get some cash (working capital) for operations but there are also income tax considerations that can work in their favor.

Rental costs under a sale and leaseback arrangement are almost always higher than ownership costs had the contractor retained title to the asset. Obviously, there is going to be some imputed interest in the rental rate. Therefore, FAR caps rental costs under sales and leaseback arrangements at the amount the contractor would be allowed (ownership costs) had the contractor retained title to the asset. The ownership costs are computed on the net book value of the asset(s), adjusted for gain or loss on the disposition of the asset(s) on the date the contractor became a lessee. Contract auditors will specific tailor their audit procedures to test for sales and leasebacks and other less than arms-length transaction.

The other thing to be concerned about with leases relates to terminated contracts. The FAR cost principle pertaining to rental costs (31.205-36) refers to a different cost principle for terminations (FAR 31.205-42). When a contract is terminated, contract performance is truncated and leases entered into for the purpose of the contract, have not yet run their course. Rental costs under unexpired leases are generally allowable under these circumstances but allowability is not automatic. The contractor must demonstrate that the lease was reasonably necessary for the performance of the terminated contract. The contractor must also demonstrate that the amount of rental claimed does not exceed the reasonable use value of the property leased for the period of the contract. Finally, the contractor must make reasonable efforts to terminate, assign, settle, or otherwise reduce the cost of such leases.

Leases between related parties. We previously covered the special rules governing leases between divisions, subsidiaries, and organizations under common control. To read that coverage, click here.