What Happens When You Don't Adjust Rental Costs for Property Under Common Control?

A marine maintenance company (IMIA) and a rental company owned by the marine maintenance company's executives (MES), have agreed to pay the Government $2.8 million to settle claims they improperly billed the Navy for rental equipment.

According to the settlement agreement, IMIA billed the Government for equipment rented from MES. Since the two companies are related, FAR (Federal Acquisition Regulations) 31.205-36, Rental Costs, limits rental costs to the actual cost of ownership.

IMIA did not disclose its relationship with MES when it billed the Navy for rental costs from MES. The Government calculated that IMIA had overbilled the Navy by $1.4 million, the amount in excess of the actual cost of ownership. The Government contends that IMIA knowingly presented such claims for unallowable costs to the Navy in violation of the False Claims Act.

The settlement agreement calls for the two companies to pay $2.8 million to the Government of which $1.4 million will go back to the Navy as restitution.

There was no mention in the Justice Department press release as to how the alleged fraud was uncovered. We think it very likely that it was uncovered as a result of an audit by DCAA (Defense Contract Audit Agency) since DCAA participated in the investigation.

Rental costs are typically a high-risk category for a contract auditor. Any time there are significant rental costs in a proposal or incurred cost submission, the auditor will undoubtedly make inquiries as to whether payments were made to related parties.

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.

Rental Costs - Part 1

There are two kinds of leases capital leases and operating leases. Earlier this year, we presented a five-part series on capital leases (see Part 1, Part 2, Part 3, Part 4, and Part 5). The cost principle governing capital leases is found in FAR 31.205-11(h). A different cost principle, FAR 31.205-36 covers operating leases.

FAR 31.205-36 applies to the cost of renting or leasing real or personal property acquired under operating leases. Generally, such rental costs are allowable, but the rates, terms, and conditions must have been reasonable at the time the lease was signed. The determination of "reasonableness" is always subjective but it is not common for contract auditors to question rental costs unless it is less than an arms-length transaction.

For a discussion on rent paid to related parties, click here.

Before entering into any rental agreement, contractors should consider and document the following FAR induced factors. The Government may ask for it.

• Rental costs of comparable property, if any
• Market conditions in the area
• The type, life expectancy, condition, and value of the property leased
• Alternatives available, and
• Other provisions of the agreement.

How much premium does five miles justify?

A number of years ago, the Government challenged a major contractor's rental payments for office space. The particular office space was adjacent to a major university and the employees working there were assigned to the contractor's research and development department. Five miles down the Interstate, the contractor leased other facilities for half the cost of those situated next to the university. The contract auditors determined that the contractor had not considered alternatives. The auditors noted that there was plenty of vacant office space in the half-price vicinity and recommended that the contractor consolidate its operations into the less expensive area. The cost savings to the Government would have been more than a million dollars per year.

The contractor argued that the particular R&D section benefited greatly by being close to a research university - its employees could more easily collaborate with University researchers than they could if they were five miles away. Basically, the contractor built a case based on perceived or intangible benefits. The contracting officer (Defense Contract Management Agency) was persuaded by the contractor's arguments and did not sustain the auditor's position.

Tomorrow we will look at other aspects of this cost principle (see Part 2)

When Black and White is Not So Black and White

In 1991, MPR, a Government contractor, negotiated at arms-length, a ten-year office space lease at reasonable, below market rental rates compared to those charged for similar facilities. Three years later, MPR, set up a related company to purchase the building. The lease cost continued the same as they were before MPR purchased the building through a related company.

The Government auditors took a position that allowable costs after the purchase was limited to the actual cost of ownership,as required under the related party provisions of FAR 31.205-36 and questioned the difference. MPR argued that the costs were reasonable at the time the lease was entered into and that the subsequent purchase of the office building did not negate that fact.

There were other issues involved in the audit of costs. During negotiations, MPR and the Government reached an oral agreement on all matters in question. MPR agreed to relinquish its position on the allowability of excessive executive compensation, patent costs and B&P costs while the contracting officer agreed to allow the full rental costs.The parties reached an oral agreement, had exchanged consideration and had a meeting of the minds on the agreement's major terms with respect to the outstanding cost issues before them. All that remained was for someone to recalculate the rates based on the agreement.

Before the oral agreement was formalized in a written agreement, the contracting officer's legal counsel advised that contracting officer lacked the authority to allow costs made unallowable by FAR 31.205-36. The contracting officer then reneged on his oral agreement and issued unilateral rates with the rental costs reduced to the actual cost of ownership. MPR appealed to the ASBCA (Armed Board of Contract Appeals).

The ASBCA ruled in favor of MPR. The Board ruled that the oral agreement was binding. The Board stated, concerning the oral agreement, that

This is not a case where the ACO violated a plain requirement of a statute or regulation. There is no plain illegality here. The ACO was authorized to exercise his judgment in interpreting the regulations to resolve the rent issue under the cost principles. The ACO's interpretation of the cost principles in light of the change in appellant's status during the course of the lease was not clearly unreasonable. Under the totality of these circumstances, therefore, the ACO acted within his authority in interpreting the regulations to resolve the doubt concerning the reasonableness of the MPR rental rates and costs and entering into the oral agreement with MPR that settled all cost issues.

Facilities Capital Cost of Money and Rent Paid to Affiliated Parties

As a general rule, in order to claim cost of money, a contractor must first propose it. FAR 31.205-10, Cost of Money, states that facilities capital cost of money (FCCOM) is allowable provided an estimate of FCCOM was specifically identified and proposed in cost proposals relating to the contract under which the cost is to be claimed. So, to claim it, you have to had proposed it.

Over in FAR 31.205-36, there is a discussion on how to compute allowable rental costs when contractors are paying rent to related parties. According to FAR 31.205-36(b), the following costs are allowable:

Charges in the nature of rent for property between any divisions, subsidiaries, or organizations under common control, to the extent that they do not exceed the normal costs of ownership, such as depreciation, taxes, insurance, facilities capital cost of money, and maintenance (excluding interest or other unallowable costs pursuant to Part 31), provided that no part of such costs shall duplicate any other allowed cost (emphasis added).

Similarly, Section 7-206.2 of the Defense Contract Audit Manual includes the following:

Leasing costs between divisions, subsidiaries, or organizations under common control for operating leases are generally allowable to the extent that costs do not exceed the normal costs of ownership (excluding interest or other costs unallowable and including cost of money) (emphasis added).

Periodically, a question arises concerning the allowability of FCCOM in a rental computation when the contractor did not originally propose FCCOM. If the contractor did not initially propose FCCOM, can it include FCCOM as one of the elements for calculating the cost of ownership?

The NASA Board of Contract Appeals answered that question in a 1988 case involving Engineering, Inc. (NASA BCA No. 187-2, CCH 88-2, pg 105.029). The Government had questioned FCCOM as part of the cost of ownership because Engineering, Inc. had waived FCCOM in its contract. The Board, in ruling against the Government, specifically ruled that Engineering Inc. was entitled to rental costs not to exceed the normal costs of ownership including FCCOM, despite having waived FCCOM in its contract.

You can read more about FCCOM here. If you have any questions concerning the application of FCCOM, feel free to contact David Koeltzow ("Kelso") at 360-910-4146.