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."

Paying for Development Costs

When it comes to paying for intellectual property under negotiated contracts, the Government always seems to want something for nothing. Businesses might spend years and years and millions of dollars to design, develop, and patent a certain product or process. The Government comes along and want to buy it, but only wants to pay the actual cost of manufacturing. Under most costing techniques, those development costs, might not be allowed.

This is a real sticky area and extremely difficult to negotiate since there are no precedents, and the value is often at opposite ends of the spectrum for the contractor and the Government. The value is often determined by other factors - how badly does the Government want/need the item versus is the Government the only market in town or are there other alternatives (sources) for the Government. Most contracting professionals would advise contractors to seek legal counsel when it comes to such matters. FAR 31.109 would recommend these type of costs be subject to an advance agreement in order to preclude later disputes over the allowability, allocability, and especially the reasonableness of such costs.

No one would expect Microsoft to sell copies of its "Office" product (Word, Excel, Access, PowerPoint, etc.) at its production costs. What would that be, a few dollars for a DVD and a box, or nothing if the customer downloaded it? No one would expect Boeing to sell its commercial aircraft at production costs. The price of those aircraft include an amortization of development costs that were incurred long before the aircraft went into production. The same argument can be made for products that the Government buys where there was significant development effort required years before the purchase is made.

One thing that contractors should do is capture and accumulate development costs even if the costs are written off as a period expense each year. This shouldn't be too difficult with today's efficient web-based timekeeping systems and accounting software products. Once the costs are known, you at least have data to support your case. You might still argue over how many units those costs should be amortized over and how much of it the Government might have already paid for (through reimbursement of Independent Research and Development (IR&D) but at least you have a starting point from which to support your position.

Patent Costs - Miscellaneous Considerations

Today we are finishing up our discussion of patents, royalties, and related costs. Essentially, if patents are required by your contract, you can claim the costs. If you must go out and pay royalties to support your contract, you can claim the royalty costs as an expense.

Because patents and royalties are often contentious areas between contractors and the Government, FAR 31.109(h) lists royalties and other costs for use of patents as an example for which advance agreements may be particularly important. Advance agreements are used when the reasonableness, the allocability, and the allowability under the specific cost principles (i.e. FAR 31.205) are difficult to determine. To avoid possible subsequent disallowance or dispute, contractors and the Government are encouraged to seek an advance agreement on how such costs will be treated. This effectively takes the auditor our the the determination process.

FAR 31.205-47, costs related to legal and other proceedings, is also relevant to our discussion on patent/royalty costs. The cost of patent infringement litigation are unallowable (unless, of course, provided for in the contract). This means that the Government is happy to use your patents but it will not pay to help defend those patents. I guess the logic here is that there is no adverse consequence to the Government when someone violates a contractor's patent rights.

The final aspect of this subject we want to highlight is the requirement to document your costs. Many costs related to patents fall under the broad category of professional and consultant service costs (FAR 31.205-33). That cost principle requires specific documentation to support the allowability; consulting agreement, invoice, and work product (or evidence of services rendered). Be sure that when you claim costs associated with patents, you also maintain the basic documentation required by this cost principle.

Royalties and Other Costs for the Use of Patents

We are continuing our discussion on patent costs from yesterday. If you missed yesterday's posting, read it here.


Royalties on a patent or amortization of the cost of purchasing a patent or patent rights necessary for the proper performance of the contract and applicable to contract products or processes are allowable unless:

1. the Government has a license or the right to a free use of the patent;
2. the patent has been adjudicated to be invalid, or has been administratively determined to be invalid;
3. the patent is considered to be unenforceable; or
4. the patent is expired.

Attempting to determine whether the Government has a license or right to a free use of a particular patent is often times difficult and there are frequent disputes between the Government and patent holders as to the Government's rights. The Government is usually aggressive in asserting its rights, especially when it feels that it has already contributed to the value of the patent.

Auditors are often concerned about the costs of royalties when there is not an arms-length transaction involved. They are especially attuned to royalties paid to persons, including corporations, affiliated with the contractor, paid to unaffiliated parties, including corporations, under an agreement entered into in contemplation that a Government contract would be awarded, and paid under an agreement entered into after the contract award.

In cases where a patent was formerly owned by the contractor, the royalty amount allowed cannot exceed the cost which would have been allowed had the contractor retained title. Acquiring records to support the costs that would have been allowed is usually problematic for contractors. The auditor's going-in position is usually zero dollars.