Background: Pursuant to a requirement in the FY 2007 National Defense Authorization Act (Section 852, P.L.
109-64), the Department of Defense (DoD) has issued an interim rule effective on April 26, 2007, that prohibits
the payment of excessive pass-through charges on certain subcontracts under prime contracts and higher-tier
subcontracts (including task orders and delivery orders) that are entered into for or on behalf of the DoD. See
72 Fed. Reg. 20,759, 4/26/07. Although the interim rule does not apply to contracts that do not involve
substantial levels of subcontracted effort, these provisions have profound implications for DoD prime
contractors or subcontractors that subcontract a significant part of their overall work under a federal contract.

Summary of DFARS Changes: The interim rule amends DFARS Parts 215 (Negotiated Contracts), 231
(Cost Principles) and 252 (Solicitation and Contract Clauses) to establish definitions and rules relating to
charges that prime and higher-tier subcontractors apply to their subcontracts. These rules were motivated by
congressional concerns that government contractors were applying charges to subcontracts while adding little
or no value to the overall contract effort. The effective date of the interim rule is April 26, 2007.

Application: The interim rule's requirements apply whenever an offeror or potential subcontractor at any
tier intends to subcontract more than 70 percent of the work to be performed under the prime contract or
subcontract to a lower-tier subcontractor. The rule also applies in the event that a contractor or
subcontractor changes the amount of subcontracted work from the level identified in its proposal to an
amount greater than 70 percent. However, the following contracts are exempt from these requirements:

  • Fixed-price contracts awarded on the basis of adequate price competition
  • Fixed-price contracts (including fixed-price contracts with economic price adjustment) for
    commercial items.

Summary of New Requirements and Key Definitions: The provisions impose specific requirements on
offerors to identify in their proposals the indirect charges and profit they are adding to subcontract work and
to describe the value they are adding to the subcontracted work. The new provisions also require the
contracting officer to determine whether such charges are excessive.

Potential prime contractors and subcontractors must specifically identify in their proposals the level
of effort they intend to perform and the level of effort they expect to be performed by each
subcontractor. If the level of subcontracted effort exceeds 70 percent, the offeror must identify:

  • The amount of the offerors' indirect costs and profit applicable to the subcontract work
  • A description of the value added by the offeror to the subcontracted work. Offerors that add “no or negligible value” to a contract or subcontract are prohibited from including "excessive pass-through charges" in proposals.
  • An offeror will be determined to be adding “no or negligible value” if it cannot demonstrate that
    its effort adds to the substantive value of the contract or subcontract.
  • “Excessive pass-through charge" is defined as “a charge to the Government...that is for indirect
    costs or profit on work performed by a subcontractor (other than charges for the costs of
    managing subcontracts and applicable indirect costs and profit based on such costs).”
  • In the event a contractor or subcontractor is determined to have charged the government an
    excessive pass-through charge, the government is entitled to a price reduction (in the case of fixedprice
    contracts) or to disallow the charge (under cost-reimbursement contracts).

Discussion and Practitioner Tips: The interim rule imposes substantial new requirements upon government
prime contractors and subcontractors whenever they contemplate subcontracting out a significant amount of
work. Although it would seem that prime contractors and higher-tier subcontractors should have little difficulty
showing that they are adding more than “negligible” value, the rule seems to imbue contracting officers with
significant discretion to determine whether pass-through charges are “excessive.” Moreover, the new rule
provides that the government shall have access to the contractor's records for up to three years after final
payment under the contract or subcontract, so such issues may not arise until long after the government has
accepted the contractor's original proposal for the work. This may complicate the contractor's ability to prove
the value it added to subcontracted work. Government prime and subcontractors should take immediate steps
to:

  • Review and, as necessary, revise their proposal policies to ensure that their proposals clearly identify all
    instances in which the level of subcontracted work will approach or exceed 70 percent of the total contract
    or subcontract value.
  • Ensure that proposals clearly identify the nature of the functions they will be performing and services they
    will be providing in order to demonstrate the value they are adding to subcontracted work.
  • Any comments concerning the interim rule that contractors may want the DoD to consider in implementing
    the final rule must be submitted on or before June 25, 2007 by mail to: Defense Acquisition Regulations
    System, Attn: Mr. John McPherson, OUSD (AT&L) DPAP (CPF), IMD 3C132, 3062 Defense Pentagon,
    Washington, DC 20301-3062; by fax to 703-602-0350; or by the Federal eRulemaking Portal at
    www.regulations.gov.