Despite decades of legal precedent to the contrary, the recent U.S. Court of Federal Claims Teknowledge Corporation decision imposes additional hurdles for federal government contractors seeking to recover research and development costs incurred in connection with commercial work. See Teknowledge Corp. v. U.S., No. 06-310C (Fed. Cl. filed January 7, 2009) (“Teknowledge Corporation”). A contractor pursuing research and development that may generate both commercial and federal government sales should recognize not only the benefits, but also the risks associated with seeking reimbursement of those research and development costs under federal government contracts.  

Contractors benefit because the federal government will reimburse an equitable share of those costs without imposing most of the Federal Acquisition Regulation (“FAR”) provisions applicable to the award and performance of a federal government research and development contract. In addition, the government generally encourages contractors to pursue contractorsponsored research and development, including Independent Research and Development (“IR&D”), to (1) increase the pool of technology to meet government needs; (2) foster greater competition through the availability of alternative technologies; and (3) generally promote technological advances that could not be achieved by government-sponsored efforts alone. See Report of Armed Services Investigating Subcommittee, Committee on Armed Services, House of Representatives, 91st Cong., 2d Sess., on Review of Independent Research and Development Program Management, at 13. However, contractors run the risk that these costs will ultimately be disallowed because of conflicting legal precedent set by the courts and the administrative boards of contract appeals regarding the recovery of research and development costs. As discussed below, the recent Court of Federal Claims decision in Teknowledge Corporation only appears to add to the controversy.  

Compliance With Accounting Standards In The Teknowledge Corporation Decision

In general, a contractor may recover a portion of its contractor-sponsored research and development costs as an indirect cost under a government contract if the contractor complies with the FAR allocability and allowability provisions; the generally accepted accounting principles, such as the Financial Accounting Standards (“FAS”); and the contractor’s established accounting practices. In Teknowledge Corporation, the Defense Contract Management Agency (“DCMA”) successfully argued that software development costs incurred by the contractor’s commercial business segment were neither allocable to government contracts, nor allowable because any potential benefit to a government contract from the software development was too speculative.  

Accounting for Software Development Costs under FAS No. 86 and the Contractor’s Established Accounting Practices. Here, FAS No. 86 is the relevant generally accepted accounting principle. FAS No. 86 governs accounting for the costs of developing and producing computer software that will be sold, leased or otherwise marketed. FAS No. 86 requires the contractor to distinguish research and development costs and production costs. Under FAS No. 86, research and development costs incurred before technological feasibility has been established should be expensed. Production costs incurred after technological feasibility has been established must be capitalized. Further, FAS No. 86 requires amortization to begin when the software product is available for general release to customers.  

Consistent with FAS No. 86, the contractor in Teknowledge Corporation treated the software development as production costs because the technological feasibility of the software had been established. In addition, consistent with its established accounting practices and as required for a production cost under FAS No. 86, the contractor capitalized its software development costs and began charging the amortized costs to its overhead pool, rather than expensing the entire cost of the development.  

Allocability of Costs to Government Contracts Under the FAR. The allocability of these amortized software development costs to government contracts is at issue in Teknowledge Corporation. The FAR determines whether the costs are allocable to government contracts. The contractor allocated a portion of those amortized software development costs incurred by its commercial division to its government contracts through its overhead pool. DCMA relied on the FAR provision discussed below to convince the Court of Federal Claims that these costs were not allocable to government contracts.  

The FAR provision applicable to determining whether a cost is allocable to a federal government contract states:  

A cost is allocable if it is assignable or chargeable to one or more cost objectives on the basis of relative benefits received or other equitable relationship. Subject to the foregoing, a cost is allocable to a Government contract if it—  

(a) Is incurred specifically for the contract;  

(b) Benefits both the contract and other work, and can be distributed to them in reasonable proportion to the benefits received; or  

(c) Is necessary to the overall operation of the business, although a direct relationship to any particular cost objective cannot be shown.

48 C.F.R. § 31.201-4 (emphasis added).

A contractor’s cost must satisfy one of the three prongs to be allocable. Prong (a) refers to the allocability of direct costs. Prongs (b) and (c) refer to the allocability of indirect costs, including the cost of contractor-sponsored research and development and IR&D. In Teknowledge Corporation, the government and the contractor agreed the software development costs were not required in the performance of any contracts, and, as such, were indirect costs that implicated prongs (b) and (c) of the allocability provision.

In addition to satisfying one of the three prongs, the U.S. Court of Appeals for the Federal Circuit has interpreted this FAR allocability provision to also require a showing that the government received some benefit from the cost incurred. See Boeing North American, Inc. v. Roche, 298 F.3d 1274, 1285 (Fed. Cir. 2002). Further, the Federal Circuit defined “benefit” as “the nexus required for accounting purposes between the cost and the contract to which it is allocated.” Id. In Teknowledge Corporation, the Court of Federal Claims held that the contractor provided no factual evidence to support either prong of the allocability provision. Further, as discussed in detail below, the contractor was unsuccessful in proving the government received any benefit from the cost incurred.  

U.S. Court of Federal Claims and the Armed Services Board of Contract Appeals Have Different Interpretations of the Federal Circuit’s ‘Benefit to a Government Contract’ Requirement for Allocability

The Court of Federal Claims and the Armed Services Board of Contract Appeals have different interpretations of the Federal Circuit’s requirement that a government contract receive a benefit from a cost incurred in order for the cost to be allocable. The Court of Federal Claims requires a showing of a general and specific benefit to a government contract. See Teknowledge Corp. v. U.S.; see also KMS Fusion, Inc. v. U.S., 24 Cl. Ct. 582, 584, 589 (1991) (“KMS Fusion”). Further, the Court of Federal Claims seems to imply that for a specific benefit to be conferred, there must be evidence of actual benefit rather than merely a potential benefit to a government contract. Id. The Armed Services Board of Contract Appeals construes the “benefit” requirement more broadly, requiring some general benefit be shown. Lockheed-Georgia Co., ASBCA No. 27660, 90-3 B.C.A. ¶ 22,957 (citing Lockheed Aircraft Corp. v. U.S., 375 F.2d 786, 794-95 (Ct. Cl. 1967) (“Lockheed Aircraft”)).  

The U.S. Court of Federal Claims Continues to Impose the ‘General and Specific Benefit’ Hurdle to Recovering Research and Development Costs Incurred in Connection With Commercial Work

The Court of Federal Claims’ decisions in Teknowledge Corporation and KMS Fusion provide insight into how a contractor may satisfy the general and specific benefit requirements for allocability. The Teknowledge Corporation decision identifies potential pitfalls to recovering research and development costs incurred in connection with commercial contracts at the Court of Federal Claims.

Teknowledge Corporation. In Teknowledge Corporation, the contractor argued unsuccessfully that the government received a benefit from the costs incurred to develop its TekPortal software. The contractor stated the government received the general benefit of the contractor’s continued viability, and the specific benefit of its commercial business absorbing indirect costs that would have otherwise been charged to the government. However, the contractor did not provide evidence that the software development contributed to its increase in commercial business. The contractor only offered evidence that it began developing the software for the financial services industry, and that it eventually unsuccessfully proposed the software in its response to three Government Requests for Proposals.

The Court of Federal Claims found that the software development did not provide the requisite general or specific benefit to a government contract. The court relied on the contractor’s statement that it was not using the software in the performance of any of its contracts. Based on that statement, the court found that the increase in its commercial business could not be attributed to the software development. Therefore, the court held that the software could not provide the general benefit of improving the overall viability of the company, nor could the software development have provided the specific benefit of reducing indirect costs allocated to its government contracts. Further, the contractor did not assert any other general or specific benefit to the contractor’s government contracts. Therefore, the court was left to conclude that “any benefit to the Government resulting from TekPortal development costs would be too remote and insubstantial to deem them allocable.”

The court’s reasoning seems to also imply that for a specific benefit to be conferred, there must be evidence of actual benefit rather than merely a potential benefit to a government contract. It was not enough for the contractor to show that the software (1) had been offered to government and commercial customers for sale; (2) had the potential to increase sales; and (3) had the potential benefit of reducing indirect costs charged to government contracts. The court concluded that the contractor needed to show actual benefit to a government contract or, in other words, that the reduction in indirect costs charged to government contracts had already occurred.

KMS Fusion, Inc. In contrast to its Teknowledge Corporation decision, the Court of Federal Claims held in its KMS Fusion decision that the costs incurred to employ a government affairs consultant provided both general and specific benefit to the government, and were allocable to the contractor’s government contracts. The contractor hired the government affairs consultant to diversify its business in the federal government market. At time the consultant was hired, the contractor provided specialized technical expertise primarily in support of one Department of Energy (“DoE”) contract. Although KMS Fusion does not address recovery of research and development costs in connection with commercial work, the arguments presented here to prove general and specific benefit to the government are useful to a contractor that intends to recover research and development costs as indirect costs under its government contracts.

The contractor successfully argued that the government received general and specific benefits as a result of the costs incurred for the consultant. The contractor stated that the DoE benefited in a general sense because the DoE could make better-informed procurement decisions based on the consultant’s insights. Relying on sales data as support that the consultant was successful in generating new business, the contractor also stated that the costs incurred for the consultant provided a specific benefit to its DoE contract because the increase in contracts (1) resulted in a decrease in the indirect costs allocated to the DoE contract and (2) enabled the contractor to remain viable if the government reduced the funding under the current DoE contract. Here, the court relied on the sales to data to find a specific benefit in the form of an actual increase rather than a potential increase in awarded contracts and a corresponding decrease in indirect costs allocated to the DoE contract. Based on this showing of general and specific benefits to a government contract, the court held that the cost of the consultant was allocable to the contractor’s government contracts.

The Armed Services Board of Contract Appeals Is More Likely to Accept a Showing of Only “General Benefit” to a Government Contract

General Benefit Requirement. Unlike the Court of Federal Claims, the Armed Services Board of Contract Appeals (“ASBCA”) is more likely to accept a showing of only general benefit to a federal government contract for purposes of allocability. In fact, the ASBCA has consistently held that IR&D costs incurred in connection with commercial work are allocable to federal government contracts without imposing the Court of Federal Claims’ specific benefit requirement. See Data-Design Labs., ASBCA No. 27535, 85-3 B.C.A. ¶18,400 (“Data-Design Labs”); see also General Dynamics Corp., Elec. Boat Div., ASBCA No. 18503, 75-2 B.C.A. ¶ 11,521, recon. den. 76-1 B.C.A. ¶11,743 (“General Dynamics”).

In Data-Design Labs, the ASBCA stated the test for allocability, citing its 1968 decision in TRW Systems Group:  

as absolute necessity [for the cost in relation to the overall operation of the business] decreases, the contractor’s burden to show some benefit to or other equitable relationship with Government contracts increases.  

See Data-Design Labs., ASBCA No. 27535, 85-3 B.C.A. ¶18,400 (citing TRW Systems Group of TRW, Inc., ASBCA No. 11499, 68-2 B.C.A. ¶7117).  

Here, the ASBCA also cited the U.S. Court of Claims’ decision in Lockheed Aircraft where the court concluded that the requirement to show a benefit is implicit in the allocability provisions, and “that the benefit required is a general one.” See Data- Design Labs (citing Lockheed Martin Corp. v. U.S., 375 F.2d 786 (Ct. Cl. 1967)). Here, the Court of Claims found that California property tax levied based on the contractor’s commercial inventory was necessary to the overall operation of the business and thus, provided a benefit to government contracts that was general in scope and sufficient to find the tax allocable to government contracts.  

Data-Design Labs Decision. In its Data-Design Labs decision, the ASBCA held that only a benefit to a government contract of a general nature is required when an IR&D project is conducted “to obtain new business to replace declining Government business.” See Data-Design Labs., ASBCA No. 27535, 85-3 B.C.A. ¶18,400 (citing General Dynamics Corp., Elec. Boat Div., 75-2 B.C.A. ¶11,521). The contractor was developing an electronic ballast that would substantially reduce the energy consumed by fluorescent lamps. The contractor intended to market the product to government and commercial customers. The ASBCA held that IR&D costs were allocable because the government would have benefitted from the energy conservation and, more generally, from a reduction in indirect costs to government contracts had the commercial business developed.  

General Dynamics Decision. In its General Dynamics decision, the ASBCA allowed the contractor to recover IR&D and Bid & Proposal (“B&P”) costs incurred in seeking commercial business with a showing of general benefit to a government contract “because [the costs] were basic to appellant’s viability as a commercial enterprise.” See General Dynamics Corp., Elec. Boat Div., ASBCA No. 18503, 75-2 B.C.A. 11,521. The ASBCA held that using IR&D and B&P to develop the arctic tanker and foreign attack submarines for a new class of commercial customers was necessary to the overall operation of its business, satisfying the third prong of the FAR allocability provision. Furthermore, the ASBCA found the contractor was ameliorating the effects of the decline in government business which, if successful, the ASBCA noted, would have benefited government contracts through (1) commercial contracts absorbing a greater portion of the contractor’s indirect costs; (2) providing the government valuable engineering and construction data; and (3) providing the contractor’s employees valuable training in the construction of submarines that was transferrable to its government contracts.

Contractors Should Proceed With Caution When Recovering Research and Development Costs Incurred in Connection With Commercial Work

Contractors conducting research and development or IR&D projects that have both commercial and government sales potential generally may recover the cost of these projects under federal government contracts. The contractor must comply with the FAR, generally accepted accounting principles, and its own established accounting practices. Finally, contractors should seek legal counsel in making a determination as to whether the costs incurred meet the FAR allocability provision as interpreted by the Court of Federal Claims and the Armed Services Board of Contract Appeals.