On March 19, 2010, the United States Court of Appeals for the Federal Circuit addressed the meaning of Independent Research and Development (IR&D) costs in a much-anticipated decision, ATK Thiokol, Inc. v. United States, No. 2009-5036 (Fed. Cir. Mar. 19, 2010). The court affirmed the 2005 decision of the Court of Federal Claims, which held that ATK properly charged rocket motor development costs to IR&D.
The issue arose when ATK incurred additional development costs to improve a "strap-on" rocket motor known as the Castor IV XL (XL). ATK sold the improved XL to Mitsubishi Heavy Industries (Mitsubishi), but Mitsubishi refused to pay the extra development costs in its contract. Consistent with ATK's disclosed cost accounting practices, ATK charged the development costs to IR&D. The Government contended that the costs were "required" in the performance of the Mitsubishi contract and disallowed the costs under FAR 31.205-18. On appeal, the principal issue was whether the FAR (and CAS) exclusionary language ("required in the performance of a contract") operated to exclude as IR&D, costs incurred for efforts that were both explicitly and implicitly required by a contract (the Government's position), or only those efforts specifically required by a contract (ATK's position).
Although the court rejected both parties' textual and regulatory history arguments, it agreed with ATK that IR&D and bid and proposal (B&P) costs must be interpreted similarly because the exclusionary language for each cost is identical. The court focused on Interpretation No. 1 of CAS 402, which the court said had the effect of equating the definitional exclusion of proposal costs that are 'required in the performance of a contract' with costs that are 'specifically required by the provisions of a contract.'" Slip op. at 10. Because the Government's interpretation of "IR&D" would result in different constructions of identical regulatory language, the court rejected it.
The court considered the Government's concern that contractors might "game the system" under the interpretation advanced by ATK. To the contrary, the court concluded that public policy favored ATK's interpretation. First, as the Defense Department has recognized, supporting IR&D has the positive effect of creating incentives for contractor innovation. Second, the Government's position - an expansive view of the IR&D exclusionary language—could have the "perverse effect" of requiring a contractor to charge all R&D for a proposed product line to the first contract in that line. This is "not sensible as a policy matter." Slip op. at 12. Accordingly, because the costs at issue were "related to the Mitsubishi contract but were not specifically required by the contract," the costs were properly charged as indirect IR&D.
ATK Thiokol clarifies an issue that has been hotly disputed between contractors and the Government for many years, and it represents a significant victory for contractors. The exclusionary language of FAR 31.205-18 now will apply only where a development effort is "specifically required" by the contract to which it relates. Contractors should remember, however, that ATK's treatment of the XL development costs was consistent with its disclosed cost accounting practices. Although the court did not directly address this issue, contractors must continue to ensure that any IR&D charging is consistent with their disclosed cost accounting practices.