United States: COFC: Independent Research and Development Defined by Intent of the Parties

The United States Court of Federal Claims just issued a long-awaited decision on the proper treatment of independent research and development (IR&D) costs and the meaning of "required in the performance of a contract" as that phrase is used in Cost Accounting Standard (CAS) 420 and Federal Acquisition Regulation (FAR) 31.205-18. ATK Thiokol, Inc. v. United States, No. 99-440C (Fed. Cl. Nov. 30, 2005). The Court held that whether a cost is so required depends on the intent of the parties as determined by contract interpretation.

ATK Thiokol, Inc. (a subsidiary of Alliant Techsystems Inc.), manufactures aerospace products, including launch vehicle motors, which it sells to the federal government, foreign governments and commercial companies. To remain competitive in its industry, Alliant performs R&D work concurrent with contract performance. Therefore, when a new contract begins, Alliant accounts for R&D costs in two separate pools: (1) development work related to the contract; and (2) development work not directly related to the contract.

In the late 1990s, Alliant and Mitsubishi Heavy Industries entered into a contract to adapt one of Alliant’s motors for use with a Japanese launch vehicle (Mitsubishi Contract). The parties agreed that Mitsubishi would pay for the contract-unique effort to adapt the motor to the Japanese launch vehicle but that Alliant would fund internally the development effort and production equipment necessary to upgrade the motor for the commercial market. In addition to its commercial business work, Alliant performed and continues to perform significant business with the federal government. As such, Alliant discloses its cost accounting practices relating to, e.g., IR&D, tooling, equipment and facilities costs. From 1990 to 1997, the government periodically reviewed and determined that Alliant’s cost accounting practices complied with CAS.

Alliant treated the IR&D costs incurred for the general improvements of the motor, costs not covered by the Mitsubishi Contract, as indirect costs. In 1999, the government disallowed the IR&D costs and production equipment costs, claiming that the costs were required by and specifically benefited Alliant’s contract with Mitsubishi. Alliant submitted a claim, which led to the case before the Court. The principal issue before the Court was whether the technical and development effort that Alliant treated as IR&D was "required in the performance of" the Mitsubishi Contract under CAS 420 and FAR 32.205-18.¹

The Court based its decision that the IR&D costs qualified as indirect costs on fundamental understandings of direct and indirect costs. To interpret the undefined phrase "required in the performance of a contract," the Court determined that CAS 420 must be construed in context with the other CAS, particularly the consistency standards in CAS 402, which include definitions of direct and indirect costs. The Court noted that the distinguishing element of whether a cost is direct or indirect is whether the cost "is identified specifically with a particular final cost objective," a "specific requirement in an existing contract." Slip op. at 31, 32. The Court held, therefore, that whether a "cost is ‘required in the performance of a contract’ is controlled by the contracting parties’ intent, as determined by traditional contract interpretation on a case-by-case basis." Id. at 39. Accordingly, the Court looked to the Mitsubishi Contract’s statement of work to determine whether the motor upgrade is a cost of the contract. The Court concluded that the motor upgrade and associated costs are not "required in the performance of the contract," because the upgrade was a prerequisite of Mitsubishi Contract work and the costs of the general improvements were not set forth in the contract’s detailed price structure. Id. at 41-42. In determining that the IR&D costs were properly treated as indirect costs, the Court also relied on Alliant’s CAS Disclosure Statement. The statement, which the Government repeatedly found CAS compliant, defined a cost as "direct" only when "(a) a contract specifically required that Plaintiff incur the cost; (b) the contract paid for the cost; or (c) at the time Plaintiff incurred the cost, the cost had no reasonably foreseeable benefit to more than one cost objective." Id. at 42 (emphasis in original). Consequently, the Court determined that, because the Mitsubishi Contract did not specifically require or pay for the IR&D work, and because a commercial market appeared viable for the motor upgrade, Alliant appropriately treated the IR&D costs as indirect costs.

The Court’s decision is significant because it is the first case by a government contract tribunal to decide the long-debated definition of the term "required in the performance of a contract." Moreover, the Court adopted the interpretation that contractors have long espoused: that one must look to the contract’s statement of work to determine whether the work and associated costs are "required in the performance of a contract." The Court left its decision flexible, however, by stating that a determination must be made on a case-by-case basis. Finally, the Court’s decision is important because it deviates from the decision in United States v. Newport News Shipbuilding, Inc., 276 F.Supp.2d 539 (E.D. Va. 2003). In that case, the district court held that a contractor could not treat IR&D costs as indirect costs if the costs were implicitly required in the performance of a contract, even if the costs stood to benefit other contracts. The Newport News decision created much distress in the government contract community. That decision will now have limited application, if any, because the Court of Federal Claims along with the Boards of Contract Appeals are the only tribunals that decide Government contract disputes.² A question remains whether the Boards of Contract Appeals will follow the Court of Federal Claims’ position in this debate. For now, however, Alliant is controlling law and contractors may rely upon the decision for treatment of IR&D costs.

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