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 October 2010 

Lt. Gen. Lawrence P. Farrell, Jr., USAF (Ret)Pressure on Defense Companies Grows, Will Continue to Mount 

October 2010

by Lt. Gen. Lawrence P. Farrell, Jr., USAF (Ret) 

Much has been said about the approaching and converging financial storm fronts on the defense industry and the projected budget adjustments. One element of the coming change has been the efficiency initiative unveiled by Defense Secretary Robert Gates and its accompanying efforts in the weapons-acquisition area announced by Undersecretary of Defense Ashton Carter.  

Industry CEOs are just now beginning to learn details about the proposed reforms and their implications. The initiatives will focus on internal Defense Department processes and procedures that deal with, among other things, the contracts that will be used in the future for development and production of defense articles and services.

The trend seems to be away from cost-plus award fees to fixed-price contracts that shift more of the risk to industry. Specifics on the implementation and policy/process to achieve these initiatives will likely roll out over several months. NDIA will follow this closely. Stay tuned as we continue to learn more about the new measures.

Two other areas of concern, meanwhile, are now working their way through the regulatory system: One is the Interim Federal Acquisition Regulation rule on executive compensation reporting. The second is the 3 percent tax withholding law that is scheduled to become effective Jan. 1.

The interim FAR rule implements the Federal Funding Accountability and Transparency Act (FFATA) of 2006 which requires the Office of Management and Budget to establish a free public website containing full disclosure of all federal contract award information. The Government Funding Transparency Act of 2008 (Section 6202) subsequently amended this rule. This last act was buried in the Government Wide Supplement Appropriations Act for 2008. The amendment requires the website to include the names and compensation of the five most highly paid employees of companies that receive prime contracts worth more than $25,000.

The General Services Administration incorporated an additional rule that called for compensation disclosure for so-called “tier one” subcontractors. NDIA, in concert with The Council of Defense and Space Industry Associations (CODSIA), objected to this proposal. The letter to GSA can be obtained at: codsia@pscouncil.org. CODSIA concluded that not only did the law place excessive burdens on industry, but that it went beyond it in adding subcontractors to the requirement. The recommendation from CODSIA is asking the executive agencies involved to seek some relief from Congress on the most severe provisions of the law.

There are many reasons for industry objections. The reporting of compensation for privately held companies is certainly one, while the additional administrative responsibility on medium and small companies is another, as they already struggle with excessive reporting demands. All defense firms should become more familiar with this issue.

Next is the 3 percent withholding tax. This was enacted in Section 511 of the Tax Increase Prevention and Reconciliation Act of 2005 (P.L. 109-222) as section 3402(t) of the Internal Revenue Service code. It mandates that federal, state and local governments withhold 3 percent of nearly all contractors’ payments, Medicare payments, farm payments and other grants. The premise of the law is that some government contractors are not paying their taxes, and this will ensure compliance. NDIA and other associations have objected vigorously to this law as it appears unfair on its face. First, the IRS has many ways to enforce tax collection, and since its passage, many more methods have come in force. Second, the vast majority of government contractors are current on tax obligations. Why burden all of these tax compliant companies to address the problems of a few violators?

Some large companies may be able to shoulder this unreasonable demand, but many medium size companies and most, if not all, small businesses will be unable to comply with this draconian rule and stay in business. Cash-strapped small businesses would be forced to increase debt levels and lines of credit. As prime contractors adjust to this demand, the fear is that the burden will be passed down to subcontractors, many of which are small businesses. NDIA contends that withholding 3 percent as a flat percentage of government payments bears no relationship to companies’ taxable incomes and will restrict the cash flow needed for day-to-day operations and investments.

This also adds substantially to administrative and capital investment costs not only for business but for government as well. The final objection is that this rule will be difficult to implement, and promises to be costly. The Defense Department reported to Congress in 2008 that this law would cost $17 billion over five years to execute.  

When combined with the current downturn in the economy and the pressure from ongoing Pentagon cost-saving efficiencies, it is difficult to make any sense of this legislation. A letter to the House Ways and Means Committee and the Senate Committee on Finance that is being sent on behalf of industry makes the case for legislative relief.

These issues reflect the tough economic times we face and the increasing burden that defense firms are being asked to bear in an ever more difficult environment for doing business.

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