A recent case ruled that a Subchapter S corporation’s state income taxes incurred on its corporate income but paid by the shareholders is an allowable contract cost (Information Systems & Networks Corp. v US, Fed. Cl. No-98-663C). Subchapter S corporations do not pay taxes but flow income to shareholders who, in turn, pay taxes. FAR 31.205-41 provides that when a contractor pays taxes from which it is exempt the taxes are unallowable but the court held that though the contractor was technically "exempt" from paying state income taxes due to its subchapter S status, the court concluded that this is not a tax exemption in the normal sense of the term. Normally an exemption results in the complete absence of payment of the tax but here the burden shifted to the shareholder and the FAR does not require that any specific part of the corporation pay the state income taxes in order to qualify for reimbursement. Neither does the FAR intend that certain organizations should be denied allowability of the tax simply because of its tax election or corporate structure.

When a contractor performs work in a foreign country the host country commonly imposes taxes on the contractor and since they are analogous to state or local taxes they are considered allowable contract costs. When a contractor has paid an income tax to a host country it can claim a foreign tax credit against its federal income tax resulting in a reduction in federal income tax by the full amount of the foreign credit. DCAA considers this a duplicative recovery of a foreign income tax expenditure – first as a contract cost and then as a reduction in its federal income tax liability. In 1991 the FAR was revised to require contractors to credit government contracts for foreign tax credits claimed on US income tax returns when these allowable foreign income taxes are claimed on contracts. Even for fixed price contracts, FAR 52.229-6(h) requires that if a contractor receives a reduction in its US tax because of any tax or duty which was included in a contract price, the amount of the reduction shall be paid or credited to the government.

The ability of a state government to tax a federal government contractor for purchases related to the contract has been a controversial matter and the outcome depends on the state involved. For example, Missouri courts have ruled the state cannot tax a contractor that is using purchased items in direct contract performance (US v. Benton, DC WD Mo. No. 89-0608). In California and Arizona, the courts have held that even indirect materials may be exempt from state taxes based on a reasonable allocation of these materials to contracts. On the other hand, Colorado courts have permitted imposition of state use and regional transportation taxes on special tooling equipment used by a contract when it is delivered to the government at the close of contract performance. As recognized in FAR 29.401-6 the New Mexico state courts have held that certain state taxes are applicable to services provided under federal contracts and until the federal government gets a ruling, any state taxes paid to New Mexico are allowable. One court has ruled that a county may tax a contractor for the beneficial use of government furnished property in its possession (DC Ne. No CV-S-94-687). In another decision the court was unmoved by the argument that the property belonged to the federal government and was used exclusively for government work (US v NY county, 178 Fed 1080).

When sales tax refunds are made, the government’s share is dependent on the type of contract and specific terms and conditions in the contract. The government is entitled to a share of any refund allocated to a cost reimbursable contract. However, for fixed price contracts, any government share is dependent on two contract clauses – progress payments based on costs and property title provisions. If a contract does not contain a progress payments clause and the contractor purchased property does not become government property when purchased, the government will not receive a share of such refunds under fixed price contracts (ASBCA No. 49339).

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