Defense Firms May Net Billions on Expired Pacts

In what would be a belated windfall from the Cold War, major defense firms appear on the verge of winning a titanic battle with the Internal Revenue Service that could net them billions of dollars in tax refunds on long-expired weapons contracts.

The contractors are seeking credits for money they spent on research and development programs as far back as the early 1980s--money that came from the federal government in the first place.

“There is a lot of money riding on this issue,” said Ralph A. Muoio, one of a handful of Washington tax attorneys representing the industry. “You are probably talking about a couple billion dollars.”

Without publicity, virtually all major defense contractors--including General Dynamics, Hughes Aircraft, TRW and General Electric--have in recent years quietly demanded refunds from the IRS, according to U.S. Tax Court records and tax attorneys.

IRS officials privately are outraged over the defense contractor demands, asserting that the government paid the firms for the research in the first place and that Congress never intended that the credits would apply to federal contracts.

“We are not going to acquiesce,” said IRS spokesman Wilson Fadley.

But the confidence of the IRS was rocked late last year in a little-noticed decision issued by the U.S. Circuit Court of Appeals that held that Fairchild Industries was entitled to a tax refund for research conducted in the early 1980s on the now-defunct Air Force T-38 trainer jet program. The IRS is now scrambling to find a new legal argument but industry officials have all but declared victory.

*

The tax battle is so intense partly because it features two establishments considered among the most knowledgeable and savvy players in the arcane world of government regulations.

The defense industry has come under particularly harsh criticism recently because of its large executive bonuses and because it has received special Pentagon reimbursements for shutting plants and laying off workers.

The genesis of the tax issue dates to the early 1980s, when the Pentagon began pumping $1 trillion into weapons development and production, fueling the largest peacetime defense mobilization in history.

Only much later did it dawn on tax attorneys in the defense industry that many of the weapons contracts could qualify for research-and-development tax credits. Although the credits were enacted in the early 1980s, tax attorneys said they became part of the tax code only when the IRS completed adopting the necessary regulations in the early 1990s.

The provisions allow a firm to claim a credit that represents a percentage of its research spending, as long as the spending increases from year to year. Congress enacted the credits as a way of giving U.S. corporations incentive to conduct research that would make the economy more productive and competitive.

The defense industry, however, did not begin to demand refunds on the credits until well after the research had been conducted--undermining the idea that the credits were an incentive.

*

Defense industry attorneys said, however, that under public law the contractors are entitled to the refunds and they have an obligation to shareholders to get them.

“What would we say to shareholders, that we wanted to give the government some more money?” said McGree Grigsby, a Latham & Watkins attorney representing Hughes Aircraft.

“Are people going to be unhappy because defense contractors prospered during the Reagan defense buildup and now are getting a refund? The credit was available to everybody,” he added.

The big legal issue in the battle involves the question of risk. Under the law, a firm can claim the credit only if it bears the risk of success and failure in the research.

The defense industry has argued that 1980s Pentagon contracts, which were issued under fixed prices, forced them to bear the risk of failure. Under this theory, the Pentagon was paying for the product of the research and not actually funding the research itself.

The IRS countered that defense firms faced essentially no risk, because the Pentagon routinely ignored its own contracts and paid defense firms, whether they succeeded or not.

The industry successfully debunked that argument in court, showing a number of instances in which defense firms lost hundreds of millions of dollars.

“The court found that argument ludicrous,” said Alexander Zakupowsky Jr., an attorney representing the Aerospace Industries Assn., which intervened on behalf of Fairchild. “God knows what the IRS is going to do now.”

Indeed, the IRS and the Justice Department, which represents the agency, have been scrambling to come up with a new theory. Justice Department attorneys declined to be interviewed.

A large bulge of tax claims dates back to the Cold War for two reasons. First, the credits are based only on year-to-year increases in research spending, which often occurred during the Reagan defense buildup. Second, is the fixed-price risk the contractors have cited. Today, much more research is funded under so-called “cost-plus” contracts, which reimburse a firm for all its expenses and therefore do not qualify for credits.

Ironically, the Fairchild case that appears to have set a precedent is among the smallest in terms of the amount in dispute, involving a refund of just $5.8 million.

*

What’s more, not only is the T-38 program now defunct--the plane was never produced--but Fairchild Industries long ago quit the aircraft business.

Hughes, TRW, Lockheed Martin and General Dynamics have cases in either Tax Court or the U.S. Court of Claims. Other cases are still wending their way through the IRS’ internal examination and audit process.

Citing IRS secrecy rules, Fadley said he could not provide a list of contractors seeking refunds. But he confirmed that the agency has additional cases.

Why this whole issue has taken so long to resolve is a result of the IRS’ method of auditing corporate tax returns that can take up to a decade even without serious disputes.

“No company I know of is happy about the fact that it is 1996 and we are still in the process of determining the tax liability for the years 1983, 1984 and 1985,” said Grigsby.