FAR 31.205-41—Taxes.
Plain-English Summary
FAR 31.205-41 explains when taxes are allowable as contract costs and when they are not. It covers allowable Federal, State, and local taxes that are paid or accrued under generally accepted accounting principles; taxes that are disputed as illegal or erroneously assessed; the special treatment of the Environmental Tax under Internal Revenue Code section 59A (the “Superfund Tax”); and the allowability of reasonable costs incurred to challenge or recover disputed taxes when the contracting officer directs or concurs. It also identifies several categories of unallowable taxes, including Federal income and excess profits taxes, taxes tied to financing or reorganizations, taxes from which the contractor can obtain an exemption, special assessments for capital improvements, certain property taxes used solely for non-Government work, specified excise taxes under subtitle D chapter 43 of the Internal Revenue Code, income tax accruals used to smooth book-tax differences, and the tax imposed under 26 U.S.C. 5000C. The section further explains how to allocate property taxes between Government and non-Government work, and how to handle refunds, credits, and foreign tax credits when taxes or related interest and penalties were previously reimbursed as contract costs. In practice, this rule matters because it determines whether a tax cost can be billed to the Government, how disputed taxes must be handled before payment, and how later refunds must be returned or credited to the Government.
Key Rules
Allowable taxes must be paid or accrued
Federal, State, and local taxes are allowable only if they are required to be paid or accrued in accordance with generally accepted accounting principles, and only to the extent no other paragraph makes them unallowable. Fines and penalties are not taxes and are not allowable as taxes.
Disputed taxes need CO direction
If a tax otherwise allowable is claimed to be illegal or erroneously assessed, the contractor must promptly ask the contracting officer for instructions before paying it. The contractor must then follow the contracting officer’s direction, or the Government’s independent decision, to challenge the assessment or seek a refund.
Challenge costs can be allowable
Reasonable costs incurred to determine the legality of the tax or to secure a refund are allowable when taken at the contracting officer’s direction or with the contracting officer’s concurrence under the disputed-tax procedure. Interest or penalties caused by nonpayment at the contracting officer’s direction, or by the contracting officer’s failure to respond timely after a prompt request, are also addressed as allowable under this rule.
Superfund Tax is allowable
The Environmental Tax under Internal Revenue Code section 59A, also called the Superfund Tax, is specifically identified as allowable under this section.
Several taxes are expressly unallowable
Unallowable items include Federal income and excess profits taxes; taxes connected with financing, refinancing, refunding, or reorganizations; taxes from which the contractor can obtain an exemption; special assessments on land that are capital improvements; certain property taxes used solely for non-Government work; excise taxes under subtitle D, chapter 43 of the Internal Revenue Code; income tax accruals used to reflect book-tax timing differences; and the tax imposed under 26 U.S.C. 5000C.
Exemptions must benefit the Government
If an exemption is available directly to the contractor, or through a Government-based exemption, the tax is unallowable unless the contracting officer decides the administrative burden of obtaining the exemption outweighs the benefit to the Government. If only part of the tax is exempt because of Government contract activity, the contractor must not charge the Government more than the amount remaining after the preferential treatment is applied.
Property taxes must be allocated by use
Taxes on property used solely for Government work or solely for non-Government work should be charged directly to the appropriate work category unless the amounts are insignificant or another reasonable result is achieved. Taxes on property used for both types of work must be apportioned based on the property’s use on the respective final cost objectives.
Refunds and credits belong to the Government
Any taxes, interest, or penalties that were allowed as contract costs and later refunded must be credited or paid to the Government as directed. If a foreign tax credit reduces U.S. Federal income tax because of a reimbursed foreign tax or duty, the reduction must be paid to the U.S. Treasury when the Federal return is filed, subject to the rule on interest actually earned on the refund.
Responsibilities
Contractor
Identify taxes correctly, record them in accordance with GAAP, and exclude all expressly unallowable taxes from contract cost claims. When a tax is disputed as illegal or erroneous, promptly request instructions from the contracting officer before paying it, then follow the directed course of action to contest the assessment or seek a refund. Return or credit any refunded taxes, interest, or penalties that were previously reimbursed, and remit required foreign tax credit reductions to the U.S. Treasury.
Contracting Officer
Provide instructions when a contractor reports a disputed tax before payment, and direct or concur in actions to challenge the assessment or recover a refund. Decide whether the administrative burden of obtaining an available exemption outweighs the benefit to the Government, and direct how refunded amounts are to be credited or paid back.
Government
Make independent determinations on the existence of a claim of illegality or erroneous assessment when appropriate, and ensure that tax preferences attributable to Government contract activity are realized by the Government rather than retained by the contractor. Receive credits, repayments, or Treasury deposits required by this section.
Accounting/Finance Function
Apply GAAP consistently to tax accruals, segregate allowable from unallowable taxes, allocate property taxes between Government and non-Government work based on use, and track refunds, interest, penalties, and foreign tax credits so they can be properly credited back.
Practical Implications
Contractors cannot simply book every tax expense to contracts; they must screen for the specific unallowable categories in this clause, especially income taxes, financing-related taxes, and taxes tied to exemptible activity.
If a tax bill looks illegal or overstated, paying it first and asking questions later can create allowability problems; the contractor should notify the contracting officer promptly and wait for direction.
Property tax allocation is a common audit issue: if the property supports both Government and commercial work, the tax must be apportioned on a reasonable use basis, not charged entirely to one side.
Refunds are not a windfall to the contractor when the original tax was reimbursed by the Government; the contractor must return the reimbursed amount, and in some cases also remit related foreign tax credit benefits.
Contractors should maintain documentation showing how tax allowability, exemptions, disputed-tax actions, allocations, and refund credits were determined, because these items are frequently reviewed in incurred cost audits and cost allowability disputes.
Official Regulatory Text
(a) The following types of costs are allowable: (1) Federal, State, and local taxes (see part 29 ), except as otherwise provided in paragraph (b) of this section that are required to be and are paid or accrued in accordance with generally accepted accounting principles. Fines and penalties are not considered taxes. (2) Taxes otherwise allowable under paragraph (a)(1) of this section, but upon which a claim of illegality or erroneous assessment exists; provided the contractor, before paying such taxes- (i) Promptly requests instructions from the contracting officer concerning such taxes; and (ii) Takes all action directed by the contracting officer arising out of paragraph (2)(i) of this section or an independent decision of the Government as to the existence of a claim of illegality or erroneous assessment, to- (A) Determine the legality of the assessment or (B) Secure a refund of such taxes. (3) Pursuant to paragraph (a)(2) of this section, the reasonable costs of any action taken by the contractor at the direction or with the concurrence of the contracting officer. Interest or penalties incurred by the contractor for non-payment of any tax at the direction of the contracting officer or by reason of the failure of the contracting officer to ensure timely direction after a prompt request. (4) The Environmental Tax found at section 59 A of the Internal Revenue Code, also called the "Superfund Tax." (b) The following types of costs are not allowable: (1) Federal income and excess profits taxes. (2) Taxes in connection with financing, refinancing, refunding operations, or reorganizations (see 31.205-20 and 31.205-27 ). (3) Taxes from which exemptions are available to the contractor directly, or available to the contractor based on an exemption afforded the Government, except when the contracting officer determines that the administrative burden incident to obtaining the exemption outweighs the corresponding benefits accruing to the Government. When partial exemption from a tax is attributable to Government contract activity, taxes charged to such work in excess of that amount resulting from application of the preferential treatment are unallowable. These provisions intend that tax preference attributable to Government contract activity be realized by the Government. The term "exemption" means freedom from taxation in whole or in part and includes a tax abatement or reduction resulting from mode of assessment, method of calculation, or otherwise. (4) Special assessments on land that represent capital improvements. (5) Taxes (including excises) on real or personal property, or on the value, use, possession or sale thereof, which is used solely in connection with work other than on Government contracts (see paragraph (c) of this section). (6) Any excise tax in subtitleD, Chapter 43 of the Internal Revenue Code of 1986, as amended. That chapter includes excise taxes imposed in connection with qualified pension plans, welfare plans, deferred compensation plans, or other similar types of plans. (7) Income tax accruals designed to account for the tax effects of differences between taxable income and pretax income as reflected by the books of account and financial statements. (8) Any tax imposed under 26 U.S.C. 5000 C. (c) Taxes on property (see paragraph (b)(5) of this section) used solely in connection with either non-Government or Government work should be considered directly applicable to the respective category of work unless the amounts involved are insignificant or comparable results would otherwise be obtained; e.g., taxes on contractor-owned work-in-process which is used solely in connection with non-Government work should be allocated to such work; taxes on contractor-owned work-in-process inventory (and Government-owned work-in-process inventory when taxed) used solely in connection with Government work should be charged to such work. The cost of taxes incurred on property used in both Government and non-Government work shall be apportioned to all such work based upon the use of such property on the respective final cost objectives. (d) Any taxes, interest, or penalties that were allowed as contract costs and are refunded to the contractor shall be credited or paid to the Government in the manner it directs. If a contractor or subcontractor obtains a foreign tax credit that reduces its U.S. Federal income tax because of the payment of any tax or duty allowed as contract costs, and if those costs were reimbursed by a foreign government, the amount of the reduction shall be paid to the Treasurer of the United States at the time the Federal income tax return is filed. However, any interest actually paid or credited to a contractor incident to a refund of tax, interest, or penalty shall be paid or credited to the Government only to the extent that such interest accrued over the period during which the contractor had been reimbursed by the Government for the taxes, interest, or penalties.