FAR 31.205-41 Taxes: Allowable Costs, Exemptions, and Refunds

Under FAR 31.205-41, taxes are allowable costs on a government contract when they are required by law and recorded under generally accepted accounting principles, with a defined list of exceptions. Allowable taxes include sales and use taxes on contract materials, payroll taxes such as FUTA and state unemployment contributions, and real estate taxes on property used in contract performance. Unallowable taxes include federal income and excess profits taxes, taxes tied to financing or reorganization, special assessments on land, taxes on property used only for commercial work, Chapter 43 excise taxes on employee benefit plans, income tax accruals for book-tax differences, and any tax the contractor could have avoided through an available exemption.¹

The Two Conditions Behind Every Allowable Tax

Two tests run through the entire cost principle. The tax has to be legally required, so voluntary payments and overpayments don’t qualify. And the tax has to be accounted for under GAAP, so an accrual-basis contractor can’t shift a tax to cash treatment to move the cost into a different period.¹

Fines and penalties are not taxes for purposes of this principle. They are governed separately by FAR 31.205-15 and are generally unallowable when they result from the contractor’s own failure to comply.²

Taxes That Are Never Allowable

The regulation names several categories that cannot be charged to a government contract under any circumstances.¹

Federal income and excess profits taxes.
Taxes incurred in connection with financing, refinancing, or corporate reorganization, which cross-reference the interest cost principle at FAR 31.205-20 and the organization cost principle at FAR 31.205-27.
Special assessments on land, which are treated as capital improvements and recovered through depreciation or amortization rather than as current tax expense.
Taxes on property used solely for non-government work.
Excise taxes imposed under IRC Subtitle D, Chapter 43, which covers qualified pension plans, welfare plans, deferred compensation, and similar arrangements.
Income tax accruals designed to account for differences between taxable income and pretax book income.

No amount of documentation or contracting officer approval will convert any of these into an allowable cost.

The Exemption Rule Is Where Most Disallowances Happen

A tax is unallowable to the extent the contractor could have obtained an exemption, either in its own right or through an exemption available to the government. The word “exemption” is defined broadly. It means freedom from taxation in whole or in part, and it includes any tax abatement or reduction resulting from the way a tax is assessed, calculated, or otherwise applied.¹

A standard sales tax exemption certificate is the obvious case. A reduced property tax assessment through a local enterprise zone, or a preferential calculation available to government suppliers, counts just as much. If the contractor didn’t pursue the reduction, the government won’t pay the difference. Partial exemptions tied to government work follow the same logic: the contractor can charge only the reduced amount, because tax preferences connected to government contracting are meant to benefit the government through lower costs.¹

One narrow escape exists. A contracting officer can determine that the administrative burden of chasing an exemption outweighs the savings. Auditors read this exception strictly, and the dollars usually have to be trivial relative to the effort for it to apply.

Property Used for Both Government and Commercial Work

Taxes on property used exclusively for a government contract are a direct charge. Taxes on property used exclusively for commercial work are unallowable against government contracts. For shared-use property, which describes most contractor assets, the tax has to be allocated across all work on the basis of the property’s actual use on each final cost objective.¹

The allocation method has to be reasonable, consistently applied, and documented. Switching between square footage and headcount from year to year invites disallowance. The regulation permits a broader allocation method when the amounts are too small to justify a direct approach or when the broader method produces comparable results.¹

Contesting a Tax You Think Is Wrong

A contractor can recover the cost of a tax it believes is illegal or incorrectly assessed, but only by following a specific sequence. Before paying the disputed tax, the contractor must promptly request instructions from the contracting officer and then follow whatever course the officer directs, whether that means challenging the assessment or pursuing a refund.¹

Reasonable costs of the challenge itself, including legal and accounting fees, are also allowable when the contractor acts at the contracting officer’s direction or with the officer’s agreement.¹ A contractor who pays a disputed tax before contacting the contracting officer loses the ability to claim it. Request instructions first; act second.

Penalties and Interest on Taxes

Penalties for late or underpaid taxes fall under FAR 31.205-15 and are unallowable when they stem from the contractor’s failure to comply with tax law.² Interest on late tax payments is treated as interest on borrowings and is unallowable under FAR 31.205-20.³

The one meaningful exception runs through the dispute process. Interest or penalties incurred because the contractor followed the contracting officer’s instructions, such as delaying a tax payment during a contested assessment, are allowable. FAR 31.205-20 specifically carves out interest assessed by state or local tax authorities under the disputed-tax provisions of FAR 31.205-41(a)(3), and FAR 31.205-15 does the same for penalties incurred under specific contract terms or written instructions from the contracting officer.³² Absent that government direction, the contractor absorbs the charge.

Foreign Taxes

Foreign taxes are allowable under the same general rule as domestic taxes, with the exemption principle applied in full. If the contractor can recover a foreign tax through a treaty, an international agreement, or a host-country refund mechanism such as a VAT reclaim, the tax is unallowable to the extent it is recoverable.¹

A separate rule catches the foreign tax credit. If a contractor is reimbursed for a foreign tax as a contract cost and then claims that same tax as a credit on its U.S. federal income tax return, the resulting reduction in U.S. tax must be paid to the Treasurer of the United States when the return is filed.¹ The rule reaches subcontractors as well, so prime contractors with international work need visibility into their subcontractors’ credit positions.

Refunds Go Back to the Government

Any taxes, interest, or penalties that were allowed as contract costs and later refunded must be credited or paid back to the government in the manner the government directs. Interest earned on the refund is also owed back, but only for the period during which the government had already reimbursed the contractor for the original cost. A tax paid in January, reimbursed in March, and refunded with interest in December produces interest owed back from March through December.¹

A property tax appeal that pays off two years after the original charge can easily slip through a contractor’s books if nobody is tracking the link back to the contract. DCAA cross-references tax payments and refunds as a routine audit step.

Taxes on Idle Facilities and Idle Capacity

Taxes on idle assets follow the allowability of the underlying asset cost under FAR 31.205-17, and the distinction between an idle facility and idle capacity matters.

An idle facility is one that is completely unused and exceeds the contractor’s current needs. Its costs are unallowable unless the facility is necessary to meet workload fluctuations, or it was reasonably needed when acquired and became idle due to unforeseeable events such as changes in requirements, production shifts, or contract terminations. Under the second exception, the costs are allowable only for a reasonable period, ordinarily not more than one year, and only if the contractor is actively trying to use, lease, or dispose of the facility.⁴ Taxes on the facility are allowable during the allowable period and unallowable after it.

Idle capacity, meaning the unused portion of a facility that is otherwise in use, is treated as a normal cost of doing business, allowable as long as the capacity was originally reasonable and cannot be reduced through subleasing or sale under sound business practice.⁴ Property taxes on a facility running at 60 percent utilization are generally allowable in full; the contractor doesn’t have to strip out the 40 percent unused share.

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1
Acquisition.GOV. Federal Acquisition Regulation 31.205-41 – Taxes
2
eCFR. 48 CFR 31.205-15 – Fines, Penalties, and Mischarging Costs
3
Acquisition.GOV. Federal Acquisition Regulation 31.205-20 – Interest and Other Financial Costs
4
eCFR. 48 CFR 31.205-17 – Idle Facilities and Idle Capacity Costs