Defense contractors want in on manufacturing tax break

The Treasury Department has interpreted a new tax cut for manufacturers in a way that denies benefits to aerospace companies for a substantial portion of their defense contracts, potentially costing the industry billions, industry and congressional sources said.

Defense companies, including Boeing, Lockheed Martin, Raytheon and United Technologies, have insisted to Treasury officials that Congress intended the manufacturing tax cut -- enacted last fall as part of a broader corporate tax bill -- to apply to all U.S. manufacturing, including government defense contracts. Having failed to persuade Treasury, they have taken their case to Congress and are pushing for a technical correction to overrule the interpretation, according to these sources.

The dispute concerns defense companies' eligibility for the deduction that was part of the law repealing the foreign sales corporation/extraterritorial income tax break. The World Trade Organization ruled FSC/ETI benefits to be an illegal export subsidy, and Congress last year replaced them with an array of new tax cuts for corporations.

The centerpiece of the bill was a provision intended to boost manufacturers that export abroad and reward companies that keep manufacturing activities in the United States. It lowered the effective tax rate for U.S. manufacturing activities from 35 to 32 percent. Originally targeted to manufacturers, it was broadened to include activities as diverse as construction and engineering services.

Treasury issued guidance in January aimed at clarifying what activities qualify. In an effort to prevent "double-dipping," or multiple companies involved in a manufacturing process claiming the benefit for the same activity, officials developed an ownership test. Only a company assuming all the "benefits and burdens of ownership" would qualify.

Defense industry officials quickly realized they had a problem. Defense contracts that involve sensitive or expensive technologies, such as the production of fighter jets, require the government to take ownership of materials as soon as they are procured. Under Treasury's interpretation, such "cost-plus" contracts would be excluded from the benefits of the manufacturing deduction.

"Neither Congress nor industry anticipated or intended that manufacturing for a government customer, whether pursuant to cost-reimbursable or fixed-price contract, would be treated differently under [the manufacturing deduction] than would manufacturing similar products for a commercial customer," the Aerospace Industries Association wrote in a March 7 letter to acting Assistant Treasury Secretary Eric Solomon.

The letter argued that the FSC/ETI bill, whose stated purpose was to boost job creation in the United States, could not have been intended to exclude the large aerospace manufacturing sector, which accounted for 560,000 jobs in 2002.

Industry officials have raised the issue with staff on the House Ways and Means and Senate Finance committees, and broached the idea of a technical correction to clarify congressional intent. They are working quietly to address the issue, rather than having lawmakers send letters or pressure Treasury in a public way, sources said.

Congressional aides said there might be support for a correction, and that Treasury is interpreting the law too narrowly. "It is clear from the legislative history and from FSC/ETI that defense contractors are intended to be eligible," said a congressional aide closely involved in the creation of the manufacturing deduction.

These sources and industry officials point to the history of the FSC/ETI benefit to illustrate that Congress meant defense manufacturers to be in on the full benefits. Before 2000, defense companies could only claim half of what commercial manufacturers were able to claim. But with the 2001 ETI law, Congress ensured that defense firms could receive 100 percent of benefits, in a provision that aides informally termed "FSC for bombs," one congressional aide said.

A senior Treasury official said the statutory language of last year's bill was a more important guide than the history of FSC/ETI. "What we have here is a situation in which what qualifies under [the manufacturing deduction] is in many respects very different than what qualified under the FSC/ETI regime," the official said.

The Treasury source also said officials used for comparison the provision that made construction services eligible for the tax cut. That language spells out that ownership of materials is not required to qualify, while no such clear-cut language is included in the manufacturing provision, the official said.

Treasury will issue a proposed regulation this summer addressing the issues contained in its January guidance. That regulation will be made final only after an additional comment period.

A technical correction would require agreement by the majority and minority sides of the Finance and Ways and Means committees, JCT and Treasury. Aides said it is not yet clear when a technical corrections bill, which would include other tweaks to various provisions in the FSC/ETI law, will move.