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

Under FAR 31.205-41, federal, state, local, and foreign taxes are allowable costs on government contracts when they are required by law and accrued under generally accepted accounting principles, with a defined set of exceptions that shift the cost back to the contractor. The exceptions are what drive most disallowances: federal income taxes, taxes tied to financing or reorganization, land assessments, taxes on property used only for commercial work, certain employee-benefit-plan excise taxes, book-tax accrual differences, any tax the contractor could have avoided through an available exemption, and any amount later refunded.¹

The Baseline Rule

Two conditions run through every allowability call. The tax must actually be required by the taxing authority, and the contractor must record it under GAAP. Voluntary payments don’t qualify. An accrual-basis contractor can’t switch to cash-basis treatment for a particular tax to move costs between periods.¹

When those conditions are met, the everyday tax costs of running a business flow through. Sales and use taxes on materials, payroll taxes such as FUTA and state unemployment, and real estate taxes on property used in contract performance are all allowable. Fines and penalties are not taxes and are handled under a separate cost principle.¹

Taxes That Are Never Allowable

Six categories are unallowable regardless of documentation or contracting officer approval: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 recovered through depreciation or amortization rather than expensed as taxes.
Taxes on any property used solely for non-government work.
Excise taxes on qualified pension, welfare, deferred compensation, and similar plans under IRC Subtitle D, Chapter 43.
Income tax accruals designed to account for differences between taxable income and pretax book income.

These lines are absolute. A federal income tax charge or a Chapter 43 excise tax never becomes reimbursable, no matter how it’s documented.

The Exemption Rule Is Broader Than It Sounds

A tax is also unallowable if the contractor could have obtained an exemption, whether one available directly to the contractor or one available through the government. The regulation defines “exemption” as freedom from taxation in whole or in part, including any tax abatement or reduction resulting from how a tax is assessed, calculated, or otherwise applied. That reaches well beyond the obvious sales tax exemption certificate. A reduced property tax assessment through a local enterprise zone, or a preferential calculation available to government suppliers, counts as an exemption the contractor was expected to pursue.¹

Partial exemptions work the same way. When a reduction is tied to government contract activity, only the reduced amount is allowable. Anything above what the contractor would owe after applying the preferential treatment falls on the contractor.¹

One narrow escape exists. A contracting officer may determine that the administrative effort to secure an exemption outweighs the savings. Auditors read that exception tightly, and expect contractors to chase exemptions unless the dollar amounts are trivial.

Splitting Taxes on Shared Property

Property used exclusively on government work generates a direct tax charge to that contract. Property used exclusively on commercial work generates an unallowable tax. Property used for both must be allocated across all work based on the property’s actual use on each final cost objective, with a method that is reasonable, consistently applied, and documented.¹

Switching allocation bases year to year invites disallowance. Building taxes allocated by square footage one year and headcount the next won’t survive scrutiny. The regulation does allow skipping direct application if the amounts are immaterial or if a broader allocation produces comparable results.¹

Contesting a Tax You Believe Is Wrong

The cost of paying a disputed tax can be allowable, but only through a specific sequence. Before paying, the contractor must promptly ask the contracting officer for instructions. The contractor then follows whatever course the officer directs, whether that means challenging the assessment or pursuing a refund.¹

Reasonable costs of the challenge itself, including legal fees, accounting work, and administrative effort, are also allowable when the contractor acts at the contracting officer’s direction or with the officer’s agreement.¹ Pay the disputed tax first and consult the officer later, and the allowability is gone.

Penalties and Interest

Fines and penalties are not taxes. Penalties for late payment or underpayment of taxes fall under FAR 31.205-15 and are unallowable when they result 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 exception covers costs caused by the government’s own direction. 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 allows penalties incurred because of specific contract terms or written instructions from the contracting officer.³² If the contractor’s own compliance failure caused the charge, it stays with the contractor.

Foreign Taxes and the Foreign Tax Credit Payback

Foreign taxes follow the same general rule as domestic taxes: required, accrued under GAAP, no available exemption. The broad definition of exemption reaches recoveries under tax treaties, international agreements, and host-country refund schemes such as value-added tax refunds. Any recoverable portion is unallowable to that extent.¹

A separate rule catches contractors who claim a U.S. foreign tax credit for a foreign tax that was already reimbursed as a contract cost. The resulting reduction in U.S. tax liability must be paid to the Treasurer of the United States when the return is filed. The rule extends to subcontractors, so prime contractors need visibility into subcontractor foreign tax credit positions on contracts with international components.¹

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 generates a payback for the interest that accrued from March through December.¹

Refunds that arrive years after the original payment are where contractors get caught. A successful property tax appeal two years later is easy to miss if the person who filed it has moved on, and the obligation to credit the refund back doesn’t lapse.

What Auditors Want to See

Documentation for tax costs turns on three questions: was the tax required, does it relate to government work, and was any exemption available. Direct charges need records tying the payment to the specific contract or asset. Indirect charges need an allocation method and base applied consistently across periods.

The exemption question draws the hardest look. A contractor should be able to show that it investigated exemptions in every jurisdiction where it pays taxes, whether through copies of certificate applications, correspondence with tax authorities, or a written analysis of why a particular exemption doesn’t fit. If a contracting officer agreed the administrative burden wasn’t worth the savings, that determination belongs in the file in writing.

Foreign contracts add a layer. Records need to show that the tax isn’t recoverable through treaties or foreign refund programs, and any foreign tax credit claimed on the U.S. return needs to be tracked against the reimbursement so the FAR 31.205-41(d) payback obligation is met.¹ A disconnect between the tax department and the government contract accounting team is one of the more common compliance failures on international work.

For refunds, the file needs to show the original charge, the reimbursement date, and the refund date, so the interest owed back to the government can be calculated correctly.¹

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