In 1980, six of the nation's top 10 defense contractors used a little-known provision of the tax code to defer far more of their federal income taxes than they actually paid the U.S. Treasury.
These deferrals were of enormous benefit to the companies, functioning as interest-free loans from the federal government.
The Reagan administration has now proposed curtailing such deferrals as part of an effort to increase revenues and hold down future deficits.
A survey of the annual reports issued by the 10 top publicly owned defense contractors shows that six of them in 1980 paid a combined total of only $63.2 million in federal taxes while using the provision known as "the completed contract method of accounting" to put off paying a total of $498.7 million. These six--General Dynamics, United Technologies, Tenneco, McDonnell Douglas, Lockheed and Grumman--were all profitable. For various reasons, including the completed contract provision, two of the firms--McDonnell Douglas and Lockheed--paid no federal tax in 1980.
General Dynamics, in that year the nation's leading defense contractor with $3.5 billion in awards, was able to use the deferral provision to postpone $88.8 million in taxes. Largely because of this tactic, the company had to pay the government only $12.1 million for the year.
The year before, partly through use of the completed contract provision, General Dynamics avoided current payment of any federal tax. General Dynamics, like all the other defense firms, paid varying amounts of state, local and foreign taxes. Under the completed contract method of accounting, firms with multiyear contracts can postpone payment of tax liability on income from the contract until the year all work is completed.
Ultimately, the tax must be paid, but the ability to put off taxes while receiving income in the form of partial payments is of enormous financial benefit to the company capitalizing on the method.
Northrop, for example, put off paying a total of $137.7 million in 1978 and 1979; instead, it got a net refund from the federal government of $3.7 million over the two years. But in 1980, according to a spokesman, the firm completed a major contract with the Royal Saudi Air Force, and the firm ended up that year paying $70.7 million to the federal government.
The Treasury Department has calculated that for a five-year contract, the postponement of taxes is equivalent to a 15 percent increase in profits. The longer the contract, the more the benefit to the firm postponing taxes. In the case of the Pentagon, many contracts run well in excess of five years.
"The use of the completed contract method of accounting has led to large and unintended tax benefits. For instance, many contractors, including virtually all in the defense and aerospace industries, can substantially reduce their current tax liabilities," the Treasury Department said. "The result has been that many corporate taxpayers, while enjoying substantial economic profits and reporting these profits to shareholders and creditors, have been reporting large losses for tax purposes."
The Reagan administration has moved to end this and some other accounting practices involving long-term contracts as part of its effort to restrain next year's projected deficit. The Treasury claims that the proposed changes in regulation and law will result in new revenues of $1.9 billion in 1983, $4.4 billion in 1984, and a total of $19 billion through 1987.
These estimates do not, however, include calculations of the amount defense contractors, which make up about 50 percent of the beneficiaries, will simply pass on to the Pentagon, in effect turning the Treasury's revenue gains into the Defense Department's losses.
Analysts at both Treasury and Defense contend that a significant portion of the raised taxes resulting from administration "reform" of the system will, in fact, slowly wend their way back into the cost of weapons procurement, as contractors lose the ability to convert their deferred taxes into what amounts to tax-free loans.
The defense and aerospace industry is not acting, however, as if it will be able to pass on all the increased costs. The Aerospace Industries Association has hired John S. Nolan, former deputy assistant treasury secretary for tax policy, to lobby against the change, and, in a typical industry comment on the proposal, McDonnell Douglas said:
"We believe that the completed contract method of accounting is an equitable method of taxing those engaged in long-term contract business. The proposed legislation will have a significant negative impact on the aerospace and construction industries."
The completed contract method of accounting dates back to 1918, although it originally applied primarily to construction projects. Through regulatory change initiated by a 1970 Presidential Task Force on Business Taxation, the method was expanded to apply to manufacturers, particularly the aerospace and shipbuilding industries. The expansion was achieved through regulations issued in 1976 by the Treasury Department.
At present, use of the tax advantage is divided as follows, according to the Treasury: 50 percent by the defense industry, 35 percent by the construction industry and most of the remaining 15 percent by the heavy-equipment industry.
A survey of 1980 annual reports to determine the extent to which the completed contract system is used by the top 10 public defense contractors (Hughes Aircraft Co., the number seven recipient of defense contracts, is a private company) shows the following:
* General Dynamics, with U.S. earnings of $248.7 million, much of it from sales of the F16 aircraft, paid a total of $12.1 million in federal taxes, while deferring $100.4 million. Most of the deferral came from $88.8 million from the completed contract method of accounting.
* McDonnell Douglas, which received $3.2 billion in Pentagon contracts in 1980 for the F15 and F18 aircraft and a number of missiles, reported paying no federal income tax in 1980 with net earnings of $144.6 million. The firm reported deferrals of $96.4 million on "earnings on uncompleted contracts." The total deferred tax was much smaller, however, because of payments on other deferred items.
* United Technologies, which received $3.1 billion in contract awards primarily for jet engines and helicopters and reported U.S. pre-tax income of $470 million, said it paid $13.5 million in federal taxes, and deferred a total of $179 million, of which $167.7 million resulted from the completed contract accounting system.
* Boeing Co., which received $2.4 billion in Pentagon awards for the AWACS (Airborne Warning and Control System) aircraft, missiles and electronic equipment, in 1980 and 1979 paid a total of $622.7 million; a good part of this appears from the company's annual report to have been taxes deferred from past years.
* General Electric, which received $2.2 billion in defense contracts on aircraft engines, nuclear submarines, missiles and other products, does not take significant advantage of the completed contract system. The firm paid $574 million to the United States and deferred only $14 million, none of which was specifically identified as resulting from the accounting system.
* Lockheed Corp., which got $2 billion in awards largely from the Trident and Polaris missiles, aircraft and assault ships, paid no federal income tax in 1980 with net earnings of $26.7 million. The firm used what it described as "contract costing methods" to defer $16.2 million in taxes.
* Raytheon Co., which won $1.7 billion in awards for Hawk, Patriot and other missiles along with other electronic goods, reported net income in 1980 of $282.3 million. The firm reported paying $112.7 million in federal taxes and deferring $70.2 million, most of which it said resulted from long-term contract deferrals.
* Tenneco, Inc., which got $1.5 billion in awards for aircraft carriers, trucks, tractors and repair work, reported net income of $726 million. It paid federal taxes of $61 million and deferred $382 million, of which $80 million resulted from long-term shipbuilding contracts.
* Grumman Corp., which received $1.3 billion in awards for the F14 and other aircraft, and for electronic equipment, said it had sales of $1.76 billion and after-tax income of $30.7 million. It paid $23 million in federal taxes, and deferred $49.6 million through use of completed contract accounting.
* Northrop Corp., which received awards of $1.2 billion for the F5 fighter aircraft, missiles, electronics and other products, reported sales of $1.3 billion and after-tax income of $35.9 million. Northrop paid $70.7 million in taxes, much of which included payments on past deferrals resulting from completion of a major contract for the Royal Saudi Air Force.