Defense contractors battle new witholding tax

Defense contractors have joined a wide-ranging coalition to strike a new tax-withholding provision affecting government contracts. And they hope that they might find allies in the new Democratic Congress.

The measure would not come into effect until 2011. But defense companies are already warning that it will sap the cash flow needed for their day-to-day operations and could force some contractors to alter their pricing schemes or stop working with the government altogether. Small companies say they could be particularly hurt.

The provision originated in the 2005 Tax Increase Prevention and Reconciliation Act. Sen. Chuck Grassley (R-Iowa), the former chairman of the Senate Finance Committee, quietly inserted a sweeping mandate that would require the federal government, as well as state and local governments with annual expenditures of $100 million or more, to withhold 3 percent of payment for goods and services in tax. Defense contracts would also fall under that provision.

Supporters of the measure say that it will narrow the difference between what the IRS thinks it will collect in taxes in a given year and what it actually does collect, also called the “tax gap.”

The news of the provision spread just as the president signed the act last May. Ensuing legislation opposing Grassley’s move, sponsored by Sen. Larry Craig (R-Idaho), fell by the wayside in the crush to pass other bills by the end of the year. But an effort to strike the provision is gaining some momentum in the new Democratic-led Congress.

Rep. Kendrick Meek (D-Fla.), a member of the House Armed Services and Ways and Means committees, introduced legislation earlier this year to repeal the provision. The Withholding Tax Relief Act of 2007 (H.R. 1023), cosponsored by Rep. Wally Herger (R-Calif.), has been promoted in a circulating letter to gain support for the measure’s repeal. The legislation is currently awaiting mark-up by the Ways and Means Committee. But lawmakers are unlikely to act soon, given that the withholding provision would only be enacted in 2011, according to a House aide.

“This is something that we had no role in enacting and [we] do not view it as a very good idea. The Senate put it in, and House Democrats were excluded from the process,” the aide added. He said that the measure is unnecessary because the big contractors are “quite compliant” on taxes.

 Some in the defense industry fear that under the current “pay-go” rules to fund any spending increases by offsets, some lawmakers will want to accelerate the withholding provision’s implementation date as a way to boost government revenue.

But the House aide said that the lower chamber would oppose any such acceleration — and that support for the provision is just not there. “It cannot conceivably be accelerated,” said the aide. Requests for comments from the Senate Finance Committee were not returned by press time.

The National Defense Industrial Association (NDIA), which has 1,370 corporate members, sent a letter to House Speaker Nancy Pelosi (D-Calif.) in January warning that some lawmakers will propose an acceleration provision to offset any spending increases in the legislation that Congress considers this year. 

NDIA, the Aerospace Industries Association, and the American Shipbuilding Association are part of the broad-based opposition group, called the Government Withholding Relief Coalition. The coalition is comprised of about 60 groups representing a large swath of interests, ranging from agriculture to engineering to healthcare. The coalition argues the provision would hurt taxpaying businesses by forcing them to provide the government with a de facto interest-free loan. It also warns that the withholding provision will hurt a company’s cash flow, because it is based on revenue from government payments, not taxable income.

According to supporters of the provision, it will increase revenue by $7 billion from 2011 to 2015. But $6 billion of that will come in 2011 alone due to accelerated tax receipts rather than any increase from improved tax compliance. In fact, the provision would generate only $215 million in 2012, rising slightly in the three years after that.

Given that so much of the defense business depends on government contracts, the provision could have wide-ranging implications.

In particular, small businesses that secure large government contracts could see significant amounts of their operating funds become unavailable for periods longer than 16 months. In turn, these firms could be deterred from working with the Pentagon and the rest of the government.

Meanwhile, companies that largely depend on government business will be at a competitive disadvantage compared to companies that have a more diversified source of revenue. In the former case, the revenue stream will be tied up in withheld payments, leaving less free cash for operating expenses.

Furthermore, large defense companies that are tax-compliant could be faced with a tax-reporting nightmare, according to an aerospace industry source. “Aerospace has very complex contracts,” the source said. “Because of the onerous reporting provisions, the government may find itself with fewer choices among contractors [when it comes to selecting] goods and services.” The long-run impact, he added, is that contracts would become more expensive if contractors form monopolies to protect themselves.