[Code of Federal Regulations]
[Title 26, Volume 12]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.1471-1]

[Page 215-236]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.1471-1  Recovery of excessive profits on government contracts.

    The inclusion of the statutory provisions of section 1471 in this 
part does not supersede the provisions of 26 CFR (1939) part 17 
(Treasury Decision 4906) and 26 CFR (1939) part 16 (Treasury Decision 
4909) as made applicable to section 1471 by Treasury Decision 6091 (19 
FR 5167, C.B. 1954-2, 47).

[T.D. 6500, 25 FR 12081, Nov. 26, 1960]

    Editorial Note: For the convenience of the user, the text of parts 
16 and 17 (not entirely superseded) of 26 CFR (1939) referred to above 
is set forth below:

         Part 16--Excess Profits on Army Contracts for Aircraft

  regulations under section 14 of the act of april 3, 1939, and other 
                               provisions

    Authority: Sections 16.1 to 16.18 issued under 52 Stat. 467; 26 
U.S.C. 3791. Interpret or apply sec. 3, 48 Stat. 505, as amended, sec. 
14, 53 Stat. 560; 34 U.S.C. 496, 10 U.S.C. 311, 312.2206
    Source: Sections 16.1 to 16.18 contained in T.D. 4909, 4 FR 2733, 
July 1, 1939, except as otherwise noted.

Sec. 16.1 Definitions. As used in the regulations in this part the 
term:
    (a) ``Act'' means the act of April 3, 1939 (53 Stat. 560; 10 U.S.C. 
311, 312, 34 U.S.C. 496), together with the applicable provisions of 
section 3 of the act of March 27, 1934, 48 Stat. 505; 34 U.S.C. 496, as 
amended by the act of June 25, 1936, 49 Stat. 1926; 34 U.S.C., Sup. IV, 
496, and as further amended by the act of April 3, 1939 (53 Stat. 560; 
34 U.S.C. 496).
    (b) ``Person'' includes an individual, a corporation, a partnership, 
a trust or estate, a joint-stock company, an association, or a 
syndicate, group, pool, joint venture or other unincorporated 
organization or group, through or by means of which any business, 
financial operation or venture is carried on.
    (c) ``Contract'' means an agreement made by authority of the 
Secretary of the Army for the construction or manufacture of any 
complete aircraft or any portion thereof for the Army.
    (d) ``Contractor'' means a person entering into a direct contract 
with the Secretary of the Army or his duly authorized representative.
    (e) ``Subcontract'' means an agreement entered into by one person 
with another person for the construction or manufacture of any complete 
aircraft or any portion thereof for the Army, the prime contract for 
such aircraft or portion thereof having been entered into between a 
contractor and the Secretary of the Army or his duly authorized 
representative.
    (f) ``Subcontractor'' means any person other than a contractor 
entering into a subcontract.
    (g) ``Contracting party'' means a contractor or subcontractor as the 
case may be.
    (h) ``Contract price'' or ``total contract price'' means the amount 
or total amount to be received under a contract or subcontract as the 
case may be.

[[Page 216]]

    (i) ``Income-taxable year'' means the calendar year, the fiscal year 
ending during such calendar year, or the fractional part of such 
calendar or fiscal year, upon the basis of which the contracting party's 
net income is computed and for which its income tax returns are made for 
Federal income tax purposes.

Sec. 16.2 Contracts and subcontracts under which excess profit 
liability may be incurred. Except as otherwise provided with respect to 
contracts or subcontracts for certain scientific equipment (see Sec. 
16.3), every contract awarded for an amount exceeding $10,000 and 
entered into after the enactment of the act of April 3, 1939 for the 
construction or manufacture of any complete aircraft or any portion 
thereof for the Army, is subject to the provisions of the act relating 
to excess profit liability. Any subcontract made with respect to such a 
contract and involving an amount in excess of $10,000 is also within the 
scope of the act. If a contracting party places orders with another 
party, aggregating an amount in excess of $10,000, for articles or 
materials which constitute a part of the cost of performing the contract 
or subcontract, the placing of such orders shall constitute a 
subcontract within the scope of the act, unless it is clearly shown that 
each of the orders involving $10,000 or less is a bona fide separate and 
distinct subcontract and not a subdivision made for the purpose of 
evading the provisions of the act.

Sec. 16.3 Contracts or subcontracts for scientific equipment. No excess 
profit liability is incurred upon a contract or subcontract entered into 
after the enactment of the act of April 3, 1939, if at the time or prior 
to the time such contract or subcontract is made it is designated by the 
Secretary of the Army as being exempt under the provisions of the act 
pertaining to scientific equipment used for communication, target 
detection, navigation, and fire control.

Sec. 16.4 Completion of contract defined. The date of delivery of the 
aircraft or portion thereof covered by the contract or subcontract shall 
be considered the date of completion of the contract or subcontract 
unless otherwise determined jointly by the Secretary of the Army and the 
Secretary of the Treasury or their duly authorized representatives. 
Except as otherwise provided in the preceding sentence, the replacement 
of defective parts or delivered articles or the performance of other 
guarantee work in respect of such articles will not operate to extend 
the date of completion. As to the treatment of the cost of such work as 
a cost of performing a contract or subcontract, see Sec. 16.8(h). As to 
a refund in case of adjustment due to any subsequently incurred 
additional costs, see Sec. 16.18. If a contract or subcontract is at 
any time cancelled or terminated, it is completed at the time of the 
cancellation or termination.

Sec. 16.5 Manner of determining liability. (a) The first step in the 
determination of the excess profit to be paid to the United States by a 
contracting party with respect to contracts and subcontracts completed 
within an income-taxable year is to ascertain the total contract prices 
of all contracts and subcontracts completed by the contracting party 
within the income-taxable year. As to total contract prices, see Sec. 
16.7.
    (b) The second step is to ascertain the cost of performing such 
contracts and subcontracts and to deduct such cost from the total 
contract prices of such contracts and subcontracts as computed in the 
first step. See Sec. 16.8. The amount remaining after such subtraction 
is the amount of net profit or net loss upon the contracts and 
subcontracts completed within the income-taxable year.
    (c) The third step, in case there is a net profit upon such 
contracts and subcontracts, is to subtract from the amount of such net 
profit as computed in the second step the sum of:
    (1) An amount equal to 12 percent of the total contract prices of 
the contracts and subcontracts completed within the income- taxable 
year;
    (2) The amount of any net loss allowable as a credit in determining 
the excess profit for the income-taxable year (see Sec. 16.9); and
    (3) The amount of any deficiency in profit allowable as a credit in 
determining the excess profit for the income-taxable year (see Sec. 
16.9). The amount remaining after such subtraction is the amount of 
excess profit for the income-taxable year.
    (d) The fourth step is to ascertain the amount of credit allowed for 
Federal income taxes paid or remaining to be paid upon the amount of 
such excess profit (see Sec. 16.10) and then subtract from the amount 
of such excess profit the amount of credit for Federal income taxes. The 
amount remaining after this subtraction is the amount of excess profit 
to be paid to the United States by the contracting party for the income-
taxable year.

[T.D. 4909, 4 FR 2733, July 1, 1939, as amended by T.D. 6511, 25 FR 
12442, Dec. 6, 1960]

Sec. 16.6 Computation of excess profit liability. The application of 
the provisions of Sec. 16.5 may be illustrated by the following 
example:
    Example. On September 1, 1939, the B Corporation, which keeps its 
books and makes its Federal income tax returns on a calendar year basis, 
entered into a contract for the construction of Army aircraft coming 
within the scope of the act, the total contract price of which was 
$200,000. On March 10, 1940, the corporation entered into another such 
contract, the total contract price of which was $40,000. Both contracts 
were completed within the calendar year 1940, the first at a cost

[[Page 217]]

of $155,000 and the second at a cost of $45,000. During the year 1940, 
the B Corporation also completed at a deficiency in profit of $2,000 a 
contract entered into after April 3, 1939, for the construction of naval 
aircraft coming within the scope of 10 U.S.C. 2382 (formerly section 3 
of the Act of March 27, 1934 (48 Stat. 505)). For the year 1939, the B 
Corporation sustained a net loss of $1,500 and a deficiency in profit of 
$1,000 on all contracts and subcontracts entered into after April 3, 
1939, for Army aircraft coming within the scope of the act and completed 
within the calendar year 1939. For the year 1939, the B Corporation also 
sustained a net loss of $1,000 on a contract, entered into after April 
3, 1939, and completed within the calendar year 1939, for naval aircraft 
coming within the scope of 10 U.S.C. 2382 (formerly section 3 of the Act 
of March 27, 1934 (48 Stat. 505)). For purposes of the Federal income 
tax, the net income of the B Corporation for the year 1940, on which the 
tax was paid, amounted to $96,000, which included the total net profit 
of $40,000 upon the two contracts entered into on September 1, 1939, and 
March 10, 1940. The excess profit liability is $4,332, computed as 
follows:

Total contract prices:
  Contract No. 1................................    $200,000
  Contract No. 2................................      40,000
                                                 -------------
                                                  ..........    $240,000
Less: Cost of performing contracts:
  Contract No. 1................................     155,000
  Contract No. 2................................      45,000
                                                 ------------
                                                  ..........    $200,000
                                                             -----------
Net profit on contracts.....................................     $40,000
Less:
  12 percent of total contract prices (12            $28,800
   percent of $240,000).........................
  Deficiency in profit (in naval aircraft              2,000
   contracts) in 1940...........................
  Net loss (in Army aircraft contracts) from           1,500
   1939.........................................

  Net loss (in naval aircraft contracts) from          1,000
   1939.........................................
  Deficiency in profit (in Army aircraft               1,000  ..........
   contracts) from 1939.........................
                                                             -----------

Excess profit for year 1940.................................       5,700
Less: Credit for Federal income taxes (Federal income tax on       1,368
 $5,700 at rates for 1940)..................................
                                                                  34,300
                                                 -------------
Amount of excess profit payable to the United States........       4,332


[T.D. 4909, 4 FR 2733, July 1, 1939, as amended by T.D. 6511, 25 FR 
12442, Dec. 6, 1960]

Sec. 16.7 Total contract price. The total contract price of a 
particular contract or subcontract (see Sec. 16.1) may be received in 
money or its equivalent. If something other than money is received, only 
the fair market value of the thing received, at the date of receipt, is 
to be included in determining the amount received. Bonuses earned for 
bettering performance and penalties incurred for failure to meet the 
contract guarantees are to be regarded as adjustments of the original 
contract price. Trade or other discounts granted by a contracting party 
in respect of a contract or subcontract performed by such party are also 
to be deducted in determining the true total contract price of such 
contract or subcontract.

Sec. 16.8 Cost of performing a contract or subcontract.--(a) General 
rule. The cost of performing a particular contract or subcontract shall 
be the sum of (1) the direct costs, including therein expenditures for 
materials, direct labor and direct expenses, incurred by the contracting 
party in performing the contract or subcontract; and (2) the proper 
proportion of any indirect costs (including therein a reasonable 
proportion of management expenses) incident to and necessary for the 
performance of the contract or subcontract.
    (b) Elements of cost. No definitions of the elements of cost may be 
stated which are of invariable application to all contractors and 
subcontractors. In general, the elements of cost may be defined for 
purposes of the act as follows:
    (1) Manufacturing cost, which is the sum of factory cost (see 
paragraph (c) of this section) and other manufacturing cost (see 
paragraph (d) of this section);
    (2) Miscellaneous direct expenses (see paragraph (e) of this 
section);
    (3) General expenses, which are the sum of indirect engineering 
expenses, usually termed ``engineering overhead'' (see paragraph (f) of 
this section) and expenses of distribution, servicing and administration 
(see paragraph (g) of this section); and
    (4) Guarantee expenses (see paragraph (h) of this section).
    (c) Factory cost. Factory cost is the sum of the following:
    (1) Direct materials. Materials, such as those purchased for stock 
and subsequently issued for contract operations and those acquired under 
subcontracts, which become a component part of the finished product or 
which are used directly in fabricating, converting or processing such 
materials or parts.
    (2) Direct productive labor. Productive labor, usually termed ``shop 
labor,'' which is performed on and is properly chargeable directly to 
the article manufactured or constructed pursuant to the contract or 
subcontract, but which ordinarily does not include direct engineering 
labor (see subparagraph (3) of this paragraph).
    (3) Direct engineering labor. The compensation of professional 
engineers and other technicists (including reasonable advisory

[[Page 218]]

fees), and of draftsmen, properly chargeable directly to the cost of the 
contract or subcontract.
    (4) Miscellaneous direct factory charges. Items which are properly 
chargeable directly to the factory cost of performing the contract or 
subcontract but which do not come within the classifications in 
subparagraphs (1), (2), and (3) of this paragraph, as for example, 
royalties which the contracting party pays to another party and which 
are properly chargeable to the cost of performing the contract or 
subcontract (but see paragraph (d) of this section).
    (5) Indirect factory expenses. Items, usually termed ``factory 
overhead,'' which are not directly chargeable to the factory cost of 
performing the contract or subcontract but which are properly incident 
to and necessary for the performance of the contract or subcontract and 
consist of the following:
    (i) Labor. Amounts expended for factory labor, such as supervision 
and inspection, clerical labor, timekeeping, packing and shipping, 
stores supply, services of tool crib attendants, and services in the 
factory employment bureau, which are not chargeable directly to 
productive labor of the contract or subcontract.
    (ii) Materials and supplies. The cost of materials and supplies for 
general use in the factory in current operations, such as shop fuel, 
lubricants, heat-treating, plating, cleaning and anodizing supplies, 
nondurable tools and gauges, stationery (such as time tickets and other 
forms), and boxing and wrapping materials.
    (iii) Service expenses. Factory expenses of a general nature, such 
as those for power, heat and light (whether purchased or produced), 
ventilation and air-conditioning and operation and maintenance of 
general plant assets and facilities.
    (iv) Fixed charges and obsolescence. Recurring charges with respect 
to property used for manufacturing purposes of the contract or 
subcontract, such as premiums for fire and elevator insurance, property 
taxes, rentals and allowances for depreciation of such property, 
including maintenance and depreciation of reasonable stand-by equipment; 
and depreciation and obsolescence of special equipment and facilities 
necessarily acquired primarily for the performance of the contract or 
subcontract. In making allowances for depreciation, consideration shall 
be given to the number and length of shifts.
    (v) Miscellaneous indirect factory expenses. Miscellaneous factory 
expenses not directly chargeable to the factory cost of performing the 
contract or subcontract, such as purchasing expenses; ordinary and 
necessary expenses of rearranging facilities within a department or 
plant; employees' welfare expenses; premiums or dues on compensation 
insurance; employers' payments to unemployment, old age and social 
security Federal and State funds not including payments deducted from or 
chargeable to employees or officers; pensions and retirement payments to 
factory employees; factory accident compensation (as to self-insurance, 
see paragraph (g) of this section); but not including any amounts which 
are not incident to services, operations, plant, equipment or facilities 
involved in the performance of the contract or subcontract.
    (d) Other manufacturing cost. Other manufacturing cost as used in 
paragraph (b) of this section includes items of manufacturing costs 
which are not properly or satisfactorily chargeable to factory costs 
(see paragraph (c) of this section) but which upon a complete showing of 
all pertinent facts are properly to be included as a cost of performing 
the contract or subcontract, as for instance, payments of royalties and 
amortization of the cost of designs purchased and patent rights over 
their useful life; and ``deferred'' or ``unliquidated'' experimental and 
development charges. For example, in case experimental and development 
costs have been properly deferred or capitalized and are amortized in 
accordance with a reasonably consistent plan, a proper portion of the 
current charge, determined by a ratable allocation which is reasonable 
in consideration of the pertinent facts, may be treated as a cost of 
performing the contract or subcontract. In the case of general 
experimental and development expenses which may be charged off 
currently, a reasonable portion thereof may be allocated to the cost of 
performing the contract or subcontract. If a special experimental or 
development project is carried on in pursuance of a contract, or in 
anticipation of a contract which is later entered into, and the expense 
is not treated as a part of general experimental and development 
expenses or is not otherwise allowed as a cost of performing the 
contract, there clearly appearing no reasonable prospect of an 
additional contract for the type of article involved, the entire cost of 
such project may be allowed as a part of the cost of performing the 
contract.
    (e) Miscellaneous direct expenses. Miscellaneous direct expenses as 
used in paragraph (b) of this section include:
    (1) Cost of installation and construction. Cost of installation and 
construction includes the cost of materials, labor and expenses 
necessary for the erection and installation prior to the completion of 
the contract and after the delivery of the product or material 
manufactured or constructed pursuant to the contract or subcontract.
    (2) Sundry direct expenses. Items of expense which are properly 
chargeable directly to the cost of performing a contract or subcontract 
and which do not constitute guarantee expenses (see paragraph (h) of 
this section) or direct costs classified as factory cost or other 
manufacturing cost (see paragraphs (c) and (d) of this section), such as 
premiums on

[[Page 219]]

performance or other bonds required under the contract or subcontract; 
State sales taxes imposed on the contracting party; freight on outgoing 
shipments; fees paid for wind tunnel and model basin tests; 
demonstration and test expenses; crash insurance premiums; traveling 
expenses. In order for any such item to be allowed as a charge directly 
to the cost of performing a contract or subcontract, (i) a detailed 
record shall be kept by the contracting party of all items of a similar 
character, and (ii) no item of a similar character which is properly a 
direct charge to other work shall be allowed as a part of any indirect 
expenses in determining the proper proportion thereof chargeable to the 
cost of performing the contract or subcontract. As to allowable indirect 
expenses, see paragraphs (c)(5), (f), (g) and (j) of this section.
    (f) Indirect engineering expenses. Indirect engineering expenses, 
usually termed ``engineering overhead,'' which are treated in this 
section as a part of general expenses in determining the cost of 
performing a contract or subcontract (see paragraph (b) of this 
section), comprise the general engineering expenses which are incident 
to and necessary for the performance of the contract or subcontract, 
such as the following:
    (1) Labor. Reasonable fees of engineers employed in a general 
consulting capacity, and compensation of employees for personal services 
to the engineering department, such as supervision, which is properly 
chargeable to the contract or subcontract, but which is not chargeable 
as direct engineering labor (see paragraph (c)(3) of this section).
    (2) Material. Supplies for the engineering department, such as paper 
and ink for drafting and similar supplies.
    (3) Miscellaneous expenses. Expenses of the engineering department, 
such as (i) maintenance and repair of engineering equipment, and (ii) 
services purchased outside of the engineering department for blue 
printing, drawing, computing, and like purposes.
    (g) Expenses of distribution, servicing and administration. Expenses 
of distribution, servicing and administration, which are treated in this 
section as a part of general expenses in determining the cost of 
performing a contract or subcontract (see paragraph (b) of this 
section), comprehend the expenses incident to and necessary for the 
performance of the contract or subcontract, which are incurred in 
connection with the distribution and general servicing of the 
contracting party's products and the general administration of the 
business, such as:
    (1) Compensation for personal services of employees. The salaries of 
the corporate and general executive officers and the salaries and wages 
of administrative clerical employees and of the office services 
employees such as telephone operators, janitors, cleaners, watchmen and 
office equipment repairmen.
    (2) Bidding and general selling expenses. Bidding and general 
selling expenses which by reference to all the pertinent facts and 
circumstances reasonably constitute a part of the cost of performing a 
contract or subcontract. The treatment of bidding and general selling 
expenses as a part of general expenses in accordance with this paragraph 
is in lieu of any direct charges which otherwise might be made for such 
expenses. The term ``bidding expenses'' as used in this section includes 
all expenses in connection with preparing and submitting bids.
    (3) General servicing expenses. Expenses which by reference to all 
the pertinent facts and circumstances reasonably constitute a part of 
the cost of performing a contract or subcontract and which are incident 
to delivered or installed articles and are due to ordinary adjustments 
or minor defects; but including no items which are treated as a part of 
guarantee expenses (see paragraph (h) of this section) or as a part of 
direct costs, such as direct materials, direct labor, and other direct 
expense.
    (4) Other expenses. Miscellaneous office and administrative 
expenses, such as stationery and office supplies; postage; repair and 
depreciation of office equipment; contributions to local charitable or 
community organizations to the extent constituting ordinary and 
necessary business expenses; employees' welfare expenses; premiums and 
dues on compensation insurance; employers' payments to unemployment, old 
age and social security Federal and State funds not including payments 
deducted from or chargeable to employees or officers; pensions and 
retirement payments to administrative office employees and accident 
compensation to office employees (as to self-insurance, see subdivision 
(i) of this subparagraph.
    (i) Subject to the exception stated in this subdivision, in cases 
where a contracting party assumes its own insurable risks (usually 
termed ``self-insurance''), losses and payments will be allowed in the 
cost of performing a contract or subcontract only to the extent of the 
actual losses suffered or payments incurred during, and in the course 
of, the performance of the contract or subcontract and properly 
chargeable to such contract or subcontract. If however, a contracting 
party assumes its own insurable risks (a) for compensation paid to 
employees for injuries received in the performance of their duties, or 
(b) for unemployment risks in States where insurance is required, there 
may be allowed as a part of the cost of performing a contract or 
subcontract a reasonable portion of the charges set up for purposes of 
self-insurance under a system of accounting regularly employed by the 
contracting party, as determined by the Commissioner of Internal 
Revenue, at rates not

[[Page 220]]

exceeding the lawful or approved rates of insurance companies for such 
insurance, reduced by amounts representing the acquisition cost in such 
companies, provided the contracting party adopts and consistently 
follows this method with respect to self-insurance in connection with 
all contracts and subcontracts subsequently performed by him.
    (ii) Allowances for interest on invested capital are not allowable 
as costs of performing a contract or subcontract.
    (iii) Among the items which shall not be included as a part of the 
cost of performing a contract or subcontract or considered in 
determining such cost, are the following: Entertainment expenses; dues 
and memberships other than of regular trade associations; donations 
except as otherwise provided above; losses on other contracts; profits 
or losses from sales or exchanges of capital assets; extraordinary 
expenses due to strikes or lockouts; fines and penalties; amortization 
of unrealized appreciation of values of assets; expenses, maintenance 
and depreciation of excess facilities (including idle land and building, 
idle parts of a building, and excess machinery and equipment) vacated or 
abandoned, or not adaptable for future use in performing contracts or 
subcontracts; increases in reserve accounts for contingencies, repairs, 
compensation insurance (except as above provided with respect to self-
insurance) and guarantee work; Federal and State income and excess-
profits taxes and surtaxes; cash discount earned up to one percent of 
the amount of the purchase, except that all discounts on subcontracts 
subject to the act will be considered; interest incurred or earned; bond 
discount or finance charges; premiums for life insurance on the lives of 
officers; legal and accounting fees in connection with reorganizations, 
security issues, capital stock issues and the prosecution of claims 
against the United State (including income tax matters); taxes and 
expenses on issues and transfers of capital stock; losses on 
investments; bad debts; and expenses of collection and exchange.
    (iv) In order that the cost of performing a contract or subcontract 
may be accounted for clearly, the amount of any excess profits repayable 
to the United States pursuant to the act should not be charged to or 
included in such cost.
    (h) Guarantee expenses. Guarantee expenses include the various items 
of factory cost, other manufacturing cost, cost of installation and 
construction, indirect engineering expenses and other general expenses 
(see paragraphs (c) to (g), of this section) which are incurred after 
delivery or installation of the article manufactured or constructed 
pursuant to the particular contract or subcontract and which are 
incident to the correction of defects or deficiencies which the 
contracting party is required to make under the guarantee provisions of 
the particular contract or subcontract. If the total amount of such 
guarantee expenses is not ascertainable at the time of filing the report 
required to be filed with the district director of internal revenue (see 
Sec. 16.15) and the contracting party includes any estimated amount of 
such expenses as part of the claimed total cost of performing the 
contract or subcontract, such estimated amount shall be separately shown 
on the report and the reasons for claiming such estimated amount shall 
accompany the report; but only the amount of guarantee expenses actually 
incurred will be allowed. If the amount of guarantee expenses actually 
incurred is greater than the amount (if any) claimed on the report and 
the contracting party has made an overpayment of excess profit, a refund 
of the overpayment shall be made in accordance with the provisions of 
Sec. 16.18. If the amount of guarantee expenses actually incurred is 
less than the amount claimed on the report and an additional amount of 
excess profit is determined to be due, the additional amount of excess 
profit shall be assessed and paid in accordance with the provisions of 
Sec. 16.18.
    (i) Unreasonable compensation. (1) The salaries and compensation for 
services which are treated as a part of the cost of performing a 
contract or subcontract include reasonable payments for salaries, 
bonuses, or other compensation for services. As a general rule, bonuses 
paid to employees (and not to officers) in pursuance of a regularly 
established incentive bonus system may be allowed as a part of the cost 
of performing a contract or subcontract.
    (2) The test of allowability is whether the aggregate compensation 
paid to each individual is for services actually rendered incident to, 
and necessary for, the performance of the contract or subcontract, and 
is reasonable. Excessive or unreasonable payments, whether in cash, 
stock or other property ostensibly as compensation for services shall 
not be included in the cost of performing a contract or subcontract.
    (j) Allocation of indirect costs. No general rule applicable to all 
cases may be stated for ascertaining the proper proportion of the 
indirect costs to be allocated to the cost of performing a particular 
contract or subcontract. Such proper proportion depends upon all the 
facts and circumstances relating to the performance of the particular 
contract or subcontract. Subject to a requirement that all items which 
have no relation to the performance of the contract or subcontract shall 
be eliminated from the amount to be allocated, the following methods of 
allocation are outlined as acceptable in a majority of cases:
    (1) Factory indirect expenses. The allowable indirect factory 
expenses (see paragraph

[[Page 221]]

(c)(5) of this section) shall ordinarily be allocated or ``distributed'' 
to the cost of the contract or subcontract on the basis of the 
proportion which the direct productive labor (see paragraph (c)(2) of 
this section) attributable to the contract or subcontract bears to the 
total direct productive labor of the production department or particular 
section thereof during the period within which the contract or 
subcontract is performed, except that if the indirect factory expenses 
are incurred in different amounts and in different proportions by the 
various producing departments consideration shall be given to such 
circumstances to the extent necessary to make a fair and reasonable 
determination of the true profit and excess profit.
    (2) Engineering indirect expenses. The allowable indirect 
engineering expenses (see paragraph (f) of this section) shall 
ordinarily be allocated or ``distributed'' to the cost of the contract 
or subcontract on the basis of the proportion which the direct 
engineering labor attributable to the contract or subcontract (see 
paragraph (c)(3) of this section) bears to the total direct engineering 
labor of the engineering department or particular section thereof during 
the period within which the contract or subcontract is performed. If the 
expenses of the engineering department are not sufficient in amount to 
require the maintenance of separate accounts, the engineering indirect 
costs may be included in the indirect factory expenses (see paragraph 
(c)(5) of this section) and allocated or distributed to the cost of 
performing the contract or subcontract as a part of such expenses, 
provided the proportion so allocated or distributed is proper under the 
facts and circumstances relating to the performance of the particular 
contract or subcontract.
    (3) Administrative expenses (or ``overhead''). The allowable 
expenses of administration (see paragraph (g) of this section) or other 
general expenses except indirect engineering expenses, bidding and 
general selling expenses, and general servicing expenses shall 
ordinarily be allocated or distributed to the cost of performing a 
contract or subcontract on the basis of the proportion which the sum of 
the manufacturing cost (see paragraph (b) of this section) and the cost 
of installation and construction (see paragraph (e) of this section) 
attributable to the particular contract or subcontract bears to the sum 
of the total manufacturing cost and the total cost of installation and 
construction during the period within which the contract or subcontract 
is performed.
    (4) Bidding, general selling, and general servicing expenses. The 
allowable bidding and general selling expenses and general servicing 
expenses (see paragraph (g) (2) and (3) of this section) shall 
ordinarily be allocated or distributed to the cost of performing a 
contract or subcontract on the basis of:
    (i) The proportion which the contract price of the particular 
contract or subcontract bears to the total sales made(including 
contracts or subcontracts completed) during the period within which the 
particular contract or subcontracts is performed, or
    (ii) The proportion which the sum of the manufacturing cost (see 
paragraph (b) of this section) and the cost of installation and 
construction (see paragraph (e) of this section) attributable to the 
particular contract or subcontract bears to the sum of the total 
manufacturing cost and the total cost of installation and construction 
during the period within which the contract or subcontract is performed,

except that special consideration shall be given to the relation which 
certain classes of such expenses bear to the various classes of articles 
produced by the contracting party in each case in which such 
consideration is necessary in order to make a fair and reasonable 
determination of the true profit and excess profit. See Sec. 16.13.

Sec. 16.9 Credit for net loss or for deficiency in profit in computing 
excess profit. (a) The term ``net loss'' as used in the act and as 
applied to contracts and subcontracts for aircraft or portions thereof 
coming within the regulations prescribed under the act or under 10 
U.S.C. 2382 (formerly section 3 of the Act of March 27, 1934 (48 Stat. 
505)) means the amount by which the total cost of performing all such 
contracts and subcontracts for aircraft entered into after April 3, 
1939, and completed by a particular contracting party within the income-
taxable year exceeds the total contract prices of such contracts and 
subcontracts. As to the meaning of income-taxable year, see Sec. 16.1.
    (b) The term ``deficiency in profit'', as used in the act and as 
applied to contracts and subcontracts for aircraft or portions thereof 
coming within the regulations prescribed under the act or under 10 
U.S.C. 2882 (formerly section 3 of the Act of March 27, 1934 (48 Stat. 
505)), means the amount by which 12 percent of the total contract prices 
of all such contracts and subcontracts for aircraft entered into after 
April 3, 1939, and completed by a particular contracting party within 
the income-taxable year exceeds the net profit upon all such contracts 
and subcontracts.
    (c) A net loss or a deficiency in profit sustained by a contracting 
party for an income-taxable year is allowable as a credit in computing 
the contracting party's excess profit on contracts and subcontracts for 
aircraft coming within the regulations prescribed under the act or under 
10 U.S.C. 2382 (formerly section 3 of the Act of March 27, 1934 (48 
Stat. 505)) and completed during the four next succeeding income-taxable 
years. Credit for such a net loss or deficiency in profit may be claimed 
in the contracting party's

[[Page 222]]

annual report of profit filed with the district director of internal 
revenue (see Sec. 16.15), but it shall be supported by separate 
schedules for each contract or subcontract involved showing total 
contract prices, costs of performance and pertinent facts relative 
thereto, together with a summarized computation of the net loss or 
deficiency in profit. The net loss or deficiency in profit claimed is 
subject to verification and adjustment. As to preservation of books and 
records, see Sec. 16.13.
    (d) Net loss or deficiency in profit sustained on contracts and 
subcontracts completed within one income-taxable year may not be 
considered in computing net loss or deficiency in profit sustained on 
contracts and subcontracts completed within another income-taxable year.
    (e) The provisions of this section may be illustrated by the 
following example:
    Example. For the calendar year 1939, the A Corporation, which keeps 
its books and makes its Federal income tax returns on a calendar year 
basis, sustained a net loss of $30,000 on the contracts and subcontracts 
for Army aircraft and portions thereof coming within the scope of the 
act and completed within that year. During the year 1939, the A 
Corporation also completed contracts for naval aircraft coming within 
the scope of 10 U.S.C. 2382 (formerly section 3 of the Act of March 27, 
1934 (48 Stat. 505)) at a deficiency in profit of $10,000. In 1940, the 
A Corporation completed similar contracts for Army aircraft totaling 
$175,000 at a cost of $155,000, whereby the A Corporation realized a net 
profit of $20,000 but sustained a deficiency in profit of $1,000 (i.e., 
12 percent of $175,000, or $21,000, less $20,000. During the year 1940, 
the A Corporation also completed contracts for naval aircraft coming 
within the scope of 10 U.S.C. 2382 (formerly section 3 of the Act of 
March 27, 1934 (48 Stat. 505)) at a net loss of $2,000. In 1941, the A 
Corporation completed contracts for Army aircraft coming within the 
scope of the act totaling $400,000 at a cost of $300,000, or at a net 
profit of $100,000. After deducting from the net profit of $100,000 for 
the year 1941 the amount of $48,000 (i.e., 12 percent of the total 
contract price of $400,000), there remains $52,000 in excess profit on 
the contracts completed in the year 1941. The A Corporation may deduct 
from such $52,000, in determining the amount of excess profit it must 
pay for the year 1941 with respect to the contracts completed in such 
year, the net loss of $30,000 and the deficiency in profit of $10,000 
sustained in 1939 on Army and naval aircraft contracts, respectively, 
and the net loss of $2,000 and the deficiency in profit of $1,000 
sustained in 1940 on naval and Army aircraft contracts, respectively.

[T.D. 4909, 4 FR 2733, July 1, 1939, as amended by T.D. 6511, 25 FR 
12442, Dec. 6, 1960]

Sec. 16.10 Credit for Federal income taxes. For the purpose of 
computing the amount of excess profit to be paid to the United States, a 
credit is allowable against the excess profit for the amount of Federal 
income taxes paid or remaining to be paid on the amount of such excess 
profit. The ``Federal income taxes'' in respect of which this credit is 
allowable include the income taxes imposed by Titles I and IA of the 
Revenue Act of 1938, and Chapter 1 and Subchapter A of Chapter 2 of the 
Internal Revenue Code, and the excess-profits taxes imposed by section 
602 of the Revenue Act of 1938 and Subchapter B of Chapter 2 of the 
Internal Revenue Code. This credit is allowable for these taxes only to 
the extent that it is affirmatively shown that they have been finally 
determined and paid or remain to be paid and that they were imposed upon 
the excess profit against which the credit is to be made. In case such a 
credit has been allowed and the amount of Federal income taxes imposed 
upon the excess profit is redetermined, the credit previously allowed 
shall be adjusted accordingly.

Sec. 16.11 Failure of contractor to require agreement by subcontractor. 
(a) Every contract or subcontract coming within the scope of the act and 
the regulations in this part is required by the act to contain, among 
other things, an agreement by the contracting party to make no 
subcontract unless the subcontractor agrees:
    (1) To make a report, as described in the act, under oath to the 
Secretary of War upon the completion of the subcontract;
    (2) To pay into the Treasury excess profit, as determined by the 
Treasury Department, in the manner and amounts specified in the act;
    (3) To make no subdivision of the subcontract for the same article 
or articles for the purpose of evading the provisions of the act;
    (4) That the manufacturing spaces and books of its own plant, 
affiliates, and subdivisions shall at all times be subject to inspection 
and audit as provided in the act.
    (b) If a contracting party enters into a subcontract with a 
subcontractor who fails to make such agreement, such contracting party 
shall, in addition to its liability for excess profit determined on 
contracts or subcontracts performed by it, be liable for any excess 
profit determined to be due the United States on the subcontract entered 
into with such subcontractor. In such event, however, the excess profit 
to be paid to the United States in respect of the subcontract entered 
into with such subcontractor shall be determined separately from any 
contracts or subcontracts performed by the contracting party entering 
into the subcontract with such subcontractor.

Sec. 16.12 Evasion of excess profit. Section 3 of the act of March 27, 
1934, as amended, provides

[[Page 223]]

that the contracting party shall agree to make no subdivisions of any 
contract or subcontract for the same article or articles for the purpose 
of evading the provisions of the act. If any such subdivision or 
subcontract is made it shall constitute a violation of the agreement 
provided for in the act, and the cost of completing a contract or 
subcontract by a contracting party which violates such agreement shall 
be determined in a manner necessary clearly to reflect the true excess 
profit of such contracting party.

Sec. 16.13 Books of account and records. (a) It is recognized that no 
uniform method of accounting can be prescribed for all contracting 
parties subject to the provisions of the act. Each contracting party is 
required by law to make a report of its true profits and excess profit. 
Such party must, therefore, maintain such accounting records as will 
enable it to do so. See Sec. 16.8. Among the essentials are the 
following:
    (1) The profit or loss upon a particular contract or subcontract 
shall be accounted for and fully explained in the books of account 
separately on each contract or subcontract.
    (2) Any cost accounting methods, however standard they may be and 
regardless of long continued practice, shall be controlled by, and be in 
accord with, the objectives and purposes of the act and of any 
regulations prescribed thereunder.
    (3) The accounts shall clearly disclose the nature and amount of the 
different items of cost of performing a contract or subcontract.
    (b) In cases where it has been the custom priorly to use so-called 
``normal'' rates of overhead expense or administrative expenses, or 
``standard'' or ``normal'' prices of material or labor charges, no 
objection will be made to the use temporarily during the period of 
performing the contract or subcontract of such methods in charging the 
contract or subcontract, if the method of accounting employed is such as 
clearly to reflect, in the final determination upon the books of 
account, the actual profit derived from the performance of the contract 
or subcontract and if the necessary adjusting entries are entered upon 
the books and they explain in full detail the revisions necessary to 
accord with the facts. As to the elements of cost, see Sec. 16.8.
    (c) All books, records, and original evidences of costs (including, 
among other things, production orders, bills or schedules of materials, 
purchase requisitions, purchase orders, vouchers, requisitions for 
materials, standing expense orders, inventories, labor time cards, pay 
rolls, cost distribution sheets) pertinent to the determination of the 
true profit, excess profit, deficiency in profit or net loss from the 
performance of a contract or subcontract shall be kept at all times 
available for inspection by internal- revenue officers, and shall be 
carefully preserved and retained so long as the contents thereof may 
become material in the administration of the act. This provision is not 
confined to books, records, and original evidences pertaining to items 
which may be considered to be a part of the cost of performing a 
contract or subcontract. It is applicable to all books, records, and 
original evidences of costs of each plant, branch or department involved 
in the performance of a contract or subcontract or in the allocation or 
distribution of costs to the contract or subcontract.

Sec. 16.14 Report to Secretary of the Army. (a) Upon the completion of 
a contract or subcontract coming within the scope of the act and the 
regulations in this part, the contracting party is required to make a 
report, under oath, to the Secretary of the Army. As to the date of 
completion of a contract or subcontract, see Sec. 16.4. Such report 
shall be in the form prescribed by the Secretary of the Army and shall 
state the total contract price, the cost of performing the contract, the 
net income from such contract, and the per centum such income bears to 
the contract price. The contracting party shall also include as a part 
of such report a statement showing:
    (1) The manner in which the indirect costs were determined and 
allocated to the cost of performing the contract or subcontract (see 
Sec. 16.8);
    (2) The name and address of every subcontractor with whom a 
subcontract was made, the object of such subcontract, the date when 
completed and the amount thereof; and
    (3) The name and address of each affiliate or other organization, 
trade or business owned or controlled directly or indirectly by the same 
interests as those who so own or control the contracting party, together 
with a statement showing in detail all transactions which were made with 
such affiliate or other organization, trade or business and are 
pertinent to the determination of the excess profit.
    (b) A copy of the report required to be made to the Secretary of the 
Army is required to be transmitted by the contracting party to the 
Secretary of the Treasury. Such copy shall not be transmitted directly 
to the Secretary of the Treasury but shall be filed as a part of the 
annual report. See Sec. 16.15.

Sec. 16.15 Annual reports for income-taxable years--(a) General 
requirements. Every contracting party completing a contract or 
subcontract within the contracting party's income-taxable year ending 
after April 3, 1939 shall file with the district director of internal 
revenue for the internal revenue district in which the contracting 
party's Federal income tax returns are required to be filed an annual 
report on the prescribed form of the profit and excess profit on all 
contracts and subcontracts coming within the scope of the

[[Page 224]]

act and the regulations in this part and completed within the particular 
income-taxable year. There shall be included as a part of such a report 
a statement, preferably in columnar form, showing separately for each 
such contract or subcontract completed by the contracting party within 
the income-taxable year the total contract price, the cost of performing 
the contract or subcontract and the resulting profit or loss on each 
contract or subcontract together with a summary statement showing in 
detail the computation of the net profit or net loss upon all contracts 
and subcontracts completed within the income-taxable year and the amount 
of the excess profit, if any, for the income-taxable year covered by the 
report. A copy of the report made to the Secretary of the Army (see 
Sec. 16.14) with respect to each contract or subcontract covered in the 
annual report, shall be filed as a part of such annual report. In case 
the income-taxable year of the contracting party is a period of less 
than twelve months (see Sec. 16.1), the report required by this section 
shall be made for such period and not for a full year.
    (b) Time for filing annual reports. Annual reports of contracts and 
subcontracts coming within the scope of the act and the regulations in 
this part completed by a contracting party within an income-taxable year 
must be filed on or before the 15th day of the ninth month following the 
close of the contracting party's income-taxable year. It is important 
that the contracting party render on or before the due date an annual 
report as nearly complete and final as it is possible for the 
contracting party to prepare. An extension of time granted the 
contracting party for filing its Federal income tax return does not 
serve to extend the time for filing the annual report required by this 
section. Authority consistent with authorizations for granting 
extensions of time for filing Federal income tax returns is hereby 
delegated to the various collectors of internal revenue for granting 
extensions of time for filing the reports required by this section. 
Application for extensions of time for filing such reports should be 
addressed to the district director of internal revenue for the district 
in which the contracting party files its Federal income tax returns and 
must contain a full recital of the causes for the delay.

Sec. 16.16 Payment of excess profit liability. The amount of the excess 
profit liability to be paid to the United States shall be paid on or 
before the due date for filing the report with the district director of 
internal revenue. See Sec. 16.15. At the option of the contracting 
party, the amount of the excess profit liability may be paid in four 
equal installments instead of in a single payment, in which case the 
first installment is to be paid on or before the date prescribed for the 
payment of the excess profit as a single payment, the second installment 
on or before the 15th day of the third month, the third installment on 
or before the 15th day of the sixth month, and the fourth installment on 
or before the 15th day of the ninth month, after such date.

Sec. 16.17 Liability of surety. The surety under contracts entered into 
with the Secretary of the Army for the construction or manufacture of 
any complete aircraft or any portion thereof for the Army shall not be 
liable for payment of excess profit due the United States in respect of 
such contracts.

Sec. 16.18 Determination of liability for excess profit, interest and 
penalties; assessment, collection, payment, refunds. (a) The duty of 
determining the correct amount of excess profit liability on contracts 
and subcontracts coming within the scope of the act and the regulations 
in this part is upon the Commissioner of Internal Revenue. Under section 
3(b) of the act of March 27, 1934, as last amended, all provisions of 
law (including the provisions of law relating to interest, penalties and 
refunds) applicable with respect to the taxes imposed by Title I of the 
Revenue Act of 1934 and not inconsistent with section 3 of the act of 
March 27, 1934, as last amended, are applicable with respect to the 
assessment, collection, or payment of excess profits on contracts and 
subcontracts coming within the scope of the act and the regulations in 
this part and to refunds of overpayments of profits into the Treasury 
under the act. Claims by a contracting party for the refund of an amount 
of excess profit, interest, penalties, and additions to such excess 
profit shall conform to the general requirements prescribed with respect 
to claims for refund of overpayments of taxes imposed by Title I of the 
Revenue Act of 1934 and, if filed on account of any additional costs 
incurred pursuant to guarantee provisions in a contract, shall be 
supplemented by a statement under oath showing the amount and nature of 
such costs and all facts pertinent thereto.
    (b) Administrative procedure for the determination, assessment and 
collection of excess profit liability under the act and the regulations 
in this part and the examination of reports and claims in connection 
therewith will be prescribed from time to time by the Commissioner of 
Internal Revenue.

                Part 17--Excess Profits on Navy Contracts

     regulations for income-taxable years ending after april 3, 1939

    Authority: Sections 17.1 to 17.19 issued under 52 Stat. 467; 26 
U.S.C. 3791. Interpret or apply sec. 3, 48 Stat. 505, as amended, 53 
Stat. 112; 34 U.S.C. 496, 26 U.S.C. 650, 651.
    Source: Sections 17.1 to 17.19 contained in T.D. 4906, 4 FR 2492, 
June 27, 1939, except as otherwise noted.


[[Page 225]]


Sec. 17.1 Definitions. As used in the regulations in this part the 
term:
    (a) Act means the act of March 27, 1934 (48 Stat. 505; 34 U.S.C. 
496), as originally enacted, as amended by the act of June 25, 1936 (49 
Stat. 1926; 34 U.S.C. 496), and as further amended by the act of April 
3, 1939 (53 Stat. 560; 34 U.S.C. 496).
    (b) Person includes an individual, a corporation, a partnership, a 
trust or estate, a joint-stock company, an association, or a syndicate, 
group, pool, joint venture or other unincorporated organization or 
group, through or by means of which any business, financial operation or 
venture is carried on.
    (c) Contract means an agreement made by authority of the Secretary 
of the Navy for the construction or manufacture of any complete naval 
vessel or aircraft or any portion thereof.
    (d) Contractor means a person entering into a direct contract with 
the Secretary of the Navy or his duly authorized representative.
    (e) Subcontract means an agreement entered into by one person with 
another person for the construction or manufacture of a complete naval 
vessel or aircraft or any portion thereof, the prime contract for such 
vessel or aircraft or portion thereof having been entered into between a 
contractor and the Secretary of the Navy or his duly authorized 
representative.
    (f) Subcontractor means any person other than a contractor entering 
into a subcontract.
    (g) Contracting party means a contractor or subcontractor as the 
case may be.
    (h) Contract price or contract price means the amount or total 
amount to be received under a contract or subcontract as the case may 
be.
    (i) Income-taxable year means the calendar year, the fiscal year 
ending during such calendar year or the fractional part of such calendar 
or fiscal year, upon the basis of which the contracting party's net 
income is computed and for which its income tax returns are made for 
Federal income tax purposes.

Sec. 17.2 Scope of this part. The regulations in this part deal with 
liability for excess profit on contracts and subcontracts for the 
construction or manufacture of any complete naval vessel or aircraft or 
any portion thereof completed within income-taxable years ending after 
April 3, 1939. As to the date of the completion of a contract or 
subcontract, see Sec. 17.5.

Sec. 17.3 Contracts and subcontracts under which excess profit 
liability may be incurred. Except as otherwise provided with respect to 
contracts or subcontracts for certain scientific equipment (see Sec. 
17.4), every contract awarded for an amount exceeding $10,000 and 
entered into after the enactment of the act of March 27, 1934 for the 
construction or manufacture of any complete naval vessel or aircraft, or 
any portion thereof, is subject to the provisions of the act relating to 
excess profit liability. Any subcontract made with respect to such a 
contract and involving an amount in excess of $10,000 is also within the 
scope of the act. If a contracting party places orders with another 
party, aggregating an amount in excess of $10,000, for articles or 
materials which constitute a part of the cost of performing the contract 
or subcontract, the placing of such orders shall constitute a 
subcontract within the scope of the act, unless it is clearly shown that 
each of the orders involving $10,000 or less is a bona fide separate and 
distinct subcontract and not a subdivision made for the purpose of 
evading the provisions of the act.

Sec. 17.4 Contracts or subcontracts for scientific equipment. No excess 
profit liability is incurred upon a contract or subcontract entered into 
after the amendment of section 3(b) of the act of June 25, 1936, if at 
the time or prior to the time such contract or subcontract is made it is 
designated by the Secretary of the Navy as being exempt under the 
provisions of the act pertaining to scientific equipment used for 
communication, target detection, navigation, or fire control. The 
exemption of contracts or subcontracts for scientific equipment does not 
extend to any contract or subcontract entered into prior to the 
enactment of such amendment of section 3(b) of the act.

Sec. 17.5 Completion of contract defined. The date of delivery of the 
vessel, aircraft or portion thereof covered by the contract or 
subcontract shall be considered the date of completion of the contract 
or subcontract unless otherwise determined jointly by the Secretary of 
the Navy and the Secretary of the Treasury or their duly authorized 
representatives. Except as otherwise provided in the preceding sentence, 
the replacement of defective parts of delivered articles or the 
performance of other guarantee work in respect to such articles will not 
operate to extend the date of completion. As to the treatment of the 
cost of such work as a cost of performing a contract or subcontract, see 
Sec. 17.9(h). As to a refund in case of adjustment due to any 
subsequently incurred additional costs, see Sec. 17.19. If a contract 
or subcontract is at any time cancelled or terminated, it is completed 
at the time of the cancellation or termination.

Sec. 17.6 Manner of determining liability with respect to contracts or 
subcontracts for complete naval vessles or portions thereof. If in an 
income-taxable year ending after April 3, 1939 a contracting party 
completes one or more contracts or subcontracts coming within the scope 
of the act and entered into for the construction or manufacture of any 
complete naval vessel or any portion thereof, the amount of excess 
profit to be paid to the

[[Page 226]]

United States with respect to all such contracts and subcontracts 
completed within the income-taxable year shall be computed as follows:
    (a) The first step is to ascertain the total contract prices of all 
such contracts and subcontracts completed by the contracting party 
within the income-taxable year. As to total contract prices, see 
Sec. Sec. 17.1 and 17.8.
    (b) The second step is to ascertain the cost of performing such 
contracts and subcontracts (see Sec. 17.9) and to deduct such cost from 
the total contract prices of such contracts and subcontracts as computed 
in the first step.

The amount remaining after such subtraction is the amount of net profit 
or net loss upon such contracts and subcontracts completed within the 
income-taxable year.
    (c) The third step, in case there is a new profit upon such 
contracts and subcontracts, is to subtract from the amount of such net 
profit as computed in the second step the sum of:
    (1) An amount equal to 10 percent of the total contract prices of 
such contracts and subcontracts completed within the income- taxable 
year; and
    (2) The amount of any net loss which was sustained in the preceding 
income-taxable year with respect to contracts or subcontracts entered 
into for the construction or manufacture of any complete naval vessel or 
any portion thereof, and which is allowable as a credit in determining 
the excess profit for the income-taxable year with respect to contracts 
and subcontracts entered into for the construction or manufacture of any 
complete naval vessel or any portion thereof (see Sec. 17.10(a)).

The amount remaining after such subtraction is the amount of excess 
profit for the income-taxable year with respect to contracts and 
subcontracts entered into for the construction or manufacture of any 
complete naval vessel or any portion thereof.
    (d) The fourth step is to ascertain the amount of credit allowed for 
Federal income taxes paid or remaining to be paid upon the amount of 
such excess profit as computed in the third step (see Sec. 17.11) and 
then subtract from the amount of such excess profit the amount of credit 
for Federal income taxes. The amount remaining after this subtraction is 
the amount of excess profit to be paid to the United States by the 
contracting party for the income-taxable year with respect to contracts 
and subcontracts entered into for the construction or manufacture of any 
complete naval vessel or any portion thereof and completed within the 
income- taxable year.
    (e) The application of the provisions of this section of the 
regulations may be illustrated by the following example:
    Example: On September 1, 1939 the A Corporation, which keeps its 
books and makes its Federal income tax returns on a calendar year basis, 
entered into a contract with the Secretary of the Navy for the 
construction of portions of a naval vessel coming within the scope of 
the act, the total contract price of which $200,000. On March 10, 1940 
the A Corporation entered into another such contract, the total contract 
price of which was $40,000. Both contracts were completed within the 
calendar year 1940, the first at a cost of $155,000 and the second at a 
cost of $45,000. During the year 1940 the A Corporation also completed 
at a loss of $10,000 two contracts entered into for the construction or 
manufacture of naval aircraft coming within the scope of the act. For 
the year 1939 the A Corporation sustained a net loss of $2,500 on all 
contracts and subcontracts for any complete naval vessel or any portion 
thereof coming within the scope of the act and completed within the 
calendar year 1939. For the year 1939 the A Corporation also sustained a 
net loss of $1,800 on all other contracts and subcontracts coming within 
the scope of the act which were completed within the calendar year 1939. 
For purposes of Federal income tax, the net income of the A Corporation 
for the year 1940 amounted to $96,000, which amount included the net 
profit of $40,000 upon the contracts entered into on September 1, 1939 
and March 10, 1940. For the year 1940 the A Corporation paid Federal 
income taxes amounting to $19,200. The excess profit liability of the A 
Corporation for 1940 is payable with respect to the contracts for 
portions of a naval vessel which were completed in 1940. The loss of 
$10,000 on other contracts completed in 1940 and the net loss of $1,800 
for 1939 on contracts and subcontracts for naval aircraft do not enter 
into the computation of such liability. Accordingly, the excess profit 
liability of the A Corporation for 1940 is $10,800 computed as follows:

Total contract prices:
  Contract No. 1................................    $200,000
  Contract No. 2................................      40,000
                                                 ------------
                                                  ..........    $240,000
  Less cost of performing contracts:
  Contract No. 1................................     155,000
  Contract No. 2................................      45,000
                                                 ------------
                                                  ..........     200,000
                                                             -----------
    Net profit on contracts.................................      40,000

Less:
  10 percent of total contract prices (10             24,000
   percent of $240,000).........................
  Net loss from 1939............................       2,500
                                                 ------------
                                                  ..........      26,500
                                                             -----------
      Excess profit for year 1940...........................      13,500

[[Page 227]]


  Less credit for Federal income taxes (Federal income tax         2,700
   on $13,500 at rates for 1940)............................
                                                 -------------
    Amount of excess profit payable to the United States....      10,800


Sec. 17.7 Manner of determining liability with respect to contracts or 
subcontracts for complete naval aircraft or portions thereof. If in an 
income-taxable year ending after April 3, 1939 a contracting party 
completes one or more contracts or subcontracts coming within the scope 
of the act and entered into for the construction or manufacture of any 
complete naval aircraft or any portion thereof, the amount of excess 
profit to be paid to the United States with respect to all such 
contracts and subcontracts completed within the income-taxable year 
shall be computed as follows:
    (a) The first step is to ascertain the total contract prices of all 
such contracts and subcontracts completed by the contracting party 
within the income-taxable year. As to total contract prices, see Sec. 
Sec. 17.1 and 17.8.
    (b) The second step is to ascertain the cost of performing such 
contracts and subcontracts (see Sec. 17.9) and to deduct such cost from 
the total contract prices of such contracts and subcontracts as computed 
in the first step.

The amount remaining after such subtraction is the amount of net profit 
or net loss upon such contracts and subcontracts completed within the 
income-taxable year.
    (c) The third step, in case there is a net profit upon such 
contracts and subcontracts, is to subtract from the amount of such net 
profit as computed in the second step the sum of:
    (1) An amount equal to 12 percent of the total contract prices of 
such contracts and subcontracts completed within the income- taxable 
year;
    (2) The amount of any net loss which was sustained in the same or a 
prior income- taxable year with respect to contracts or subcontracts for 
the construction or manufacture of any complete aircraft or any portion 
thereof, and which is allowable as a credit in determining the excess 
profit for the income-taxable year with respect to contracts and 
subcontracts entered into for the construction or manufacture of 
complete aircraft or any portion thereof (see Sec. 17.10(b)); and
    (3) The amount of any deficiency in profit which was sustained in 
the same or a prior income-taxable year with respect to contracts or 
subcontracts for the construction or manufacture of any complete 
aircraft or any portion thereof, and which is allowable as a credit in 
determining the excess profit for the income-taxable year with respect 
to contracts and subcontracts entered into for the construction or 
manufacture of complete aircraft or any portion thereof (see Sec. 
17.10(c)).

The amount remaining after such subtraction is the amount of excess 
profit for the income-taxable year with respect to contracts and 
subcontracts entered into for the construction or manufacture of 
complete naval aircraft or any portion thereof.
    (d) The fourth step is to ascertain the amount of credit allowed for 
Federal income taxes paid or remaining to be paid upon the amount of 
such excess profit as computed in the third step (see Sec. 17.11) and 
then subtract from the amount of such excess profit the amount of credit 
for Federal income taxes. The amount remaining after this subtraction is 
the amount of excess profit to be paid to the United States by the 
contracting party for the income-taxable year with respect to contracts 
and subcontracts entered into for the construction or manufacture of 
complete naval aircraft or any portion thereof and completed within the 
income-taxable year.
    (e) The application of the provisions of this section of the 
regulations may be illustrated by the following example:
    Example. On September 1, 1939, the B Corporation, which keeps its 
books and makes its Federal income tax returns on a calendar year basis, 
entered into a contract with the Secretary of the Navy for the 
construction of naval aircraft coming within the scope of the act, the 
total contract price of which was $200,000. On March 10, 1940, the B 
Corporation entered into another such contract, the total contract price 
of which was $40,000. Both contracts were completed within the calendar 
year 1940, the first at a cost of $155,000 and the second at a cost of 
$45,000. During the year 1940, the B Corporation also completed at a 
deficiency in profit of $2,000 a contract entered into for the 
construction of Army aircraft coming within the scope of the act. During 
the year 1940, the B Corporation also completed at a loss of $10,000 two 
contracts entered into for the construction or manufacture of portions 
of a naval vessel coming within the scope of the act. For the year 1939, 
the B Corporation sustained a net loss of $2,500 and a deficiency in 
profit of $1,000 on all contracts and subcontracts for naval aircraft 
coming within the scope of the act and completed within the calendar 
year 1939. For the year 1939, the B Corporation also sustained a net 
loss of $1,800 on a contract for the construction of Army aircraft 
coming within the scope of the act which was completed within the 
calendar year 1939. For the purposes of the Federal income tax, the net 
income of the B Corporation for the year 1940, on which the tax was 
paid, amounted to $96,000, which included the net profit of $40,000 upon 
the contracts entered into on September 1, 1939, and March 10, 1940. The 
excess profit liability of the B Corporation for 1940 is payable with 
respect to the

[[Page 228]]

contracts for naval aircraft which were completed in 1940. The loss of 
$10,000 on the contracts for portions of a naval vessel completed in 
1940 does not enter into the computation of such liability. Accordingly, 
the excess profit liability of the B Corporation for 1940 is $2,964 
computed as follows:

Total contract prices:
  Contract No. 1................................    $200,000
  Contract No. 2................................      40,000
                                                 ------------
                                                  ..........    $240,000
Less: Cost of performing contracts:
  Contract No. 1................................     155,000
  Contract No. 2................................      45,000
                                                 ------------
                                                  ..........     200,000
                                                             -----------
Net profit on contracts.....................................      40,000

Less:
  12 percent of total contract prices (12             28,800
   percent of $240,000).........................
  Deficiency in profit (in Army aircraft               2,000
   contracts) in 1940...........................
  Net loss (in naval aircraft contracts) from          2,500
   1939.........................................
  Net loss (in Army aircraft contracts) from           1,800
   1939.........................................
  Deficiency in profit (in naval aircraft              1,000
   contracts) from 1939.........................
                                                 ------------
                                                  ..........      36,100
                                                             -----------

Excess profit for year 1940.................................       3,900

Less: Credit for Federal income taxes (Federal income tax on         936
 $3,900 at rates for 1940)..................................
                                                 -------------
Amount of excess profit payable to the United States........       2,964


[T.D. 4906, 4 FR 2492, June 27, 1939, as amended by T.D. 6512, 25 FR 
12443, Dec. 6, 1960]

Sec. 17.8 Total contract price. The total contract price of a 
particular contract or subcontract (see Sec. 17.1) may be received in 
money or its equivalent. If something other than money is received, only 
the fair market value of the thing received, at the date of receipt, is 
to be included in determining the amount received. Bonuses earned for 
bettering performance and penalties incurred for failure to meet the 
contract guarantees are to be regarded as adjustments of the original 
contract price. Trade or other discounts granted by a contracting party 
in respect of a contract or subcontract performed by such party are also 
to be deducted in determining the true total contract price of such 
contract or subcontract.

Sec. 17.9 Cost of performing a contract or subcontract--(a) General 
rule. The cost of performing a particular contract or subcontract shall 
be the sum of (1) the direct costs, including therein expenditures for 
materials, direct labor and direct expenses, incurred by the contracting 
party in performing the contract or subcontract; and (2) the proper 
proportion of any indirect costs (including therein a reasonable 
proportion of management expenses) incident to and necessary for the 
performance of the contract or subcontract.
    (b) Elements of cost. No definitions of the elements of cost may be 
stated which are of invariable application to all contractors and 
subcontractors. In general, the elements of cost may be defined for 
purposes of the act as follows:
    (1) Manufacturing cost, which is the sum of factory cost (see 
paragraph (c) of this section) and other manufacturing cost (see 
paragraph (d) of this section);
    (2) Miscellaneous direct expenses (see paragraph (e) of this 
section);
    (3) General expenses, which are the sum of indirect engineering 
expenses, usually termed ``engineering overhead'' (see paragraph (f) of 
this section) and expenses of distribution, servicing and administration 
(see paragraph (g) of this section); and
    (4) Guarantee expenses (see paragraph (h) of this section).
    (c) Factory cost. Factory cost is the sum of the following:
    (1) Direct materials. Materials, such as those purchased for stock 
and subsequently issued for contract operations and those acquired under 
subcontracts, which become a component part of the finished product or 
which are used directly in fabricating, converting or processing such 
materials or parts.
    (2) Direct productive labor. Productive labor, usually termed ``shop 
labor,'' which is performed on and is properly chargeable directly to 
the article manufactured or constructed pursuant to the contract or 
subcontract, but which ordinarily does not include direct engineering 
labor (see subparagraph (3) of this paragraph).
    (3) Direct engineering labor. The compensation of professional 
engineers and other technicists (including reasonable advisory fees), 
and of draftsmen, properly chargeable directly to the cost of the 
contract or subcontract.
    (4) Miscellaneous direct factory charges. Items which are properly 
chargeable directly to the factory cost of performing the contract or 
subcontract but which do not come within the classifications in 
subparagraphs (1), (2), and (3) of this paragraph, as for example, 
royalties which the contracting party pays to another party and which 
are properly chargeable to the cost of performing the contract or 
subcontract (but see paragraph (d) of this section).
    (5) Indirect factory expenses. Items, usually termed ``factory 
overhead,'' which are not directly chargeable to the factory cost of 
performing the contract or subcontract but

[[Page 229]]

which are properly incident to and necessary for the performance of the 
contract or subcontract and consist of the following:
    (i) Labor. Amounts expended for factory labor, such as supervision 
and inspection, clerical labor, timekeeping, packing and shipping, 
stores supply, services of tool crib attendants, and services in the 
factory employment bureau, which are not chargeable directly to 
productive labor of the contract or subcontract.
    (ii) Materials and supplies. The cost of materials and supplies for 
general use in the factory in current operations, such as shop fuel, 
lubricants, heat-treating, plating, cleaning and anodizing supplies, 
nondurable tools and gauges, stationery (such as time tickets and other 
forms), and boxing and wrapping materials.
    (iii) Service expenses. Factory expenses of a general nature, such 
as those for power, heat and light (whether purchased or produced), 
ventilation and air conditioning and operation and maintenance of 
general plant assets and facilities.
    (iv) Fixed charges and obsolescence. Recurring charges with respect 
to property used for manufacturing purposes of the contract or 
subcontract, such as premiums for fire and elevator insurance, property 
taxes, rentals and allowances for depreciation of such property, 
including maintenance and depreciation of reasonable standby equipment; 
and depreciation and obsolescence of special equipment and facilities 
necessarily acquired primarily for the performance of the contract or 
subcontract. In making allowances for depreciation, consideration shall 
be given to the number and length of shifts.
    (v) Miscellaneous indirect factory expenses. Miscellaneous factory 
expenses not directly chargeable to the factory cost of performing the 
contract or subcontract, such as purchasing expenses; ordinary and 
necessary expenses of rearranging facilities within a department or 
plant; employees' welfare expenses; premiums or dues on compensation 
insurance; employers' payments to unemployment, old age and social 
security, Federal and State funds not including payments deducted from 
or chargeable to employees or officers; pensions and retirement payments 
to factory employees; factory accident compensation (as to self-
insurance, see paragraph (g) of this section); but not including any 
amounts which are not incident to services, operations, plant, equipment 
or facilities involved in the performance of the contract or 
subcontract.
    (d) Other manufacturing cost. Other manufacturing cost as used in 
paragraph (b) of this section includes items of manufacturing costs 
which are not properly or satisfactorily chargeable to factory costs 
(see paragraph (c) of this section) but which upon a complete showing of 
all pertinent facts are properly to be included as a cost of performing 
the contract or subcontract, as for instance, payments of royalties and 
amortization of the cost of designs purchased and patent rights over 
their useful life; and ``deferred'' or ``unliquidated'' experimental and 
development charges. For example, in case experimental and development 
costs have been properly deferred or capitalized and are amortized in 
accordance with a reasonably consistent plan, a proper portion of the 
current charge, determined by a ratable allocation which is reasonable 
in consideration of the pertinent facts, may be treated as a cost of 
performing the contract or subcontract. In the case of general 
experimental and development expenses which may be charged off 
currently, a reasonable portion thereof may be allocated to the cost of 
performing the contract or subcontract. If a special experimental or 
development project is carried on in pursuance of a contract, or in 
anticipation of a contract which is later entered into, and the expense 
is not treated as a part of general experimental and development 
expenses or is not otherwise allowed as a cost of performing the 
contract, there clearly appearing no reasonable prospect of an 
additional contract for the type of article involved, the entire cost of 
such project may be allowed as a part of the cost of performing the 
contract.
    (e) Miscellaneous direct expenses. Miscellaneous direct expenses as 
used in paragraph (b) of this section include:
    (1) Cost of installation and construction. Cost of installation and 
construction includes the cost of materials, labor and expenses 
necessary for the erection and installation prior to the completion of 
the contract and after the delivery of the product or material 
manufactured or constructed pursuant to the contract or subcontract.
    (2) Sundry direct expenses. Items of expense which are properly 
chargeable directly to the cost of performing a contract or subcontract 
and which do not constitute guarantee expenses (see paragraph (h) of 
this section) or direct costs classified as factory cost or other 
manufacturing cost (see paragraphs (c) and (d) of this section), such as 
premiums on performance or other bonds required under the contract or 
subcontract; State sales taxes imposed on the contracting party; freight 
on outgoing shipments; fees paid for wind tunnel and model basin tests; 
demonstration and test expenses; crash insurance premiums; traveling 
expenses. In order for any such item to be allowed as a charge directly 
to the cost of performing a contract or subcontract, (i) a detailed 
record shall be kept by the contracting party of all items of a similar 
character, and (ii) no item of a similar character which is properly a 
direct charge to other work shall be allowed as a part of any indirect 
expenses in determining the proper proportion thereof chargeable to the 
cost of performing the contract or subcontract. As to allowable indirect 
expenses,

[[Page 230]]

see paragraphs (c)(5), (f), (g), and (j) of this section.
    (f) Indirect engineering expenses. Indirect engineering expenses, 
usually termed ``engineering overhead,'' which are treated in this 
section as a part of general expenses in determining the cost of 
performing a contract or subcontract (see paragraph (b) of this 
section), comprise the general engineering expenses which are incident 
to and necessary for the performance of the contract or subcontract, 
such as the following:
    (1) Labor. Reasonable fees of engineers employed in a general 
consulting capacity, and compensation of employees for personal services 
to the engineering department, such as supervision, which is properly 
chargeable to the contract or subcontract, but which is not chargeable 
as direct engineering labor (see paragraph (c)(3) of this section).
    (2) Material. Supplies for the engineering department, such as paper 
and ink for drafting and similar supplies.
    (3) Miscellaneous expenses. Expenses of the engineering department, 
such as (i) maintenance and repair of engineering equipment, and (ii) 
services purchased outside of the engineering department for blue- 
printing, drawing, computing, and like purposes.
    (g) Expenses of distribution, servicing and administration. Expenses 
of distribution, servicing and administration, which are treated in this 
section as a part of general expenses in determining the cost of 
performing a contract or subcontract (see paragraph (b) of this 
section), comprehend the expenses incident to and necessary for the 
performance of the contract or subcontract, which are incurred in 
connection with the distribution and general servicing of the 
contracting party's products and the general administration of the 
business, such as:
    (1) Compensation for personal services of employees. The salaries of 
the corporate and general executive officers and the salaries and wages 
of administrative clerical employees and of the office services 
employees such as telephone operators, janitors, cleaners, watchmen and 
office equipment repairmen.
    (2) Bidding and general selling expenses. Bidding and general 
selling expenses which by reference to all the pertinent facts and 
circumstances reasonably constitute a part of the cost of performing a 
contract or subcontract. The treatment of bidding and general selling 
expenses as a part of general expenses in accordance with this paragraph 
is in lieu of any direct charges which otherwise might be made for such 
expenses. The term ``bidding expenses'' as used in this section includes 
all expenses in connection with preparing and submitting bids.
    (3) General servicing expenses. Expenses which by reference to all 
the pertinent facts and circumstances reasonably constitute a part of 
the cost of performing a contract or subcontract and which are incident 
to delivered or installed articles and are due to ordinary adjustments 
or minor defects; but including no items which are treated as a part of 
guarantee expenses (see paragraph (h) of this section) or as a part of 
direct costs, such as direct materials, direct labor, and other direct 
expense.
    (4) Other expenses. Miscellaneous office and administrative 
expenses, such as stationery and office supplies; postage; repair and 
depreciation of office equipment; contributions to local charitable or 
community organizations to the extent constituting ordinary and 
necessary business expenses; employees' welfare expenses; premiums and 
dues on compensation insurance; employers' payments to unemployment, old 
age and social security Federal and State funds not including payments 
deducted from or chargeable to employees or officers; pensions and 
retirement payments to administrative office employees and accident 
compensation to office employees (as to self-insurance, see subdivision 
(i) of this subparagraph).
    (i) Subject to the exception stated in this subdivision, in cases 
where a contracting party assumes its own insurable risks (usually 
termed ``self-insurance''), losses and payments will be allowed in the 
cost of performing a contract or subcontract only to the extent of the 
actual losses suffered or payments incurred during, and in the course 
of, the performance of the contract or subcontract and properly 
chargeable to such contract or subcontract. If, however, a contracting 
party assumes its own insurable risks (a) for compensation paid to 
employees for injuries received in the performance of their duties, or 
(b) for unemployment risks in States where insurance is required, there 
may be allowed as a part of the cost of performing a contract or 
subcontract a reasonable portion of the charges set up for purposes of 
self-insurance under a system of accounting regularly employed by the 
contracting party, as determined by the Commissioner of Internal 
Revenue, at rates not exceeding the lawful or approved rates of 
insurance companies for such insurance, reduced by amounts representing 
the acquisition cost in such companies, provided the contracting party 
adopts and consistently follows this method with respect to self-
insurance in connection with all contracts and subcontracts subsequently 
performed by him.
    (ii) Allowances for interest on invested capital are not allowable 
as costs of performing a contract or subcontract.
    (iii) Among the items which shall not be included as a part of the 
cost of performing a contract or subcontract or considered in 
determining such cost, are the following: Entertainment expenses; dues 
and memberships other than of regular trade associations; donations 
except as otherwise provided above; losses on other contracts; profits 
or losses

[[Page 231]]

from sales or exchanges of capital assets; extraordinary expenses due to 
strikes or lockouts; fines and penalties; amortization of unrealized 
appreciation of values of assets; expenses, maintenance and depreciation 
of excess facilities (including idle land and building, idle parts of a 
building, and excess machinery and equipment) vacated or abandoned, or 
not adaptable for future use in performing contracts or subcontracts; 
increases in reserve accounts for contingencies, repairs, compensation 
insurance (except as above provided with respect to self-insurance) and 
guarantee work; Federal and State income and excess-profits taxes and 
surtaxes; cash discount earned up to one percent of the amount of the 
purchase, except that all discounts on subcontracts subject to the act 
will be considered; interest incurred or earned; bond discount or 
finance charges; premiums for life insurance on the lives of officers; 
legal and accounting fees in connection with reorganizations, security 
issues, capital stock issues and the prosecution of claims against the 
United States (including income tax matters); taxes and expenses on 
issues and transfers of capital stock; losses on investments; bad debts; 
and expenses of collection and exchange.
    (iv) In order that the cost of performing a contract or subcontract 
may be accounted for clearly, the amount of any excess profits repayable 
to the United States pursuant to the act should not be charged to or 
included in such cost.
    (h) Guarantee expenses. Guarantee expenses include the various items 
of factory, cost, other manufacturing cost, cost of installation and 
construction, indirect engineering expenses and other general expenses 
(see paragraphs (c) to (g) of this section) which are incurred after 
delivery or installation of the article manufactured or constructed 
pursuant to the particular contract or subcontract and which are 
incident to the correction of defects or deficiencies which the 
contracting party is required to make under the guarantee provisions of 
the particular contract or subcontract. If the total amount of such 
guarantee expenses is not ascertainable at the time of filing the report 
required to be filed with the district director of internal revenue (see 
Sec. 17.16) and the contracting party includes any estimated amount of 
such expenses as part of the claimed total cost of performing the 
contract or subcontract, such estimated amount shall be separately shown 
on the report and the reasons for claiming such estimated amount shall 
accompany the report; but only the amount of guarantee expenses actually 
incurred will be allowed. If the amount of guarantee expenses actually 
incurred is greater than the amount (if any) claimed on the report and 
the contracting party has made an overpayment of excess profit, a refund 
of the overpayment shall be made, in accordance with the provisions of 
Sec. 17.19. If the amount of guarantee expenses actually incurred is 
less than the amount claimed on the report and an additional amount of 
excess profit is determined to be due, the additional amount of excess 
profit shall be assessed and paid in accordance with the provisions of 
Sec. 17.19.
    (i) Unreasonable compensation. (1) The salaries and compensation for 
services which are treated as a part of the cost of performing a 
contract or subcontract include reasonable payments for salaries, 
bonuses, or other compensation for services. As a general rule, bonuses 
paid to employees (and not to officers) in pursuance of a regularly 
established incentive bonus system may be allowed as a part of the cost 
of performing a contract or subcontract.
    (2) The test of allowability is whether the aggregate compensation 
paid to each individual is for services actually rendered incident to, 
and necessary for, the performance of the contract or subcontract, and 
is reasonable. Excessive or unreasonable payments whether in cash, stock 
or other property ostensibly as compensation for services shall not be 
included in the cost of performing a contract or subcontract.
    (j) Allocation of indirect costs. No general rule applicable to all 
cases may be stated for ascertaining the proper proportion of the 
indirect costs to be allocated to the cost of performing a particular 
contract or subcontract. Such proper proportion depends upon all the 
facts and circumstances relating to the performance of the particular 
contract or subcontract. Subject to a requirement that all items which 
have no relation to the performance of the contract or subcontract shall 
be eliminated from the amount to be allocated, the following methods of 
allocation are outlined as acceptable in a majority of cases:
    (1) Factory indirect expenses. The allowable indirect factory 
expenses (see paragraph (c)(5) of this section) shall ordinarily be 
allocated or ``distributed'' to the cost of the contract or subcontract 
on the basis of the proportion which the direct productive labor (see 
paragraph (c)(2) of this section) attributable to the contract or 
subcontract bears to the total direct productive labor of the production 
department or particular section thereof during the period within which 
the contract or subcontract is performed, except that if the indirect 
factory expenses are incurred in different amounts and in different 
proportions by the various producing departments consideration shall be 
given to such circumstances to the extent necessary to make a fair and 
reasonable determination of the true profit and excess profit.
    (2) Engineering indirect expenses. The allowable indirect 
engineering expenses (see paragraph (f) of this section) shall 
ordinarily be allocated or ``distributed'' to the cost of the contract 
or subcontract on the basis of the

[[Page 232]]

proportion which the direct engineering labor attributable to the 
contract or subcontract (see paragraph (c)(3) of this section) bears to 
the total direct engineering labor of the engineering department or 
particular section thereof during the period within which the contract 
or subcontract is performed. If the expenses of the engineering 
department are not sufficient in amount to require the maintenance of 
separate accounts, the engineering indirect costs may be included in the 
indirect factory expenses (see paragraph (c)(5) of this section) and 
allocated or distributed to the cost of performing the contract or 
subcontract as a part of such expenses, provided the proportion so 
allocated or distributed is proper under the facts and circumstances 
relating to the performance of the particular contract or subcontract.
    (3) Administrative expenses (or ``overhead''). The allowable 
expenses of administration (see paragraph (g) of this section) or other 
general expenses except indirect engineering expenses, bidding and 
general selling expenses, and general servicing expenses shall 
ordinarily be allocated or distributed to the cost of performing a 
contract or subcontract on the basis of the proportion which the sum of 
the manufacturing cost (see paragraph (b) of this section) and the cost 
of installation and construction (see paragraph (e) of this section) 
attributable to the particular contract or subcontract bears to the sum 
of the total manufacturing cost and the total cost of installation and 
construction during the period within which the contract or subcontract 
is performed.
    (4) Bidding, general selling, and general servicing expenses. The 
allowable bidding and general selling expenses and general servicing 
expenses (see paragraph (g) (2) and (3) of this section) shall 
ordinarily be allocated or distributed to the cost of performing a 
contract or subcontract on the basis of:
    (i) The proportion which the contract price of the particular 
contract or subcontract bears to the total sales made (including 
contracts or subcontracts completed) during the period within which the 
particular contract or subcontract is performed, or
    (ii) The proportion which the sum of the manufacturing cost (see 
paragraph (b) of this section) and the cost of installation and 
construction (see paragraph (e) of this section) attributable to the 
particular contract or subcontract bears to the sum of the total 
manufacturing cost and the total cost of installation and construction 
during the period within which the contract or subcontract is performed.

except that special consideration shall be given to the relation which 
certain classes of such expenses bear to the various classes of article 
produced by the contracting party in each case in which such 
consideration is necessary in order to make a fair and reasonable 
determination of the true profit and excess profit. See Sec. 17.14.

Sec. 17.10 Credits for net loss and deficiency in profit in computing 
excess profit--(a) Net loss on contracts and subcontracts for naval 
vessels or portions thereof. In the case of contracts or subcontracts 
for the construction or manufacture of any complete naval vessel or any 
portion thereof coming within the scope of the act which are completed 
within an income-taxable year ending after April 3, 1939, the term ``net 
loss'' as used in the act and in this part means the amount by which the 
total costs of performing all such contracts and subcontracts completed 
within such income-taxable year exceeds the total contract prices of 
such contracts and subcontracts. Such net loss sustained by a 
contracting party for an income-taxable year ending after April 3, 1939, 
is allowable as a credit in computing the contracting party's excess 
profit on contracts and subcontracts for the construction or manufacture 
of any complete naval vessel or any portion thereof which are completed 
within the next succeeding income-taxable year.
    (b) Net loss on contracts and subcontracts for aircraft or portions 
thereof. In the case of contracts or subcontracts for the construction 
or manufacture of any complete aircraft or any portion thereof coming 
within the scope of the act, which are completed within an income-
taxable year ending after April 3, 1939, the term ``net loss'' as used 
in the act and in these regulations means the amount by which the total 
costs of performing all such contracts and subcontracts completed within 
such income-taxable year exceeds the total contract prices of such 
contracts and subcontracts. Such net loss sustained by a contracting 
party for an income-taxable year ending after April 3, 1939, is 
allowable as a credit in computing the contracting party's excess profit 
on contracts and subcontracts for the construction or manufacture of any 
complete aircraft or any portion thereof which are completed within the 
four next succeeding income-taxable years.
    (c) Deficiency in profit. The term ``deficiency in profit'' as used 
in the act and in this part relates to contracts and subcontracts coming 
within the scope of the act which are for the construction or 
manufacture of any complete aircraft or any portion thereof and are 
completed within an income-taxable year ending after April 3, 1939. As 
so used, the term ``deficiency in profit'' means the amount by which 12 
percent of the total contract prices of such contracts and subcontracts 
which are completed by a particular contracting party within the income-
taxable year exceeds the net profit upon such contracts and 
subcontracts. A deficiency in profit sustained by a contracting party 
with respect to such contracts and subcontracts

[[Page 233]]

for the construction or manufacture of complete aircraft or any portion 
thereof and completed within any income-taxable year ending after April 
3, 1939, is allowable as a credit in computing the contracting party's 
excess profit on contracts and subcontracts for the construction or 
manufacture of complete aircraft or any portion thereof which are 
completed within the same or the four next succeeding income-taxable 
years.
    (d) Claim for credit. Credit for a deficiency in profit or a net 
loss may be claimed in the contracting party's annual report of profit 
filed with the district director of internal revenue (see Sec. 17.16), 
but it shall be supported by separate schedules for each contract or 
subcontract involved showing total contract prices, costs of performance 
and pertinent facts relative thereto, together with a summarized 
computation of the deficiency in profit or net loss. The deficiency in 
profit or net loss claimed is subject to verification and adjustment. As 
to preservation of books and records, see Sec. 17.14. A deficiency in 
profit or net loss sustained on contracts and subcontracts completed 
within one income-taxable year may not be considered in computing a net 
loss or deficiency in profit sustained on contracts and subcontracts 
completed within another income- taxable year.
    (e) Examples. The provisions of this section of the regulations may 
be illustrated by the following examples:
    Example (1) For the calendar year 1939 the A Corporation, which 
keeps its books and makes its Federal income tax returns on a calendar 
year basis, sustained a net loss of $50,000 upon all contracts and 
subcontracts coming within the scope of the act which were entered into 
for the construction or manufacture of any complete naval vessel or any 
portion thereof and were completed within the calendar year 1939. For 
the calendar year 1940 the A Corporation had a net profit of $30,000 
upon all such contracts and subcontracts completed within the year 1940. 
It also had a net profit of $10,000 upon other contracts completed 
within that year all such contracts being for naval aircraft coming 
within the scope of the act. For the calendar year 1941 the corporation 
had a net profit of $25,000 upon contracts completed within that year. 
The net loss of $50,000 sustained in 1939 may be taken as a credit 
against the net profit of $30,000 realized in 1940 upon the contracts 
for the construction or manufacture of complete naval vessels or 
portions thereof completed within that year; but the excess of $20,000 
($50,000 minus $30,000) may not be taken as a credit in computing the 
excess profit realized upon the other contracts completed in 1940 at a 
net profit of $10,000 or as a credit in computing the excess profit upon 
the contracts completed within the year 1941 at a net profit of $25,000.
    Example (2). For the calendar year 1939, the B Corporation, which 
keeps its books and makes its Federal income tax returns on a calendar 
year basis, sustained a net loss of $10,000 and a deficiency in profit 
of $35,000 upon all contracts and subcontracts for naval aircraft and 
portions thereof coming within the scope of the act and completed within 
that year. During the year 1939, the B Corporation also completed 
contracts for Army aircraft coming within the scope of the Act at a net 
profit which was $15,000 in excess of 12 percent of the total contract 
prices of such contracts. On all contracts and subcontracts for naval 
aircraft coming within the scope of the act and completed within the 
calendar year 1940, the B Corporation realized a net profit which was 
$25,000 in excess of 12 percent of the total contract prices of such 
contracts and subcontracts while sustaining a deficiency in profit of 
$10,000 on like contracts and subcontracts for Army aircraft. On all 
contracts and subcontracts for naval aircraft coming within the scope of 
the act and completed within the calendar year 1941, the B Corporation 
realized a net profit which was $20,000 in excess of 12 percent of the 
total contract prices of such contracts. The net loss of $10,000 and 
deficiency in profit of $35,000 (or a total of $45,000) sustained in 
1939 with respect to contracts and subcontracts for naval aircraft 
completed within that year may be taken as a credit to the extent of 
$15,000 in computing the excess profit on the contracts and subcontracts 
for Army aircraft completed in 1939. The remainder of such net loss and 
such deficiency in profit ($45,000 minus $15,000, or $30,000) may be 
combined with the deficiency in profit of $10,000 sustained in 1940 on 
contracts for Army aircraft and taken as a credit to the extent of 
$25,000 in computing the excess profit on the contracts and subcontracts 
for aircraft completed during 1940. The sum of such net loss and such 
deficiency in profit then remaining ($40,000 minus $25,000, or $15,000) 
may be taken as a credit in computing the excess profit realized on the 
contracts and subcontracts for aircraft completed in the year 1941.
[T.D. 4906, 4 FR 2492, June 27, 1939, as amended by T.D. 6512, 25 FR 
12444, Dec. 6, 1960]

Sec. 17.11 Credit for Federal income taxes. For the purpose of 
computing the amount of excess profit to be paid to the United States, a 
credit is allowable against the excess profit for the amount of Federal 
income taxes paid or remaining to be paid on the amount of such excess 
profit. The ``Federal income taxes'' in respect of which this credit is 
allowable include the income taxes imposed by Titles I and IA of the 
Revenue Act of 1938, and Chapter 1 and Subchapter A of Chapter 2 of the

[[Page 234]]

Internal Revenue Code, and the excess-profits taxes imposed by section 
602 of the Revenue Act of 1938, and Subchapter B of Chapter 2 of the 
Internal Revenue Code. This credit is allowable for these taxes only to 
the extent that it is affirmatively shown that they have been finally 
determined and paid or remain to be paid and that they were imposed upon 
the excess profit against which the credit is to be made. In case such a 
credit has been allowed and the amount of Federal income taxes imposed 
upon the excess profit is redetermined, the credit previously allowed 
shall be accordingly adjusted.

Sec. 17.12 Failure of contractor to require agreement by subcontractor. 
(a) Every contract or subcontract coming within the scope of the act is 
required by the act to contain, among other things, an agreement by the 
contracting party to make no subcontract unless the subcontractor 
agrees:
    (1) To make a report, as described in the act, under oath to the 
Secretary of the Navy upon the completion of the subcontract;
    (2) To pay into the Treasury excess profit, as determined by the 
Treasury Department, in the manner and amounts specified in the act;
    (3) To make no subdivision of the subcontract for the same article 
or articles for the purpose of evading the provisions of the act;
    (4) That the manufacturing spaces and books of its own plant, 
affiliates, and subdivisions shall at all times be subject to inspection 
and audit as provided in the act.
    (b) If a contracting party enters into a subcontract with a 
subcontractor who fails to make such agreement, such contracting party 
shall, in addition to its liability for excess profit determined on 
contracts or subcontracts performed by it, be liable for any excess 
profit determined to be due the United States on the subcontract entered 
into with such subcontractor. In such event, however, the excess profit 
to be paid to the United States in respect of the subcontract entered 
into with such subcontractor shall be determined separately from any 
contracts or subcontracts performed by the contracting party entering 
into the subcontract with such subcontractor.

Sec. 17.13 Evasion of excess profit. Section 3 of the act provides that 
the contracting party shall agree to make no subdivisions of any 
contract or subcontract for the same article or articles for the purpose 
of evading the provisions of the act. If any such subdivision or 
subcontract is made it shall constitute a violation of the agreement 
provided for in the act, and the cost of completing a contract or 
subcontract by a contracting party which violates such agreement shall 
be determined in a manner necessary clearly to reflect the true excess 
profit of such contracting party.

Sec. 17.14 Books of account and records. (a) It is recognized that no 
uniform method of accounting can be prescribed for all contracting 
parties subject to the provisions of the act. Each contracting party is 
required by law to make a report of its true profit and excess profit. 
Such party must, therefore, maintain such accounting records as will 
enable it to do so. See Sec. 17.9. Among the essentials are the 
following:
    (1) The profit or loss upon a particular contract or subcontract 
shall be accounted for and fully explained in the books of account 
separately on each contract or subcontract.
    (2) Any cost accounting methods, however standard they may be and 
regardless of long continued practice, shall be controlled by, and be in 
accord with, the objectives and purposes of the act and of any 
regulations prescribed thereunder.
    (3) The accounts shall clearly disclose the nature and amount of the 
different items of cost of performing a contract or subcontract.
    (b) In cases where it has been the custom priorly to use so-called 
``normal'' rates of overhead expense or administrative expenses, or 
``standard'' or ``normal'' prices of material or labor charges, no 
objection will be made to the use temporarily during the period of 
performing the contract or subcontract of such methods in charging the 
contract or subcontract, if the method of accounting employed is such as 
clearly to reflect, in the final determination upon the books of 
account, the actual profit derived from the performance of the contract 
or subcontract and if the necessary adjusting entries are entered upon 
the books and they explain in full detail the revisions necessary to 
accord with the facts. As to the elements of cost, see Sec. 17.9.
    (c) All books, records, and original evidences of costs (including, 
for example, production orders, bills or schedules of materials, 
purchase requisitions, purchase orders, vouchers, requisitions for 
materials, standing expense orders, inventories, labor time cards, 
payrolls, cost distribution sheets) pertinent to the determination of 
the true profit, excess profit, deficiency in profit, or net loss from 
the performance of a contract or subcontract shall be kept at all times 
available for inspection by internal revenue officers, and shall be 
carefully preserved and retained so long as the contents thereof may 
become material in the administration of the act. This provision is not 
confined to books, records and original evidences pertaining to items 
which may be considered to be a part of the cost of performing a 
contract or subcontract. It is applicable to all books, records and 
original evidences of costs of each plant, branch or department involved 
in the performance of a contract or subcontract or in the distribution 
of costs to the contract or subcontract.


[[Page 235]]


Sec. 17.15 Report to Secretary of the Navy. (a) Upon the completion of 
a contract or a subcontract coming within the scope of the act and this 
part, the contracting party is required to make a report, under oath, to 
the Secretary of the Navy. As to the date of completion of a contract or 
subcontract, see Sec. 17.5. The act requires that such report shall be 
in the form prescribed by the Secretary of the Navy and shall state the 
total contract price, the cost of performing the contract, the net 
income from such contract, and the per centum such income bears to the 
contract price. The contracting party shall also include as a part of 
such report a statement showing:
    (1) The manner in which the indirect costs were determined and 
allocated to the cost of performing the contract or subcontract (see 
Sec. 17.9);
    (2) The name and address of every subcontractor with whom a 
subcontract was made, the object of such subcontract, the date when 
completed and the amount thereof; and
    (3) The name and address of each affiliate or other organization, 
trade or business owned or controlled directly or indirectly by the same 
interests as those who so own or control the contracting party, together 
with a statement showing in detail all transactions which were made with 
such affiliate or other organization, trade or business and are 
pertinent to the determination of the excess profit.
    (b) A copy of the report required to be made to the Secretary of the 
Navy is required to be transmitted by the contracting party to the 
Secretary of the Treasury. Such copy shall not be transmitted directly 
to the Secretary of the Treasury but shall be filed as a part of the 
annual report. See Sec. 17.16.

Sec. 17.16 Annual reports for income-taxable years--(a) General 
requirements. Every contracting party completing a contract or 
subcontract within the contracting party's income-taxable year ending 
after April 3, 1939 shall file, with the district director of internal 
revenue for the internal revenue district in which the contracting 
party's Federal income tax return is required to be filed, annual 
reports on the prescribed forms of the profit and excess profit on all 
contracts and subcontracts coming within the scope of the act. If any 
contracts or subcontracts so completed by the contracting party were 
entered into for the construction or manufacture of any complete naval 
vessel or any portion thereof, the profit and excess profit on all such 
contracts and subcontracts completed within the income-taxable year 
ending after April 3, 1939 shall be computed in accordance with the 
provisions of Sec. 17.6. If any contracts or subcontracts so completed 
by the contracting party were entered into for the construction or 
manufacture of any complete naval aircraft or any portion thereof, the 
profit and excess profit on all such contracts and subcontracts 
completed within the income-taxable year ending after April 3, 1939 
shall be computed in accordance with the provisions of Sec. 17.7. There 
shall be included as a part of the annual report a statement, preferably 
in columnar form, showing separately for each contract or subcontract 
completed by the contracting party within the income-taxable year and 
covered by the report, the total contract price, the cost of performing 
the contract or subcontract and resulting profit or loss on each 
contract or subcontract together with a summary statement showing in 
detail the computation of the net profit or net loss upon each group of 
contracts and subcontracts covered by the report and the amount of the 
excess profit, if any, with respect to each group of contracts and 
subcontracts covered by the report. A copy of the report made to the 
Secretary of the Navy (see Sec. 17.15) with respect to each contract or 
subcontract covered in the annual report, shall be filed as a part of 
such annual report. In case the income-taxable year of the contracting 
party is a period of less than twelve months (see Sec. 17.1), the 
reports required by this section shall be made for such period and not 
for a full year.

    (b) Time for filing annual reports. Annual reports of contracts and 
subcontracts completed by a contracting party within an income-taxable 
year ending after April 3, 1939 shall be filed on or before the 15th day 
of the ninth month following the close of the contracting party's 
income-taxable year. It is important that the contracting party render 
on or before the due date annual reports as nearly complete and final as 
it is possible for the contracting party to prepare. An extension of 
time granted the contracting party for filing its Federal income tax 
return does not serve to extend the time for filing the annual reports 
required by this section. Authority consistent with authorizations for 
granting extensions of time for filing Federal income tax returns is 
hereby delegated to the various district directors of internal revenue 
for granting extensions of time for filing the reports required by this 
section. Application for extensions of time for filing such reports 
should be addressed to the district director of internal revenue for the 
district in which the contracting party files its Federal income tax 
returns and must contain a full recital of the causes for the delay.

Sec. 17.17 Payment of excess profit liability. The amount of the excess 
profit liability to be paid to the United States shall be paid on or 
before the due date for filing the report with the district director of 
internal revenue. See Sec. 17.16. At the option of the contracting 
party, the amount of the excess profit liability may be paid in four 
equal installments instead of in a single payment, in which case

[[Page 236]]

the first installment is to be paid on or before the date prescribed for 
the payment of the excess profit as a single payment, the second 
installment on or before the 15th day of the third month, the third 
installment on or before the 15th day of the sixth month, and the fourth 
installment on or before the 15th day of the ninth month, after such 
date.

Sec. 17.18 Liability of surety. The surety under contracts entered into 
after the amendment of section 3(b) of the act of June 25, 1936 shall 
not be liable for payment of excess profit due the United States in 
respect of such contracts.

Sec. 17.19 Determination of liability for excess profit, interest and 
penalties; assessment, collection, payment, refunds. (a) The duty of 
determining the correct amount of excess profit liability on contracts 
and subcontracts coming within the scope of the act is upon the 
Commissioner of Internal Revenue. Under section 3(b) of the act, as 
amended, and section 651 of the Internal Revenue Code, all provisions of 
law (including the provisions of law relating to interest, penalties and 
refunds) applicable with respect to the taxes imposed by Title I of the 
Revenue Act of 1934 and not inconsistent with section 3 of the act are 
applicable with respect to the assessment, collection, or payment of 
excess profits on contracts and subcontracts coming within the scope of 
the act and to refunds of overpayments of profits into the Treasury 
under the act. Claims by a contracting party for the refund of an amount 
of excess profit, interest, penalties, and additions to such excess 
profit shall conform to the general requirements prescribed with respect 
to claims for refund of overpayments of taxes imposed by Title I of the 
Revenue Act of 1934 and, if filed on account of any additional costs 
incurred pursuant to guarantee provisions in a contract, shall be 
supplemented by a statement under oath showing the amount and nature of 
such costs and all facts pertinent thereto.
    (b) Administrative procedure for the determination, assessment and 
collection of excess profit liability under section 3 of the act, 
sections 650 and 651 of the Internal Revenue Code, and this part, and 
the examination of reports and claims in connection therewith will be 
prescribed from time to time by the Commissioner of Internal Revenue.

      MITIGATION OF EFFECT OF RENEGOTIATION OF GOVERNMENT CONTRACTS