B-174839.2, JANUARY 3, 1984, 63 COMP.GEN. 145

B-174839.2, JANUARY 3, 1984, 63 COMP.GEN. 145

VESSELS - CHARTERS - LONG-TERM - OBLIGATIONAL AVAILABILITY - NAVY INDUSTRIAL FUND - ANTI-DEFICIENCY ACT COMPLIANCE NAVY CONTRACTS FOR LONG-TERM LEASE OF 13 TAKX PREPOSITIONING SHIPS PROVIDE FOR THE NAVY TO INDEMNIFY CONTRACTORS IN CASE OF CERTAIN CONTINGENCIES, PRINCIPALLY THE LOSS OF SPECIFIED TAX BENEFITS. BECAUSE THE GOVERNMENT'S LIABILITY UNDER SUCH CLAUSES IS DETERMINABLE IN ADVANCE OR, WHERE NOT SO DETERMINABLE, MAY BE AVOIDED BY SEPARATE ACTION BY THE NAVY, GENERAL ACCOUNTING OFFICE DOES NOT CONSIDER SUCH PROVISIONS TO IMPOSE AN "INDEFINITE OR POTENTIALLY UNLIMITED CONTINGENT LIABILITY" IN VIOLATION OF THE ANTIDEFICIENCY ACT. IN ADDITION, WITH THE EXCEPTION OF A PROVISION CONCERNING ADDITIONAL TAX LIABILITY FOR INCREASED RENTAL PAYMENTS RESULTING FROM GOVERNMENT ORDERED IMPROVEMENTS, SUCH INDEMNIFICATION CLAUSES ARE AUTHORIZED AS REASONABLY INCIDENTAL TO THE TAKX PROGRAM.

TO THE HONORABLE HOWARD M. METZENBAUM, UNITED STATES SENATE, JANUARY 3, 1984:

YOU HAVE REQUESTED US TO RESPOND TO A NUMBER OF QUESTIONS CONCERNING THE NAVY'S TAKX PREPOSITIONING SHIP CHARTERING PROGRAM. MOST OF YOUR QUESTIONS CONCERN THE INCLUSION OF TAX INDEMNIFICATION PROVISIONS IN CONTRACTS FOR TAKX VESSELS, AND, AS REQUESTED BY YOUR STAFF, THIS LETTER WILL RESPOND ONLY TO THOSE QUESTIONS. OUR RESPONSES TO YOUR QUESTIONS ON OTHER ASPECTS OF THE TAKX PROGRAM WILL BE PROVIDED SEPARATELY.

AS DESCRIBED IN DETAIL BELOW, WE HAVE EXAMINED INDEMNIFICATION PROVISIONS IN THE TAKX CONTRACTS, AND CONCLUDE, WITH ONE EXCEPTION, THAT SUCH AGREEMENTS ARE AUTHORIZED AS INCIDENTAL TO THE PROVISION OF TRANSPORTATION SERVICES UNDER THE PROGRAM, AND TO NOT POSE AN INDEFINITE OR UNLIMITED CONTINGENT LIABILITY IN VIOLATION OF THE ANTIDEFICIENCY ACT, 31 U.S.C. 1341(A).

BACKGROUND

THE NAVY HAS ENTERED INTO CONTRACTS TO CHARTER 13 TAKX PREPOSITIONING VESSELS IN SUPPORT OF THE RAPID DEPLOYMENT FORCE. THERE ARE 13 CONTRACTORS INVOLVED, EACH A SPECIALLY CREATED SUBSIDIARY OF THREE MAJOR CORPORATIONS: GENERAL DYNAMICS CORPORATION, WATERMAN STEAMSHIP CORPORATION, AND MAERSK LINES, LTD. BRIEFLY SUMMARIZED, EACH VESSEL IS TO BE CHARTERED UNDER A LEVERAGED LEASE ARRANGEMENT THAT OPERATES IN THE FOLLOWING MANNER: THE NAVY, AS CHARTERER, CONTRACTS WITH AN INTERMEDIATE LESSEE TO OPERATE THE VESSEL. THE INTERMEDIATE LESSEE "BAREBOAT" CHARTERS THE VESSEL FROM THE OWNER/LESSOR AND IN TURN "TIME" CHARTERS THE VESSEL TO THE NAVY. THE INTERMEDIATE LESSEE (THE "CONTRACTOR") ACTUALLY ENTERS INTO TWO CONTRACTS WITH THE NAVY FOR EACH VESSEL: AN AGREEMENT TO CHARTER AND A TIME CHARTER PARTY. THE FIRST CONTRACT GOVERNS THE RIGHTS AND RESPONSIBILITIES OF THE PARTIES UNTIL THE TIME OF VESSEL DELIVERY. THIS CONTRACT SETS THE TERMS OF VESSEL ACCEPTANCE, AS WELL AS CALCULATION OF CAPITAL HIRE. THE SECOND CONTRACT, WHICH BECOMES EFFECTIVE UPON THE NAVY'S ACCEPTANCE OF VESSEL DELIVERY, SETS OUT THE TERMS OF THE CHARTER ITSELF. SEE OUR PREVIOUS DISCUSSION OF THESE TWO CONTRACTUAL ARRANGEMENTS IN 62 COMP.GEN. 143 (1983).

THE SHIP CHARTERING PROGRAM HAS BEEN STRUCTURED SO THAT THE TAX BENEFITS THAT ARE ORDINARILY AVAILABLE TO PRIVATE OWNERS IN THIS KIND OF LEASING TRANSACTION ARE PASSED ON TO THE NAVY IN THE FORM OF REDUCED CHARTER HIRE RATES. BOTH TYPES OF TAKX CONTRACTS CONTAIN PROVISIONS UNDER WHICH THE GOVERNMENT ACCEPTS THE RISK OF A NUMBER OF CONTINGENCIES, INCLUDING THE LOSS OF CERTAIN TAX BENEFITS THAT THE PARTIES HAVE EXPLICITLY "ASSUMED" WILL BE AVAILABLE TO EACH CONTRACTOR UNDER THE AGREEMENTS.

UNDER ARTICLE VII OF THE AGREEMENT TO CHARTER, CAPITAL HIRE AND TERMINATION COSTS ARE SUBJECT TO ADJUSTMENT IN ORDER TO PREVENT THE EQUITY OWNERS' AFTER-TAX ECONOMIC YIELD FROM BEING ADVERSELY AFFECTED BY MODIFICATIONS IN SPECIFIED "ASSUMPTIONS SUBJECT TO ADJUSTMENTS." THUS, ADJUSTMENTS CAN BE MADE FOR A NUMBER OF REASONS, INCLUDING CHANGES IN COST RECOVERY DEDUCTIONS FOR INCOME TAX PURPOSES, THE UNAVAILABILITY OF INVESTMENT TAX CREDITS, AND CHANGES TO THE INTERNAL REVENUE CODE AND REGULATIONS IN EFFECT AT THE TIME OF THE BEST AND FINAL OFFER (AUGUST 11, 1982). OTHER SPECIFIED "ASSUMPTIONS SUBJECT TO ADJUSTMENT" THAT.DO NOT RELATE DIRECTLY TO THE CONTRACTOR'S TAX LIABILITY INCLUDE BOND INTEREST RATE AND AMORTIZATION SCHEDULES, AND THE DEBT/EQUITY RATIO. BY THESE PROVISIONS, THE NAVY HAS, IN EFFECT, INDEMNIFIED THE OTHER PARTIES TO EACH LEASE TRANSACTION FOR ANY LOSSES DUE TO CHANGES IN THE PRINCIPAL ASSUMPTIONS UNDERLYING THE TRANSACTION. ANY RESULTING ADJUSTMENTS TO THE CAPITAL HIRE RATES MUST BE MADE ON OR BEFORE THE LEASE COMMENCEMENT DATE.

LIKE THE AGREEMENT TO CHARTER, THE TIME CHARTER PARTY ALSO CONTAINS CERTAIN INDEMNIFICATION PROVISIONS, PRINCIPALLY DEALING WITH TAX MATTERS. UNDER ARTICLE 40 OF THE CONTRACT, THE NAVY HAS AGREED TO PAY THE CONTRACTOR ANY AMOUNT INCURRED BY ANY SHIP-OWNING PARTNER DUE TO A LOSS OF SPECIFIED TAX BENEFITS, AT LEAST TO THE EXTENT THAT THE CONTRACTOR IS REQUIRED TO REIMBURSE SUCH PARTNER UNDER THE BAREBOAT CHARTER BETWEEN THOSE TWO PARTIES. THE INDEMNIFICATION PROVISION COVERS LOSSES CAUSED AS A RESULT OF THE CHARTER AGREEMENT BEING TREATED FOR FEDERAL INCOME TAX PURPOSES AS A LEASE (AS OPPOSED TO A SERVICE CONTRACT), AS WELL AS FOR ADDITIONAL TAX LIABILITY RESULTING FROM THE NAVY'S TAKING ANY ACTION NOT REQUIRED UNDER THE CONTRACT, OR FAILING TO TAKE ANY ACTION REQUIRED (FOR EXAMPLE, GOVERNMENT ORDERED CHANGES IN THE VESSELS). REIMBURSEMENT FOR ANY "LOSS" UNDER ARTICLE 40 IS TO BE MADE WITHIN 20 DAYS OF RECEIPT OF A WRITTEN DEMAND BY THE CONTRACTOR (BUT ONLY AFTER THE ACTUAL PAYMENT OF INCREASED TAX LIABILITY BY A PARTNER). THE NAVY MAY REQUIRE THE CONTRACTOR TO CAUSE THE PARTNER TO CONTEST ANY DISALLOWANCE OF TAX BENEFIT BY THE INTERNAL REVENUE SERVICE, PROVIDED THE NAVY AGREES TO PAY THE PARTNER'S COSTS AND EXPENSES (INCLUDING ATTORNEY'S FEES) FOR SO DOING.

DISCUSSION QUESTION 1: UNDER WHAT AUTHORITY MAY THE NAVY ENTER INTO THE TAKX INDEMNIFICATION AGREEMENTS? ANSWER: THE SOURCE OF AUTHORITY FOR AN INDEMNIFICATION AGREEMENT IS GENERALLY THE SAME AS THAT FOR THE ACTIVITY OR PROGRAM IMPLEMENTED BY THE CONTRACT CONTAINING THE INDEMNIFICATION PROVISION. THIS AUTHORITY, HOWEVER, IS SUBJECT TO TWO MAJOR LIMITATIONS. FIRST, A FEDERAL AGENCY MAY NOT ENTER INTO AN INDEMNIFICATION AGREEMENT THAT WOULD IMPOSE AN INDEFINITE OR POTENTIALLY UNLIMITED CONTINGENT LIABILITY ON THE , GOVERNMENT, UNLESS SPECIFICALLY AUTHORIZED TO DO SO BY LAW. 35 , COMP.GEN. 85, 87 (1955); B-201394, APRIL 23, 1981. SECOND, EVEN IF THE POTENTIAL LIABILITY IS LIMITED, SUCH AGREEMENTS ARE PERMISSIBLE ONLY TO THE EXTENT THAT THEY ARE REASONABLY NECESSARY OR INCIDENT TO THE EXECUTION OF THE APPLICABLE PROGRAM OR ACTIVITY. COMP.GEN. 369, 373-4 (1980); 54 ID. 824, 826 (1975); B-201394, APRIL 23, 1981.

THE PROHIBITION AGAINST ENTERING INTO INDEFINITE OR POTENTIALLY UNLIMITED INDEMNIFICATION AGREEMENTS IS BASED UPON THE ANTIDEFICIENCY ACT, 31 U.S.C. 1341, WHICH PROHIBITS AGENCIES FROM INCURRING OBLIGATIONS IN EXCESS OF AVAILABLE APPROPRIATIONS. SEE 35 COMP.GEN. 85, 87 (1955). ALL TYPES OF CONTINGENT LIABILITIES INVOLVE A RISK THAT OCCURRENCE OF THE APPLICABLE CONTINGENCY COULD RESULT IN AN OBLIGATION IN EXCESS OF AVAILABLE FUNDS. IN THE ORDINARY SITUATION, THE RISK OF POTENTIAL ANTIDEFICIENCY ACT VIOLATIONS MAY BE MINIMIZED BY THE PRIOR ADMINISTRATIVE RESERVATION OR OBLIGATION OF ADDITIONAL FUNDS TO MEET THE CONTINGENCY. SEE B-198161, NOVEMBER 25, 1980. WHEN, HOWEVER, THE CONTINGENT LIABILITY IS OF AN UNLIMITED OR INDETERMINATE NATURE, THE ADMINISTRATIVE RESERVATION OF FUNDS IS NOT AN EFFECTIVE PROTECTION. THE ONLY PROTECTION THIS OFFICE HAS RECOGNIZED IN SUCH A CASE IS AN EXPLICIT CONTRACTUAL LIMITATION OF LIABILITY TO FUNDS AVAILABLE AT THE TIME OF THE OCCURRENCE OF THE CONTINGENCY, COUPLED WITH THE ASSURANCE THAT NOTHING IN THE AGREEMENT WILL BE VIEWED AS BINDING CONGRESS TO APPROVE ADDITIONAL FUNDS TO COVER A POSSIBLE DEFICIENCY. SEE, E.G., B-202518, JANUARY 8, 1982. RECENTLY, HOWEVER, WE HAVE STATED OUR TENTATIVE POSITION THAT OPEN-ENDED INDEMNIFICATION AGREEMENTS SHOULD NOT BE ENTERED INTO REGARDLESS OF THE EXISTENCE OF SUCH LANGUAGE OF LIMITATION, UNLESS AUTHORIZED BY LAW. COMP.GEN. 361, 368 (1983).

A. PROHIBITION AGAINST INDEFINITE OR UNLIMITED LIABILITY. AS PREVIOUSLY STATED, BOTH TYPES OF TAKX CHARTER AGREEMENTS CONTAIN INDEMNIFICATION PROVISIONS. THOSE UNDER THE AGREEMENT TO CHARTER ARE FRAMED IN VERY BROAD TERMS (I.E., "ANY CHANGE IN THE PROVISIONS OF THE (INTERNAL REVENUE) CODE OR THE REGULATIONS PROMULGATED THEREUNDER * * * .") THESE INDEMNIFICATION PROVISIONS, HOWEVER, ONLY COME INTO PLAY IF VESSELS ARE ACCEPTED FOR DELIVERY; THE CLAUSES ARE EXECUTED THROUGH ADJUSTMENTS IN THE HIRE RATE TO BE CHARGED UNDER THE CHARTER ITSELF.

THIS OFFICE HAS PREVIOUSLY HELD THAT THE NAVY'S LIABILITY UNDER THE TAKX AGREEMENT TO CHARTER IS LIMITED BY ITS POWER TO TERMINATE THE AGREEMENT PRIOR TO ACCEPTANCE OF VESSEL DELIVERY. 62 COMP.GEN. 143, 145 (1983). THIS PRINCIPLE IS EQUALLY APPLICABLE TO THE NAVY'S CONTINGENT LIABILITY UNDER INDEMNIFICATION PROVISIONS IN THE AGREEMENT TO CHARTER: THE NAVY'S CONTRACTUAL RIGHT TO TERMINATE SETS A CEILING ON ITS LIABILITY UNDER THE AGREEMENT TO CHARTER. /1/ BECAUSE OF THIS CEILING, WE DO NOT CONSIDER SUCH INDEMNIFICATION PROVISIONS AS IMPOSING AN UNLIMITED OR INDETERMINATE CONTINGENT LIABILITY, ALTHOUGH WE AGREE THEY ARE BROADLY DRAWN. /2/ LIABILITY IN EXCESS OF THE TERMINATION CEILING , IMPOSED UNDER ARTICLE VII OF THE AGREEMENT TO CHARTER COULD BE AVOIDED BY THE NAVY, IF NECESSARY, THROUGH ITS REFUSAL TO ACCEPT VESSEL DELIVERY. ONCE ACCEPTED, HOWEVER, ANY ADDITIONAL LIABILITY UNDER THE ADJUSTMENT CLAUSES OF THE AGREEMENT TO CHARTER WOULD BE SPECIFICALLY IDENTIFIED AND INCLUDED AS PART OF THE NAVY'S OBLIGATION UNDER THE CHARTER PARTY.

THE INDEMNIFICATION PROVISIONS INCLUDED IN THE TAKX CHARTER PARTY CONTRACTS ARE MORE SPECIFIC THAN THE COST-ADJUSTMENT CLAUSES OF THE AGREEMENT TO CHARTER. FIRST, THESE PROVISIONS, INCLUDED IN ARTICLE 40, DEAL ALMOST EXCLUSIVELY WITH THE TAX EFFECTS OF THE TAKX CONTRACTUAL ARRANGEMENTS. SECOND, MAXIMUM CONTINGENT LIABILITY UNDER ARTICLE 40 IS, WITH ONE EXCEPTION, CALCULABLE UPON COMMENCEMENT OF THE CHARTER. THE EXCEPTION, TO BE DISCUSSED BELOW, DEALS WITH TAX LIABILITY FOR ADDITIONAL RENT PAID TO SHIPOWNERS DUE TO GOVERNMENT-ORDERED IMPROVEMENTS OR ADDITIONS TO THE TAKX VESSELS.

UNDER ARTICLE 40 OF THE CHARTER PARTY, THE NAVY HAS AGREED TO PAY TO THE CONTRACTOR ANY AMOUNT THAT THE CONTRACTOR IS REQUIRED TO REIMBURSE ANY SHIP-OWNING PARTNER (UNDER A SIMILAR PROVISION INCLUDED IN THE BAREBOAT CHARTER BETWEEN THOSE TWO PARTIES) FOR ADDITIONAL TAX LIABILITY OF THE PARTNER DUE TO IRS DENIAL OF THREE SPECIFIED TAX BENEFITS. THESE BENEFITS ARE:

(1) ACCELERATED COST RECOVERY SYSTEM (ACRS) DEPRECIATION DEDUCTIONS THAT WOULD OTHERWISE BE TAKEN BY THE SHIPOWNER OVER A 5-YEAR RECOVERY PERIOD, CALCULATED USING A BASIS OF BASIC CAPITALIZED COSTS (SPECIFIED IN THE AGREEMENT TO CHARTER), LESS AMORTIZABLE FEES AND EXPENSES (ALSO SPECIFIED);

(2) DEDUCTIONS FOR INTEREST (AFTER COMMENCEMENT OF THE LEASE PERIOD) ON SHIPOWNERS' DEBT FINANCING; AND

(3) INVESTMENT TAX CREDITS, CALCULATED AS 10 PERCENT OF BASIC CAPITALIZED COSTS (LESS AMORTIZABLE FEES AND EXPENSES). THE PROVISION WOULD COVER LOSS OF ANY OR ALL OF THESE BENEFITS RESULTING FROM IRS TREATMENT OF THE CHARTER ARRANGEMENT AS A LEASE.

AS DESCRIBED, THE GOVERNMENT'S LIABILITY UNDER THE TAX INDEMNIFICATION CLAUSE OF THE CHARTER PARTY (WITH THE EXCEPTION TO BE DISCUSSED BELOW) IS LIMITED TO THESE THREE TAX BENEFITS. BECAUSE THE ACTUAL VALUE OF THESE BENEFITS WILL BE CALCULABLE UPON COMMENCEMENT OF THE CHARTER (AND IN FACT MAY BE ESTIMATED IN ADVANCE WITH SOME DEGREE OF ACCURACY), WE DO NOT CONSIDER INDEMNIFICATION FOR THEIR LOSS TO CONSTITUTE AN "INDEFINITE OR POTENTIALLY UNLIMITED" CONTINGENT LIABILITY.

ARTICLE 40 OF THE CHARTER PARTY ALSO CONTAINS TAX INDEMNIFICATION LANGUAGE THAT IS NOT LIMITED TO THE THREE TAX BENEFITS DESCRIBED ABOVE. THE ARTICLE PROVIDES AS FOLLOWS (PARAGRAPH DESIGNATIONS AND NON PERTINENT LANGUAGE REMOVED FOR CLARITY): IF, SOLELY AS A RESULT * * * (THE GOVERNMENT) TAKING ANY ACTION WHICH IS NOT REQUIRED BY THE TERMS OF THIS CHARTER, * * * ANY PARTNER IS REQUIRED BY THE INTERNAL REVENUE SERVICE TO INCLUDE IN GROSS INCOME FOR FEDERAL INCOME TAX PURPOSES DURING THE CHARTER PERIOD ANY AMOUNT AS ADDITIONAL RENTAL AS A RESULT OF ANY NON-SEVERABLE IMPROVEMENT OR ADDITION TO THE VESSEL MADE BY THE CONTRACTOR AT THE REQUEST OF (THE GOVERNMENT), * * * THEN (THE GOVERNMENT) SHALL REIMBURSE THE CONTRACTOR * * * THE AGGREGATE AMOUNT OF ADDITIONAL FEDERAL INCOME TAX PAYABLE BY SUCH PARTNER AS A RESULT OF SUCH (INCLUSION), * * * TO THE EXTENT THAT THE CONTRACTOR IS REQUIRED TO AND DOES PAY SUCH AMOUNT TO SUCH PARTNER PURSUANT TO APPLICABLE PROVISIONS OF THE BAREBOAT CHARTER * * * . THIS LANGUAGE WOULD APPEAR TO PROVIDE THAT ADDITIONAL RENT CHARGED BY THE CONTRACTOR DUE TO GOVERNMENT-ORDERED VESSEL IMPROVEMENTS OR ADDITIONS WILL BE TAX FREE. THERE WOULD BE NO FINANCIAL LIMITATION TO THIS LANGUAGE: THE GREATER THE IMPROVEMENT AND SUBSEQUENT RENTAL INCREASE, THE LARGER THE AMOUNT OF TAX REIMBURSEMENT REQUIRED UNDER THE PROVISION.

ALTHOUGH THE FOREGOING LANGUAGE APPEARS TO BE "INDEFINITE OR POTENTIALLY UNLIMITED," THERE IS ONE MAJOR LIMITATION THAT PROTECTS AGAINST THE POSSIBILITY OF FUTURE ANTIDEFICIENCY ACT VIOLATIONS: THE CONTINGENCY IS SOLELY IN THE HANDS OF THE NAVY. THUS, THE NAVY MAY CHOOSE TO FOREGO OR DELAY ORDERING VESSEL IMPROVEMENTS OR ADDITIONS UNTIL SUFFICIENT FUNDING AUTHORITY IS OBTAINED TO COVER BOTH ADDITIONAL RENTAL AND TAX REIMBURSEMENT PAYMENTS UNDER ARTICLE 40. THEREFORE, WE DO NOT CONSIDER THIS LANGUAGE TO FALL UNDER THE PROHIBITION AGAINST INDEFINITE OR UNLIMITED CONTINGENT LIABILITIES. IT IS OUR VIEW, HOWEVER, THAT THE PROVISION OF TAX-FREE RENTAL DUE TO GOVERNMENT ORDERED ADDITIONS WOULD BE HIGHLY QUESTIONABLE ON POLICY GROUNDS, AND COULD NOT BE SUPPORTED AS NECESSARY OR INCIDENT TO THE TAKX PROGRAM. SEE DISCUSSION BELOW. FINALLY, AS DESCRIBED EARLIER, PARAGRAPH (G) OF ARTICLE 40 CONTAINS A PROVISION REQUIRING THE NAVY TO REIMBURSE THE OWNER OF THE VESSEL FOR ANY LEGAL EXPENSES AND OTHER COSTS INCURRED BY THE OWNER PURSUANT TO THE NAVY'S DEMAND THAT THE OWNER CONTEST ANY ADVERSE TAX RULINGS BY THE IRS. THIS IS ANALOGOUS IN OUR VIEW TO AN OPEN-ENDED INDEMNIFICATION PROVISION. AS IS THE CASE WITH ADDITIONAL TAX LIABILITY DUE TO GOVERNMENT-ORDERED VESSEL IMPROVEMENTS, HOWEVER, THE NAVY ITSELF DETERMINES WHETHER THE OWNER WILL INCUR ANY SUCH EXPENSES. CONSEQUENTLY, WE DO NOT BELIEVE THIS PROVISION VIOLATES THE GENERAL RULE PROHIBITING UNLIMITED CONTINGENT LIABILITIES.

B. REQUIREMENT THAT EXPENDITURES BE REASONABLY NECESSARY OR INCIDENT TO THE APPLICABLE PROGRAM. AS STATED ABOVE, EXPENDITURES UNDER AN INDEMNIFICATION AGREEMENT, LIKE ANY OTHER EXPENDITURE, ARE PERMISSIBLE ONLY TO THE EXTENT THAT THEY ARE REASONABLY NECESSARY OR INCIDENT TO THE EXECUTION OF AN AUTHORIZED PROGRAM OR ACTIVITY. 59 COMP.GEN. 369, SUPRA. THE DETERMINATION AS TO WHETHER AN EXPENSE IS NECESSARY OR INCIDENT TO THE OBJECT OF THE APPLICABLE FUNDING SOURCE IS DETERMINED ON A CASE-BY-CASE BASIS. LY AFFORDS AGENCIES BROAD DISCRETION IN DETERMINING WHETHER A SPECIFIC EXPENDITURE IS REASONABLY RELATED TO THE ACCOMPLISHMENT OF AN AUTHORIZED PURPOSE, AN AGENCY'S DISCRETION IN SUCH MATTERS IS NOT UNLIMITED. 18 COMP.GEN. 285, 292 (1938). THIS OFFICE HAS HAD OCCASION BOTH TO APPROVE AND TO DISAPPROVE CONTRACT INDEMNIFICATION PROVISIONS AS NECESSARY OR INCIDENT TO THE OBJECT OF THE APPLICABLE FUNDING SOURCE. COMPARE 42 COMP.GEN. 708, 712 (1963) WITH B-137976, DECEMBER 4, 1958.

THE TAKX PROGRAM IS FUNDED OUT OF THE NAVY INDUSTRIAL FUND, A REVOLVING FUND ESTABLISHED TO PROVIDE CAPITAL FOR INDUSTRIAL AND COMMERCIAL-TYPE ACTIVITIES OF THE NAVY. SEE 10 U.S.C. 2208(A)(2) (1980). THE FUND IS REIMBURSED BY ANNUAL OPERATIONS AND MAINTENANCE (O&M) FUNDS OF THE DEPARTMENT OF THE NAVY, AND IS THUS AVAILABLE ONLY FOR THE PURPOSES PERMISSIBLE UNDER THAT SOURCE APPROPRIATION, AND SUBJECT TO THE SOURCE RESTRICTIONS. SEE 28 COMP.GEN.365 (1948).

ASSUMING WITHOUT DECIDING THAT THE TAKX PROJECT IS ITSELF A PROPER ACTIVITY OF THE NAVY INDUSTRIAL FUND (AND THUS, INDIRECTLY, OF ANNUAL NAVY O&M APPROPRIATIONS), /3/ THE QUESTION REMAINS WHETHER INDEMNIFICATION AGREEMENTS ENTERED INTO IN CONNECTION WITH THAT PROGRAM ARE ALSO "NECESSARY OR INCIDENT" TO THE OBJECT OF THE APPLICABLE FUNDING SOURCE.

INDEMNIFICATION PROVISIONS UNDER THE TAKX AGREEMENT TO CHARTER ARE DESIGNED TO ESTABLISH THE BASIS FOR ADJUSTING COST CALCULATIONS UNDER THE ACTUAL CHARTER. BECAUSE OF THE DELAY BETWEEN THE TIME THAT CONTRACTS ARE SIGNED AND COMMENCEMENT OF THE CHARTER PERIOD (APPROXIMATELY 2 YEARS), IT IS, IN OUR VIEW, REASONABLE TO PROVIDE FOR COST ADJUSTMENTS DUE TO FORESEEABLE CHANGES IN FINANCING COSTS, DELIVERY SCHEDULES, AND EVEN TAX LIABILITY. THESE "INDEMNIFICATION" PROVISIONS DO NOT PROVIDE ANY WINDFALL TO THE APPLICABLE CONTRACTOR, BUT SIMPLY ENSURE THAT PAYMENTS UNDER THE CHARTER PARTY ACCURATELY REFLECT THE CONTRACTOR'S ACTUAL COSTS. ADDITION, IT SHOULD BE NOTED THAT MANY OTHER FEDERAL CONTRACTS CONTAIN PRICE ADJUSTMENT CLAUSES, EVEN FOR ADDITIONAL TAX LIABILITY. SEE, E.G., DEFENSE ACQUISITION REGULATION 7-103.10 (PROVIDING FOR CONTRACT PRICE ADJUSTMENT FOR CHANGES IN EXCISE TAX LIABILITY DUE TO STATUTORY OR REGULATORY CHANGES, OR DUE TO ADVERSE REVENUE RULINGS). CONSEQUENTLY, WE CONSIDER SUCH PROVISIONS TO BE REASONABLY NECESSARY OR INCIDENTAL TO THE TAKX PROGRAM, AND WOULD NOT OBJECT TO PAYMENTS MADE UNDER SUCH PROVISIONS (BY INCREASING CHARTER HIRE PAYMENTS UNDER THE CHARTER PARTY).

SIMILARLY, IT IS OUR VIEW THAT INDEMNIFICATION PROVISIONS IN THE TAKX CHARTER PARTY, WITH THE EXCEPTION OF THE PROVISION DEALING WITH TAX LIABILITY FOR INCREASED RENT DUE TO GOVERNMENT-ORDERED IMPROVEMENTS, MAY BE CONSIDERED REASONABLY NECESSARY OR INCIDENTAL TO THE PROGRAM. THE TAKX CONTRACTS WERE SPECIFICALLY DESIGNED TO PERMIT TAKX SHIP OWNERS TO TAKE ADVANTAGE OF CERTAIN TAX BENEFITS, PARTICULARLY THE 10 PERCENT INVESTMENT TAX CREDIT AND ACCELERATED DEPRECIATION DEDUCTIONS. THESE ANTICIPATED TAX BENEFITS ARE REFLECTED IN LOWER CONTRACT COSTS CHARGED TO THE NAVY. THE TAX INDEMNIFICATION PROVISIONS SIMPLY REQUIRE THAT THE LOSS OF ANY SUCH BENEFITS WOULD BE REFLECTED BY INCREASING CHARGES UNDER THE CONTRACT. AGAIN, THE CONTRACTOR WOULD NOT BE RECEIVING A WINDFALL SINCE, IN EFFECT, THE NAVY WOULD ONLY BE REIMBURSING THE CONTRACTOR FOR ANY ADDITIONAL TAX PAYMENTS TO THE UNITED STATES TREASURY. /4/ ACCORDINGLY, WE BELIEVE THAT IT WAS REASONABLE FOR THE NAVY TO PROVIDE FOR INCREASED CHARTER PAYMENTS TO COMPENSATE THE OWNERS FOR THE LOSS OF ANTICIPATED TAX BENEFITS.

IN ADDITION, WE BELIEVE THAT THE PROVISION REQUIRING THE NAVY TO REIMBURSE THE OWNER FOR ANY LEGAL EXPENSES AND RELATED COSTS ARISING OUT OF THE OWNER'S CHALLENGES OF ANY ADVERSE TAX RULINGS, WHILE UNUSUAL AND PERHAPS SUBJECT TO SOME CRITICISM ON GENERAL POLICY GROUNDS, IS NOT UNREASONABLE UNDER THE CIRCUMSTANCES. NOT ONLY DOES THE NAVY DETERMINE WHETHER OR NOT THE OWNER SHALL MOUNT SUCH A CHALLENGE, BUT THE NAVY ALSO WOULD BE THE "SOLE" BENEFICIARY IF THE OWNER'S LEGAL CHALLENGE PROVES SUCCESSFUL IN RESTORING THE LOST TAX BENEFITS THAT WOULD OTHERWISE RESULT IN INCREASED CHARTER PAYMENTS BY THE NAVY.

FINALLY, WE PREVIOUSLY NOTED THAT ARTICLE 40 OF THE TAKX CHARTER PARTY APPARENTLY PROVIDES FOR REIMBURSEMENT BY THE NAVY OF ANY ADDITIONAL TAX LIABILITY INCURRED AS A RESULT OF RENT INCREASES DUE TO GOVERNMENT-ORDERED VESSEL ADDITIONS OR IMPROVEMENTS. UNLIKE INDEMNIFICATION FOR LOSS OF INVESTMENT TAX CREDITS OR ACCELERATED DEPRECIATION DEDUCTIONS, THIS ADDITIONAL INDEMNIFICATION LANGUAGE, SO FAR AS WE CAN DISCERN, DOES NOT REFLECT ANY CONTRACTUAL BENEFIT TO THE NAVY (SUCH AS REDUCED HIRE COSTS). RATHER THAN AFFORDING COMPENSATION FOR CONTRACTUAL CONCESSIONS GRANTED TO THE GOVERNMENT, REIMBURSEMENT OF ADDITIONAL TAX LIABILITY IN SUCH A CASE WOULD CONSTITUTE A WINDFALL TO THE SHIP-OWNING PARTNER. IN OUR VIEW SUCH A PAYMENT DOES NOT APPEAR TO BE JUSTIFIED AS REASONABLY NECESSARY OR INCIDENT TO THE TAKX PROGRAM, OR ANY OTHER AUTHORIZED ACTIVITY OF THE NAVY INDUSTRIAL FUND. CONSEQUENTLY, UNLESS THE NAVY CAN SHOW THAT WE HAVE MISINTERPRETED THE LANGUAGE IN QUESTION, OR CAN PROVIDE A SUITABLE EXPLANATION FOR SUCH A PROVISION, WE CONSIDER THAT PARTICULAR PORTION OF ARTICLE 40 TO BE VOID AS OUTSIDE THE SCOPE OF AUTHORITY OF THE CONTRACTING OFFICER. SEE 16 COMP.GEN. 803, 804 (1937). BECAUSE THIS LANGUAGE IS READILY SEPARABLE, HOWEVER, WE WOULD NOT CONSIDER ITS INVALIDITY AS AFFECTING THE LEGALITY OF THE TAKX CONTRACTS AS A WHOLE. SEE, E.G., 15 S.WILLISTON, A TREATISE ON THE LAW OF CONTRACTS 1779 (3D ED. 1961). QUESTION 2: DOES THE NAVY HAVE AUTHORITY TO INDEMNIFY THIRD-PARTY SHIPOWNERS UNDER THE TAKX CONTRACTS? ANSWER: WE DO NOT AGREE THAT THE NAVY, UNDER THE TAKX CONTRACTS, HAS INDEMNIFIED THIRD-PARTY SHIPOWNERS, ALTHOUGH THE ARRANGEMENTS MAY IN FACT HAVE THIS EFFECT. UNDER ARTICLE 40 OF THE CHARTER PARTY, THE NAVY IS INDEMNIFYING THE SPECIFIC CONTRACTOR INVOLVED IN THE TAKX CHARTER ARRANGEMENT. ALTHOUGH THE MEASURE OF INDEMNIFICATION IS THE ADDITIONAL TAX LIABILITY INCURRED BY THE VESSEL OWNERS, THE NAVY'S PAYMENT UNDER THE CLAUSE WOULD BE MADE TO CONTRACTORS, AND ONLY TO THE EXTENT THAT THE CONTRACTOR IS REQUIRED TO AND DOES REIMBURSE THE SHIP-OWNING PARTNER UNDER THE SEPARATE AGREEMENT BETWEEN THEM (BAREBOAT CHARTER). THUS, THE NAVY'S AGREEMENT IS TO INDEMNIFY THE CONTRACTOR FOR ANY LOSS IT INCURS UNDER ITS SEPARATE AGREEMENT TO REIMBURSE THE SHIPOWNER.

THE FACT THAT A THIRD-PARTY SHIPOWNER WILL BE THE EVENTUAL BENEFICIARY OF THE NAVY'S INDEMNIFICATION AGREEMENT WITH THE CONTRACTOR DOES NOT, IN OUR VIEW, RENDER THAT AGREEMENT VOID. BECAUSE THE CONTRACTOR'S COSTS (AS INCURRED UNDER THE BAREBOAT CHARTER) MAY VARY WITH THE IRS' DETERMINATION OF THE SHIPOWNER'S TAX LIABILITY, IT IS REASONABLE TO RECOGNIZE SUCH POTENTIAL COST VARIATIONS UNDER THE CHARTER PARTY. QUESTION 3: IF INDEMNIFICATION WAS IN FACT REQUIRED, FROM WHAT SOURCE WOULD PAYMENT COME? ANSWER: AS INDICATED ABOVE, INDEMNIFICATION UNDER THE TAKX AGREEMENT TO CHARTER IS EFFECTED THROUGH ADJUSTMENTS IN CAPITAL HIRE, SET PRIOR TO THE DATE OF COMMENCEMENT OF THE CHARTER. CONSEQUENTLY, ANY INCREASED CHARTER PAYMENTS WOULD BE PAID FROM THE NAVY INDUSTRIAL FUND, WHICH IS REIMBURSED THROUGH ANNUAL O&M APPROPRIATIONS.

UNDER THE INDEMNIFICATION PROVISIONS OF THE CHARTER PARTY, PAYMENT TO BE "NOT LATER THAN 20 DAYS AFTER A WRITTEN DEMAND THEREFOR FROM THE CONTRACTOR," BUT NOT PRIOR TO ACTUAL PAYMENT OF ADDITIONAL TAX BY A SHIPOWNING PARTNER (OR THE REDUCTION OF ANY TAX REFUND). THE NAVY ANTICIPATES THAT THE TAKX CONTRACTOR WILL OBTAIN A RULING FROM THE IRS ON THE TAX TREATMENT OF THE TAKX ARRANGEMENT PRIOR TO COMMENCEMENT OF THE CHARTER. IF SO, IT IS LIKELY THAT INDEMNIFICATION WOULD BE MADE UNDER THE AGREEMENT TO CHARTER RATHER THAN THE CHARTER PARTY, AND WOULD BE REFLECTED AS ADDITIONAL RENTAL PAYMENT OVER THE COURSE OF THE LEASE. TO THE EXTENT THAT PAYMENT IS REQUIRED UNDER THE CHARTER PARTY, THE NAVY INDUSTRIAL FUND PRESUMABLY WOULD REMAIN THE SOURCE OF FUNDING. BECAUSE, AS DISCUSSED PREVIOUSLY, WE HAVE ASSUMED THAT FUND TO BE A PROPER SOURCE FOR ACQUISITION OF TRANSPORTATION SERVICES UNDER THE TAKX PROGRAM, IT WOULD ALSO BE A PROPER SOURCE FOR AN EXPENDITURE UNDER AN INDEMNIFICATION AGREEMENT INCIDENTAL TO THAT PROGRAM. /5/ QUESTION 4: HAS THE NAVY ALREADY BECOME LIABLE UNDER THE TAKX CONTRACTS FOR TAX LAW CHANGES MADE SINCE THEY WERE SIGNED? ANSWER: TO OUR KNOWLEDGE NO TAX LAW CHANGES, IRS RULINGS, OR REGULATION CHANGES HAVE YET OCCURRED THAT WOULD REQUIRE ADJUSTMENT TO CAPITAL HIRE RATES UNDER INDEMNIFICATION PROVISIONS OF THE TAKX AGREEMENT TO CHARTER. TWO RECENTLY INTRODUCED BILLS WOULD SPECIFICALLY DENY ACCELERATED DEPRECIATION DEDUCTIONS AND INVESTMENT TAX CREDITS UNDER CIRCUMSTANCES SUCH AS THOSE THAT EXIST IN THE TAKX PROGRAM, BUT NEITHER BILL HAS BEEN ENACTED INTO LAW. SEE H.R. 4170, 98TH CONG., 1ST SESS. (1983); S. 1564, 98TH CONG., 1ST SESS. (1983). IN ADDITION, AT LEAST ONE OF THE TWO BILLS (H.R. 4170), AS REPORTED, HAS AN EFFECTIVE DATE THAT WOULD EXEMPT THE TAKX PROGRAM. H.R. 4170, TIT. I, SEC. 102(G), 98TH CONG., 1ST SESS. (1983).

WE HOPE THAT THE FOREGOING WILL BE OF ASSISTANCE TO YOU.

/1/ THE NAVY'S TERMINATION LIABILITY UNDER ARTICLE XI OF THE AGREEMENT TO CHARTER WOULD CONSIST OF THE AMOUNT OF BASIC CAPITALIZED COSTS INCURRED BY THE SHIPOWNER TO THE DATE OF TERMINATION, NOT TO EXCEED THE TOTAL AMOUNT OF BASIC CAPITALIZED COSTS INCLUDED IN THE AGREEMENT TO CHARTER. BASIC CAPITALIZED COSTS ARE SET OUT IN DETAIL IN ARTICLE XI OF THE CONTRACT (I.E., $192,591,086 FOR MAERSK NO. 1, AS ITEMIZED IN THE APPLICABLE CONTRACT), SUBJECT TO MINOR ADJUSTMENTS FOR INCREASED COSTS DUE TO REQUIREMENT CHANGES, INTERIM LOAN INTEREST RATES, COMMITMENT FEES, ETC.

/2/ COMPARE B-201394, APRIL 23, 1981, IN WHICH WE STATED THAT A BROADLY DRAWN INDEMNIFICATION CLAUSE WOULD BE PERMISSIBLE IF LIMITED BY A CLAUSE RESTRICTING THE GOVERNMENT'S LIABILITY TO THE AMOUNT OF APPROPRIATIONS AVAILABLE WHEN THE CONTINGENCY OCCURS.

/3/ THE NAVY'S POSITION IS THAT THE TAKX PROGRAM IS FOR THE PROVISION OF TRANSPORTATION SERVICES, AN AUTHORIZED ACTIVITY OF BOTH THE NAVY INDUSTRIAL FUND AND THE NAVY O&M APPROPRIATION. AS WE STATED IN 62 COMP.GEN. 143, 144 N. 1 (1983), WE DO NOT QUESTION THE USE OF THE NAVY INDUSTRIAL FUND FOR THE PURPOSES OF THIS PROGRAM, AS WE APPROVED THE USE OF THE FUND TO FINANCE SIMILAR CONTRACTS IN OUR DECISION 51 COMP.GEN. 598 (1972). WE ARE IN THE PROCESS, HOWEVER, OF REEXAMINING THE PURPOSES FOR WHICH INDUSTRIAL FUNDS ARE USED BY THE MILITARY DEPARTMENTS. SEE H.R. REP. NO. 943, 97TH CONG., 2D SESS. 48 49 (1982).

/4/ WE ALSO NOTE THAT PARAGRAPH (D) OF ARTICLE 40, IN EFFECT, REQUIRES THE SHIP-OWNING PARTNER TO PAY TO THE NAVY ANY REDUCTIONS IN FEDERAL INCOME TAX RESULTING FROM UNANTICIPATED TAX BENEFITS RECEIVED DURING THE COURSE OF THE CHARTER. IN OUR VIEW, THIS PROVIDES ADDITIONAL SUPPORT FOR OUR CONCLUSION THAT THE TAX INDEMNIFICATION PROVISIONS ARE REASONABLE UNDER THE CIRCUMSTANCES.

/5/ AS WITH OTHER CONTINGENT LIABILITIES, THERE IS THE POSSIBILITY THAT, UNLESS APPROPRIATE SAFEGUARDS ARE TAKEN, THE OCCURRENCE OF THE CONTINGENCY WILL IMPOSE A LIABILITY IN EXCESS OF AVAILABLE FUNDING, THEREBY VIOLATING THE ANTIDEFICIENCY ACT. THIS DANGER IS DIMINISHED IN THE CASE OF THE NAVY INDUSTRIAL FUND, WHICH HAS A LARGER DEGREE OF FLEXIBILITY THAN OTHER APPROPRIATION ACCOUNTS (FOR EXAMPLE, THROUGH BROAD TRANSFER AUTHORITY ANNUALLY ENACTED IN DEFENSE APPROPRIATION BILLS-- SEE, E.G., SECTION 733 OF THE DEPARTMENT OF DEFENSE APPROPRIATION ACT, 1983, INCLUDED IN SECTION 101(C) OF PUB. L. NO. 97 377, 96 STAT. 1830, 1836 (1982)). IN ADDITION, LIABILITY UNDER ARTICLE 40 OF THE TAKX CHARTER PARTY WOULD LIKELY BE SPREAD OUT OVER A PERIOD OF TIME, AS IT WOULD BE BASED ON ADDITIONAL TAX PAYMENTS MADE BY THE SHIPOWNER OVER THE COURSE OF THE LEASE. NONETHELESS, THE NAVY SHOULD EXAMINE THE NEED FOR ESTABLISHING A RESERVE IN THE NAVY INDUSTRIAL FUND TO COVER ANY SUCH CONTINGENCIES.