Industry Insight: Federal Withholding for Government Contractors a Bad Idea

In 2006, Congressional conferees huddled behind closed doors and added a provision to the Tax Increase Prevention and Reconciliation Act (TIPRA) that will withhold three percent of all payments to government contactors and providers. The measure was designed to make sure a handful of corporate scofflaws paid up on unreported revenue. Unfortunately, it instead will punish the majority of law abiding corporate taxpayers for the already illegal actions of a few firms.

Now a provision in the Tax Collection Responsibility Act (HR 3056), passed recently by Ways and Means, would delay implementation of the withholding provision from January 1, 2011 to January 1, 2012 and would require the Department of Treasury to study the impact of the measure. While the Information Technology Association of America and other industry groups continue to push for a full repeal, the delay sends a welcome signal that Congress is beginning to grasp the problem.

Meanwhile, we look forward to working with the Department in its study, and hope they will understand and report that the withholding—if ever implemented—will be a bad deal for taxpayers, the government and vendors.

To begin with, the administrative costs to the government, as well as to companies, will be substantial. Companies' internal systems are not set up to track these payments, nor are government systems set up to receive them. Meanwhile, the $7 billion in "increased revenue" derived from this legislation from 2011 to 2015 does not take the inevitable refunds from overpayments into account. The provision will really only generate $215 million of improved tax compliance in 2012 and slightly more in each of the following years. That means over $6.5 billion of the estimated $7 billion of revenue comes from an accounting gimmick.

The provision also acts like a de facto interest free loan from contractors to the government, because unlike other withholdings, which are adjusted to more closely reflect tax liability, this one is based on a company's revenue stream only, regardless of profit. As a result, companies will have to hand over to the government more money than they actually owe. That money will then be withheld until the company normally files its tax returns and can claim the refund. The provision therefore removes capital that could be used productively by companies between the time of withholding and when any refunds would be paid.

While it is not scheduled to go into effect until 2011, there have been several attempts in Congress to accelerate implementation of the withholding. Meanwhile, since government contracts frequently cover periods of five years or longer in length, long-term contracts are already being affected because companies must account for the future loss of revenue stream caused by the tax withholding provision and adjust their costs to the government upward.

Therefore, while there is hope, the problem remains pressing. As the House and Senate continue to consider changes to the tax laws for 2008, we hope to see more light bulbs go on over Capitol Hill and ultimately passage of a delay " or repeal " of the three percent withholding.

Phil Bond is president and CEO of Information Technology Association of America.