Offset Fundamentals

Frank KenlonProfessor of Int’l Acq (Intermittent)DAU/DSMC Int’l Acquisition Center Frank.Kenlon@dau.eduFebruary 18, 2020

Overview

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• Offset Fundamentals– Definitions and Background– USG Policy– Types, Valuation, and Reporting– Offset Relationships

• Offsets on FMS Programs– Cost Recovery and LOA Terms & Conditions– Offset Costs & Disclosure

• Industry Perspectives• Summary

Offset Definition• Compensation practices required as a condition of

purchase by foreign countries for FMS, DCS, and Hybrid defense sales

• Required by the foreign country and agreed to through arrangements established with U.S. contractor

• Obligates the U.S. contractor to perform action(s) that will “offset” the outflow of money from the foreign country purchasing the U.S.-origin defense articles/services

• Also known as industrial cooperation, industrial participation, countertrade, industrial benefits, etc

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Background

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• Use of offsets is commonplace in global defense trade in purchases from U.S. and other foreign defense contractors

• Virtually all U.S. defense trading partners impose some type of offset requirement

– Required by about 80 countries – often required by their laws or regulations

• Countries require offsets to ease the burden of large defense purchases on their economy, increase or preserve domestic employment, obtain desired technology and/or promote industrial sectors

Offsets can be a deciding factor in foreign gov source selection decisions

1990 Presidential Policy

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• No agency of the USG shall encourage, enter directly into, or commit U.S. firms to any offset arrangement in connection with the sale of defense goods or services to foreign governments.

• The decision whether to engage in offsets, and the responsibility for negotiating and implementing offset arrangements, reside with the companies involved.

• Codified into law in 1992 amendments to the Defense Production Act Public Law 102-558)

• Basic USG policy on offsets in defense trade is that they are considered to be “economically inefficient and trade distorting”

Types of Offsets & Transactions

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Direct OffsetsOffset transactions that are directly related to the article or service being exported

Indirect OffsetsOffset transactions that are unrelated to the article or service being exported

Direct Offset• Co-development• Co-production• Defense services

Direct or Indirect Offset• Technology Transfer (training,

intellectual property, etc.)• Foreign Direct Investment,

Credit Assistance, Financing

Indirect Offset• Purchase of items or

services• Export Assistance• Offset

Barter/Swapping

Types of Transactions

See Commerce Dept Bureau of Industry & Security (BIS) website for details

Offset Valuation

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Actual value of offset transactions without taking into account multipliers or intangible factors

The value credited for the offset transaction by application of a multiplier, any intangible factors, or other method. The credit value may be greater than, equal to, or less than the actual value of the offset transaction

A factor applied to the actual value of certain offset transactions to calculate the credit value earned. Foreign purchasers use multipliers to provide firms with incentives to offer offsets that benefit targeted areas of economic growth. May be positive or negative.

Actual Value Multiplier Credit Value

Offset obligation often characterized as a percentage of the main contract value

Offset Example

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400 mil

300 tanks

Offsets

400 Million 300 Tanks+

Offsets

Seller Purchaser

Direct

Indirect

Co-production

Foreign Direct Investment

Technology Transfer

Export Assistance/Marketing

Multiplier CreditValue

3 210 mil

4 58 mil

7 140 mil

72 mil3

ActualValue

70 mil

14.5 mil

20 mil

3 mil/y X8 yrs

128.5 mil 480 mil

This would be reported as a 120% offset

Offset Reporting Requirements

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• Defense Production Act requires the President to submit a report to Congress on the impact of offsets on the defense preparedness, industrial competitiveness, employment, and trade of the U.S.

• Commerce Department’s Bureau of Industry and Security (BIS) develops the report through the Offset Reporting Regulation, 15 CFR Part 105

• Industry reporting requirements– Any U.S. firm that enters into a contract to provide defense articles or defense

services to a foreign country or foreign firm pursuant to an offset agreement exceeding $5 million in value must report that agreement

– U.S. firms must also report each offset transaction completed in performance of existing offset commitments for which offset credit of $250,000 or more has been claimed from a foreign representative

See BIS’s Guidance for Reporting on Offset Agreements and Transactions

Offset Relationships

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Foreign Government

U.S. Contractor

DoD

FMS Case

Foreign Military Sales(FMS)

Offset Agreement

Commercial Contract

USGExport

Authorization

Direct Commercial Sales(DCS)

USG is not a party to these agreements

FAR ContractIncludes reimbursement of offset costs

Foreign Government requests, USG allows, and Industry manages

Note: Hybrid Sales may include both types of offset arrangements

Offsets on FMS or Hybrid Programs

• Have you dealt with offsets?• What were the challenges?

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FMS Offset Relationships

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United States Government

Defense Contractor

OffsetRelationship

FMSPurchaser

Contractor can recover all Offset

costs in the contract

All Offset costs are included in

the LOA

FMS Offset Costs

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• Industry provided offset costs should be included in P&A data and in estimated prices quoted in the LOAs− Incorporate in major end item price in line 1 of the

LOA – not spread in other line items• Contractor must disclose the estimated offset costs to

the DoD contracting officer and the FMS customer• Requests to include offset costs after LOA acceptance

require an LOA modification or amendment

See SAMM C6.3.9 for additional information

Cost Recovery (DFARS 225.7303-2)

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• A U.S. defense contractor may recover all costs incurred for offset agreements with a foreign government or international organization if the LOA is financed wholly with foreign government or international organization customer cash or repayable foreign military finance credits.

• The U.S. Government assumes no obligation to satisfy or administer the offset agreement or to bear any of the associated costs.

• Indirect offset costs are deemed reasonable for purposes of FAR parts 15 and 31 with no further analysis necessary on the part of the contracting officer, provided that the U.S. defense contractor submits to the contracting officer a signed offset agreement or other documentation showing that the FMS customer has made the provision of an indirect offset a condition of the FMS acquisition. FMS customers are placed on notice through the LOA that indirect offset costs are deemed reasonable without any further analysis by the contracting officer.

Cost Sufficiency Reviews

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DFARS Direct and Indirect Offset Definitions (2018)

Direct Offset Costs• Normal Contracting Officer

cost sufficiency review

Indirect Offset Costs• Deemed reasonable w/o

further Contracting Officer analysis

LOA Standard Terms and Conditions

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2.8. Any offset arrangement is strictly between the Purchaser and the U.S. defense contractor. The U.S. Government is not a party to any offset agreement that may be required by the Purchaser in relation to the sales made in this LOA. The USG assumes no obligation to administer or satisfy any offset requirements or bear any of the associated costs. Although offsets, as defined in the Defense Federal Acquisition Regulation Supplement, are not within the scope of the DoD contracts entered into to fulfill the requirements of this LOA, offset costs may be recovered through such contracts. Indirect offset costs may be deemed reasonable without further analysis in accordance with the Defense Federal Acquisition Regulation Supplement. If the Purchaser wishes to obtain information regarding offset costs, the Purchaser should request information directly from the U.S. defense contractor.

Disclosure of Offset Information

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• Inappropriate for USG personnel to discuss with the purchaser the nature or details of an offset arrangement

• The fact that offset costs have been included in the P&A or LOA price estimate may be confirmed, should the purchaser inquire

• Purchaser should be directed to the U.S. contractor for answers to all questions associated with offset agreements, including questions regarding their costs

• Involvement in any discussion of offset costs (beyond confirmation of the inclusion of these costs in price estimates) must be avoided

See SAMM C6.3.9.3 for additional information

Industry Perspectives

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• Believes that USG hands-off offset policy is at odds with global market realities and the presidents April 2018 Conventional Arms Transfer (CAT) policy

• CAT policy promotes USG “advocacy” of US defense industry sales and ties foreign sales to U.S. economic security and maintenance of the industrial base

(a) In General. Recognizing that certain offsets for military exports are economically inefficient and market distorting, and mindful of the need to minimize the adverse effects of offsets in military exports while ensuring that the ability of United States firms to compete for military export sales is not undermined, it is the policy of the Congress that--

Public Law 102-558

• U.S. companies and trade associations are lobbying for changes to USG policy that would provide for greater government involvement

Industry Recommendations

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US Chamber of Commerce (June 2018):“We recommend the U.S. government engage on a case-by-case basis when an allied/friendly nation offset policy is particularly contrary to U.S. practice to shape partner nation expectations and recommend actions to modify their offset policy. We also recommend The Secretary of Defense direct MILDEP program offices to review potential direct offset/industrial participation with prime/major subs as part of MILDEP assessments and briefings to the DoD release”

Other Industry Recommendations

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• Align USG/contractor(s) regarding anticipated direct offset/industrial participation levels on key USG weapons systems transfers

• Coordinate within USG (DoD and interagency) and with U.S. prime/major subs on scope of releasable technology/capability for industrial cooperation/offset projects related to U.S. platform transfers during “LOA build” process

• Encourage focus on direct or indirect offset projects that include maintenance to ensure sustainability rather than short-term system development or initial production offset projects

• Provide contractors with USG assistance to help mitigate ‘onerous’ country offset policies, and deconflict when a U.S. contractor(s) believes it is being treated unfairly

• Include related to offset policy issues within USG & DoD/country bi-lateral discussions to influence countries with ‘onerous’ offset policies.

• Establish a USG/DoD first point of contact for industry if there are difficulties with an offset requirement

Any Questions

What can DAU do help you in this area?

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Summary

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• Offsets are a fact of life in the sale of defense systems• No agency of the USG shall encourage, enter directly into, or commit

U.S. firms to any offset arrangement• Offsets are categorized as direct or indirect - variety of transaction

types• Offset costs provided by the contractor are included in P&A data and

the LOA• Fact that offset costs are included in P&A/LOA prices may be

confirmed – direct further purchaser inquiries to the contractor• Contractor can recover offset costs through contracts that implement

FMS cases – indirect offset costs are deemed reasonable• Industry lobbying for greater USG involvement

Linked Chart

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Direct and Indirect Offsets

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• New (2018) definitions from DFARS 252.215-7014 “Exception from Certified Cost or Pricing Data Requirements for FMS Indirect Offsets”

• Offset” means a benefit or obligation agreed to by a contractor and a foreign government or international organization as an inducement or condition to purchase supplies or services pursuant to a foreign military sale (FMS). There are two types of offsets: direct offsets and indirect offsets.

– A direct offset involves benefits or obligations, including supplies or services that are directly related to the item being purchased and are integral to the deliverable of the FMS contract. For example, as a condition of a foreign military sale, the contractor may require or agree to permit the customer to produce in its country certain components or subsystems of the item being sold. Generally, direct offsets must be performed within a specified period, because they are integral to the deliverable of the FMS contract.

– An indirect offset involves benefits or obligations, including supplies or services that are not directly related to the specific item(s) being purchased and are not integral to the deliverable of the FMS contract. For example, as a condition of a foreign military sale, the contractor may agree to purchase certain manufactured products, agricultural commodities, raw materials, or services, or make an equity investment or grant of equipment required by the FMS customer, or may agree to build a school, road or other facility. Indirect offsets would also include projects that are related to the FMS contract but not purchased under said contract (e.g., a project to develop or advance a capability, technology transfer, or know-how in a foreign company). Indirect offsets may be accomplished without a clearly defined period of performance.