                       T.C. Memo. 1997-420



                     UNITED STATES TAX COURT



   GENERAL DYNAMICS CORPORATION AND SUBSIDIARIES, Petitioner
         v. COMMISSIONER OF INTERNAL REVENUE, Respondent

       GENERAL DYNAMICS FOREIGN SALES CORP., Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



    Docket Nos. 19202-94, 19203-94.   Filed September 22, 1997.



    David C. Bohan, Richard T. Franch, James M. Lynch, Philip A.

Stoffregen, Francis J. Wirtz, David D. Baier, Lawrence S.

Schaner, Gregory S. Gallopoulos, and Debbie L. Berman, for

petitioners.

     William H. Quealy, Jr., Alice M. Harbutte, Jeffrey A.

Hatfield, Thomas C. Pliske, and William T. Derick, for

respondent.
                                 - 2 -


              MEMORANDUM FINDINGS OF FACT AND OPINION

     GERBER, Judge:   General Dynamics Corp. and its consolidated

subsidiaries (GENDYN) (docket No. 19202-94) and its foreign sales

corporation, General Dynamics Foreign Sales Corp.

(GENDYN/FOREIGN) (docket No. 19203-94), are the petitioners in

these consolidated cases.     Respondent determined corporate income

tax deficiencies for GENDYN in the amounts of $26,118,976 and

$291,218,973 for its 1985 and 1986 taxable years, respectively.

With respect to GENDYN/FOREIGN, respondent determined a $586,533

corporate income tax deficiency for its 1986 taxable year.       These

cases are consolidated and related for purposes of briefing and

opinion, and the issues have been divided into two generalized

categories:   domestic and foreign.      This opinion addresses the

domestic issues involving GENDYN.1

     The issues for our consideration here pertain to GENDYN’s

accounting methods for Federal income tax purposes.       With respect

to Government contract numbered F33657-82-C-2034 (Contract 2034

or 2034), the parties agree that GENDYN was entitled to use the

completed contract method.2    GENDYN reported the income and

related deductions based on the premise that its Government

     1
        See General Dynamics Corp. & Subs. v. Commissioner, 108
T.C. 107 (1997), for foreign issues.
     2
        For purposes of this case, references to the Government
are to the Federal Government as a party that contracted with
petitioners. We do not use the term “Government” to refer to
respondent.
                                - 3 -


contract was a 48-month contract (multiyear) for delivery of 480

aircraft.   Respondent determined that 2034 should be treated as

four separate agreements, each for the delivery of 120 aircraft.

     With respect to Government contract numbered F33657-82-C-

2038 (Contract 2038 or 2038), GENDYN allocated the income and

expenses to multiyear Contract 2034 so that Contract 2038 was

reported under the completed contract method for Federal income

tax purposes.    Respondent determined that the income and expenses

from 2038 were not part of the completed contract reporting for

Contract 2034.   Consequently, respondent also determined that

Contract 2038 should have been separately accounted for under the

accrual method of accounting.

                          FINDINGS OF FACT3

     GENDYN was incorporated on February 21, 1952, and, at all

relevant times, was the common parent of a group of corporations

that filed consolidated corporate Federal income tax returns.    At

the time the petitions were filed in these cases, GENDYN's and

GENDYN/FOREIGN's principal places of business were in Falls

Church, Virginia.   GENDYN engineered, developed, and manufactured

various products for the U.S. Government and, to a lesser extent,

foreign Governments, including military aircraft, missiles, gun

systems, space systems, tanks, submarines, and electronics, and


     3
        The parties’ stipulation of facts and exhibits are
incorporated by this reference.
                                - 4 -


produced and/or provided other miscellaneous goods and services.

GENDYN was also involved in other business activities, including

the design, engineering, and manufacture of commercial aircraft;

the mining of coal, lime, limestone, sand, and gravel; the

manufacture and sale of ready-mix concrete, concrete pipe, and

other building products; production of commercial aircraft

subassemblies; the design, engineering, and manufacture of

commercial space launch vehicles; and shipbuilding.

     GENDYN, for the taxable years 1977 through 1986 (concerning

the contracts under consideration), used the completed contract

method (CCM) for reporting Federal income tax and the percentage

of completion method for its financial accounting purposes.    In

1976, GENDYN applied to respondent for permission to change its

accounting method to the completed contract method for reporting

income from its long-term contracts for all of its divisions.

GENDYN advised respondent that CCM would not be used for

financial reporting purposes.   In 1977, respondent approved

GENDYN's use of CCM for all its long-term contracts.

     During 1980, an Internal Revenue Service examining agent

challenged GENDYN's use of CCM.   The agent submitted a request

for a technical advice memorandum to respondent's National

Office.   The agent argued, inter alia, that GENDYN's use of CCM

resulted in the unreasonable deferral of income.   In a technical

advice memorandum released in 1983, the National Office rejected
                                - 5 -


the agent's arguments and affirmed GENDYN's permission to use

CCM.

       GENDYN manufactured the F-16, a tactical military aircraft.

Originally designed as a "dog fighter", the F-16 evolved into a

multirole aircraft, capable of performing air-to-air combat, air

defense, and air-to-ground missions in all types of conditions.

       In January 1972, the Air Force issued a Request for Proposal

(RFP) for the development of a prototype aircraft designated the

"Light Weight Fighter".    In April 1972, the Air Force selected

two aerospace companies, Northrop Corp. and GENDYN, to develop

competing prototypes.    Following a "fly off" of the two

prototypes, on January 13, 1975, the Air Force awarded GENDYN

contract numbered F33657-75-C-0310 (0310 contract) for the full-

scale development of what ultimately became the F-16.

       The 0310 contract required GENDYN to complete development of

the F-16 and to build several developmental aircraft, which

differed considerably from the prototype.     The 0310 contract also

granted the Air Force options to procure production F-16's (as

opposed to the developmental versions) for the program years

1977, 1978, and 1979, as well as a separate option to purchase

348 F-16's for foreign Governments.     The first developmental

aircraft flew in December 1976, and the first production version

flew and was delivered during 1978.     From the time the Air Force

selected GENDYN through 1981, the Air Force purchased more than

650 F-16's.
                                 - 6 -


     At the time that the F-16 was being developed, the Air Force

was also developing a significant variety of new weapons and

avionics systems, including missiles, infrared navigation and

targeting equipment, and advanced countermeasures.    During 1978

and 1979, GENDYN and the Air Force jointly developed a plan for

the systematic, phased integration of new technologies into the

F-16.   This plan was known as the Multinational Staged

Improvement Program or “MSIP”.    MSIP was designed to be

implemented in three stages.   The first phase involved the

redesign of the aircraft's structure, wiring, and cooling systems

to accommodate new navigation, targeting, and other systems.    In

the second phase, GENDYN would introduce entirely new computers,

environmental control systems, pilot-vehicle interface systems,

and avionics systems, and would make other changes in

anticipation of various new weapons and sensors which were then

under development.   In the final phase, GENDYN would introduce

the remaining new systems, as they became available.

     MSIP was originally authorized under the first F-16

contract, the 0310 contract, and, after April 15, 1982, it was

continued under Contract 2038.    MSIP was made part of a separate

contract, primarily to delineate it from the production contracts

(i.e., Contract 2034) and developmental work.

     While the Air Force and GENDYN were planning the

technological evolution of the F-16, they were also exploring

ways to lower the future unit costs of the aircraft so as to make
                               - 7 -


the enhanced versions more affordable.   One approach explored by

the Air Force and GENDYN was to use multiyear contracts (a

contract covering more than 1 year) rather than a series of

single-year contracts.   From GENDYN’s point of view, single-year

contracts provided little incentive to invest in capital

equipment or otherwise attempt to reduce its costs.

Additionally, they did not allow GENDYN to take advantage of

quantity discounts in ordering materials from subcontractors and

related suppliers.   Finally, GENDYN found the single-year

contract approach to be more expensive to negotiate and

administer, and it resulted in higher overhead costs per

aircraft.

     The Air Force, however, could not make a contractual

commitment that transcended the Government's fiscal year because

of the Antideficiency Act, 31 U.S.C. sec. 1341 (1994) (formerly

31 U.S.C. sec. 665).   The Antideficiency Act prohibits the

executive branch from obligating funds not yet appropriated by

Congress.   Multiyear contracting is an exception to the full-

funding rule.

     A multiyear contract enabled the Government to provide for

up to 5 years of requirements without authorized full funding at

the awarding of a contract.   With a multiyear contract, the first

year's requirement is usually funded in full, but the ensuing

years’ are not.   A multiyear contract commits the Government to

purchase the quantity of items specified in the contract.     The
                               - 8 -


contractor commences work on the entire quantity, not just the

(lesser) quantity that has been fully funded.   So, for example,

the contractor may commit to purchase sufficient quantities of

parts from subcontractors to construct all of the contracted

items, even though the parts may not be utilized until several

years later.

     The Government may cancel or terminate a multiyear contract

if funds are not appropriated by Congress or the contracting

department or agency no longer requires the item being procured.

If a multiyear contract is canceled, the contractor may attempt

to recover certain of its incurred costs, plus a reasonable

profit, not to exceed a specified “cancellation ceiling”.   The

provisions governing cancellation are unique to multiyear

contracts; no other form of Government contract may be canceled.

The Government may cancel a portion of a multiyear contract only

on the first day of each successive fiscal year encompassed

within the contract.   Any cancellation applies to all remaining

years in the canceled contract.

     In the second half of 1980, the Air Force assembled a task

force to study the potential benefits of multiyear contracting

for the F-16.   Based upon its analysis, it was estimated that the

Air Force could save approximately 10 percent per aircraft by

procuring the F-16 through one or more multiyear contracts as

opposed to using the annual contracting approach.
                                - 9 -


     The Air Force asked GENDYN to analyze the savings potential

by using multiyear contracts.   GENDYN surveyed its subcontractors

and suppliers to determine whether (and by how much) it could

negotiate lower prices for larger buys and higher production

rates.   GENDYN also evaluated potential savings in the areas of

labor and overhead.

     GENDYN and the Air Force anticipated that multiyear

contracting would enable GENDYN to lower its material cost

and result in labor cost savings.   Overhead cost savings were

expected, and GENDYN and the Air Force anticipated other benefits

from a multiyear procurement of F-16's.   Both GENDYN and the Air

Force had significant business purposes for entering into a

multiyear contract instead of the single-year contracts to which

they were then committed.

     Under the military regulations governing multiyear

contracts, sole source contracts may be awarded if a Government

department can demonstrate certain benefits and conditions.    In

order to meet the regulations, the Air Force, on January 22,

1981, issued a notice inviting GENDYN to submit comparative

alternate proposals for the production of 480 F-16 aircraft

applying either to a series of annual-buy contracts or a

multiyear contract.

     GENDYN responded to the RFP on March 17, 1981.   In its

comparative price proposals, GENDYN priced the aircraft using a

variety of assumptions.   As requested in the RFP, GENDYN
                              - 10 -


submitted a firm price for all 480 aircraft to be delivered at

the rate of 8 per month assuming, on the one hand, a single

multiyear contract spanning 5 program years and, on the other

hand, a series of 5 annual buys.   GENDYN also submitted

comparative price proposals for a multiyear contract and a series

of 4 annual procurements assuming a delivery rate of 10 per

month.   GENDYN's comparative price proposals demonstrated that

the price for the aircraft would be significantly lower if

purchased under a multiyear contract rather than under a series

of annual buys.   Savings would inure whether the delivery rate

was assumed to be 8 or 10 aircraft per month.   Assuming a

delivery rate of 10 per month, GENDYN estimated cost savings to

the Air Force of approximately $325 million, or 11.2 percent of

the total contract price.

     From its point of view, GENDYN was unwilling to commit to a

single 1982 program-year contract and fixed-price options for

program years 1983-1985 because that would have exposed GENDYN to

all of the risks of cost overruns in prior program years while

allowing GENDYN none of the potential rewards of cost underruns.

GENDYN believed that if costs were overrun, the Air Force would

exercise the options at the predetermined price and thus avoid

having to share in the overrun; and that if the costs were

underrun, the Air Force would decline to exercise the options and

simply negotiate new, lower prices for subsequent program years.
                               - 11 -


In this regard the Air Force generally would determine whether

lower prices could be negotiated.

     The Air Force, by reviewing GENDYN's Fort Worth operation,

confirmed that there would be savings in a multiyear approach.

Based in part on the information it received in response to the

RFP, the Air Force submitted a justification package to Congress

in October of 1981, as required under the multiyear legislation.

Late in 1981, the Air Force decided it wished to purchase the

aircraft through a multiyear procurement.    At that time, however,

Congress had not yet authorized the Air Force to proceed in that

manner.    In addition, Congress had not amended the multiyear

legislation to increase the maximum allowable cancellation

ceiling to an amount above $5 million, a change that was

necessary to permit multiyear contracting for large contracts.

     While awaiting congressional action to increase the maximum

allowable cancellation ceiling, on December 3, 1981, GENDYN and

the Air Force entered into the 480-aircraft agreement (Contract

2034).    Contract 2034 concerned the production of 480 F-16

aircraft, 120 in each of the 4 program years 1982-1985.    Contract

2034 was subjected to numerous modifications.    Although it

provided for 480 aircraft to be delivered at a rate of 120 per

program year, GENDYN was authorized to perform work leading to

the delivery of all 480 aircraft.

     Initially, money for the first year's production (1982) was

appropriated, along with funding for long-lead items and
                              - 12 -


“Economic Order Quantity” (EOQ) for all 4 fiscal years, including

the 1983, 1984, and 1985 program years.    Long-lead items consist

of parts or components required to protect future delivery

schedules, even beyond the year of procurement.    EOQ items are

parts and components that a contractor may procure in sufficient

volume to obtain quantity discounts.    EOQ is a concept that is

unique to multiyear contracting.

     In certain types of Government contracting, after a contract

has been awarded and work commenced, prices may be ultimately

negotiated by a process known as “definitization”.

Definitization of the Air Force's price for the F-16's was to be

accomplished with respect to all 480 aircraft.    Contract 2034

identified the items required to be delivered by use of Contract

Line Item Numbers, or “CLIN’s”.    CLIN’s, in the broadest of

terms, describe the part or item under contract.    For example,

CLIN 0002AC contains the following:    “45 EACH - USAF FY83 F-16C

AIRCRAFT”.   Other CLIN’s in Contract 2034 required GENDYN, among

other requirements, to:   Incorporate engineering changes in the

aircraft, furnish training equipment and incorporate engineering

changes in such equipment, provide support equipment and

incorporate engineering changes in such equipment, furnish

retrofit kits and alternate mission equipment, generate a variety

of test and other data, and provide repair services for certain

Government-furnished equipment.
                               - 13 -


       Contract 2034, in CLIN 0001, also provides that the

deliverables identified in the other CLIN’s “are neither priced

nor funded nor is the Government under any obligation to

subsequently acquire said items.”       Contract 2034, in addition to

the CLIN’s, contains about 200 pages of clauses that define the

terms and conditions under which GENDYN would manufacture and

deliver the 480 aircraft.    Included in the subject matter of

these clauses, among other items, are requirements and terms for

EOQ contracts, change proposals, rights in data, definitization,

etc.

       In essence, therefore, Contract 2034 was a basic multiyear

agreement between the Air Force and GENDYN, under which GENDYN

was expressly authorized to begin work on the delivery of 480

aircraft, including the ability for EOQ and long-lead items.     In

response to the agreements reached with the Air Force, GENDYN's

Fort Worth Division began planning for the production of all 480

aircraft, including the exercise of options obtained from vendors

to convert their annual subcontracts into multiyear subcontracts.

       On December 29, 1981, Congress passed the fiscal year 1982

Department of Defense Authorization Act, 10 U.S.C. sec. 2301

(Supp. V 1981), which increased the cancellation ceiling

applicable to multiyear contracts from $5 million to $100 million

and expressly authorized the Air Force's multiyear procurement of

F-16's.    This legislation significantly expanded the use of
                             - 14 -


multiyear contracting for the procurement of large, complex

weapons systems.

     GENDYN and the Air Force moved quickly to modify Contract

2034 to accommodate the multiyear procedure, which, in

particular, would encompass the increased cancellation ceiling.

This modification was embodied in Modification P00002 (POO 2),

which was executed on January 26, 1982.   POO 2 provided:

          The USAF FY83 thru FY85 Economic Order Quantity
     effort from 6 Nov 81 through 31 Jan 82 is hereby
     amended to become the USAF FY82 thru FY85 program on a
     multiyear basis thru 31 Oct 82. This modification
     P00002 supersedes the USAF FY82 long lead effort
     authorized on contract FY33657-78-C-0669 in its
     entirety. * * *

     In addition to memorializing Congress' approval of the

multiyear procurement of F-16's, POO 2 also transferred to

Contract 2034 $292 million that had been obligated for the long-

lead effort on the 120 aircraft identified for the 1982 program

year and obligated an additional $188.5 million for long-lead and

EOQ items for all 4 program years.    These amounts, however, were

insufficient to fully fund the production of 480 aircraft but

were intended for EOQ and long-lead items.

     POO 2 also contained the following language:

          The Contractor is authorized, consistent with
     Special Provision H-77 entitled "Material Commitment",
     to incur labor, material and other associated and
     allowable costs for any Program Year hereunder.

     POO 2 also added a “Cancellation of Items” provision, unique

to multiyear contracts, which defines the rights and obligations
                             - 15 -


of the Air Force and GENDYN in the event the Air Force cancels

its requirement for the items covered by the contract.   Clause

I-6 of Contract 2034 permitted the Air Force to cancel for any

program year that had not yet been fully funded, in the event

Congress did not appropriate the necessary funds.

     In the event that the Air Force canceled the contract,

GENDYN was entitled to recover costs incurred on items concerning

aircraft that were not yet fully funded.   GENDYN was also

entitled to recover specified amounts on the aircraft that were

fully funded and would be ultimately completed and delivered to

the Air Force after the contract cancellation.

     In particular, GENDYN's cancellation claim could include:

          (i) reasonable preproduction and other non-
     recurring costs, incurred by the Prime Contractor or
     his subcontractors applicable to and which normally
     would be amortized in all items to be furnished under
     the multiyear requirements (such as plant
     rearrangement, special tooling, preproduction
     engineering, initial rework, initial spoilage, and
     pilot runs);

          (ii) labor, materials and other costs incurred by
     the Contractor or its subcontractors for production of
     the cancelled items consistent with Special Provision
     H-77 entitled "Material Commitment";

          (iii) the reversionary cost impact on the non-
     cancelled items; and

          (iv) a reasonable profit on such incurred costs.

     “Reversionary cost impact” would involve cost variations

(presumably increased cost to GENDYN because of losing the

benefit of volume discounts and labor savings).   In the event of
                              - 16 -


cancellation, not all of the costs identified in clause I-6(f)

would necessarily be recoverable.   Only those costs that were

allowable could be recovered, and only in an amount that did not

exceed the negotiated cancellation ceiling.   The cancellation

ceiling agreed to in Contract 2034 was less than the amount

GENDYN had originally estimated and proposed would be necessary

to make itself financially whole in the event the program was

canceled.

     In addition to its right to cancel Contract 2034 for lack of

funding or because it no longer needed the aircraft, the Air

Force possessed the right (which is standard and required in all

Government contracts) to terminate the contract for convenience

or for default.   In a termination for convenience, the Government

orders a contractor to stop work for any or no reason at any time

prior to the delivery of the last item required under the

contract.   The contractor then submits a claim to recover its

incurred costs plus a reasonable profit.   Not all of the

contractor's costs may be recoverable.

     In a termination for default, the Government orders the

contractor to halt work because the contractor has not complied

with all of the material terms and conditions of the contract.

The Government may then have a claim against the contractor to

recover unliquidated advances and other contract damages.

     As of the execution of POO 2, Contract 2034 remained

“undefinitized”, that is, unpriced.    It was not until March 11,
                              - 17 -


1983, that an agreement on price was reached and July 31, 1983,

that the agreement was formalized in an amendment to Contract

2034.

     In late 1981 GENDYN became aware that 300 of the 480 F-16

aircraft to be produced under Contract 2034 were to be

technologically advanced models.   Accordingly, GENDYN submitted

revised cost estimates consistent with the technological

upgrades.   After a revision of the initial submission, the Air

Force accepted GENDYN's proposal for negotiation.

     The Air Force conducted extensive “fact-finding” with

respect to the assumptions underlying GENDYN's proposals.    For

example, the Air Force reviewed purchase orders accounting for at

least 90 percent of GENDYN's material and subcontract costs to

confirm their prices, terms, and conditions.    It also reviewed

the learning curves on which GENDYN's labor hour estimates were

based to ensure that GENDYN was performing and could continue to

perform at the levels indicated in the proposal.

     Because Contract 2034, was to be a fixed-price incentive,

firm-target contract, the Air Force and GENDYN did not negotiate

the contract price itself but instead negotiated the formula by

which the final price would be determined upon completion of the

contract.   Specifically, the Air Force and GENDYN agreed upon the

target cost, target profit, target price, ceiling price, and

sharing ratio to be included in the contract.    Target cost is the

negotiated estimated cost at completion.   Target price is the
                               - 18 -


target cost plus target profit.    The ceiling price is the maximum

amount the Government is required to pay under a contract,

regardless of the contractor's costs.    The sharing ratio is the

negotiated percentage by which the Government and the contractor

split target cost overruns or underruns.

     In negotiating the profit rate to be applied to Contract

2034, the weighted guideline method was used.    This was a method

used prior to multiyear contracts, and GENDYN and the Air Force

recognized that the maximum weighting permitted should be used to

account for risks they believed would be inherent in multiyear

contracting, which at that time was a unique approach for Federal

Government contracting.

     Using the maximum weighting allowed by Department of Defense

regulations to arrive at the target profit, GENDYN and the Air

Force agreed to the following contract values:    Target cost,

target profit, and target price of $2,328,864,419, $315,902,006,

and $2,644,766,425, respectively.    The agreed ceiling price was

$2,863,110,458.   The sharing ratio was to be GENDYN 40 percent

and Air Force 60 percent, respectively.

     The actual price that GENDYN would receive under Contract

2034 would, ultimately, be determined at the time the contract

was completed.    It would be based upon a comparison of GENDYN's

actual cost with the negotiated target cost.    If actual cost was

lower than the target cost, then GENDYN would receive its total

final cost plus the target profit plus 40 percent of the
                               - 19 -


difference between actual cost and target cost.    If the actual

cost was higher than the target cost, GENDYN would receive its

total final costs and target profit less 40 percent of the

difference between actual and target cost.    Under no

circumstances would GENDYN receive an amount greater than the

ceiling price, regardless of its actual cost.

     The negotiated target cost, ceiling price, and sharing ratio

implicitly defined an amount above which GENDYN bore 100 percent

of all additional cost.   Above this point, called the point of

total cost assumption, GENDYN's profit declined dollar-for-dollar

with every dollar of additional cost.    The negotiated contract

values and the formula by which the final contract price would be

determined were set out in the Incentive Price Revision clause,

which was added to Contract 2034 by Modification P00080 (POO 80),

dated July 31, 1983.    Consequently, a single target cost, target

price, ceiling price, and sharing ratio were established for the

entire quantity of 480 aircraft.

     The final price for the aircraft delivered pursuant to

Contract 2034 was to be determined upon the delivery of the last

aircraft, based upon a comparison of GENDYN's total costs with

the contract's target cost.    Contract 2034 did not prescribe a

mechanism by which price and profit could be separately computed

for any program year.   As of the beginning of 1993, a final price

determination had not been made for Contract 2034 and related

modifications.
                              - 20 -


      Such modifications to Contract 2034 contained separate

prices for each of the CLIN’s that identified for billing

purposes the quantities and models of F-16 aircraft required for

each program year.   CLIN prices were adjusted by program year

from time to time based upon comparisons of GENDYN's actual costs

with the contract's target cost.   These billing price adjustments

were sometimes retroactive; that is, they changed the billing

price of aircraft already delivered.

      Although the Air Force and GENDYN had negotiated a single

pricing arrangement covering all 480 aircraft, it was necessary

for the proposed costs to be individually broken out by program

year for traceability and funding reasons.   It was also necessary

to evaluate and negotiate amounts for each fiscal year in the

same manner.

      The F-16 aircraft procured under Contract 2034 were

manufactured by GENDYN's Fort Worth Division in a

Government-owned, contractor-operated manufacturing facility in

Fort Worth, Texas.   At the height of production, approximately

12,000 GENDYN employees worked on the F-16 program, including

more than 1,000 engineers.   GENDYN manufactured a total of 534

aircraft under Contract 2034 and subsequent modifications, the

480 plus 54 aircraft acquired by the Government through the

exercise of the options that were added to Contract 2034 by POO

80.   The aircraft were continuously produced and delivered

without any inter-program year interruptions.   Some F-16's were
                               - 21 -


delivered prior to, or simultaneously with, F-16's identified for

earlier program years.   There was no fixed model or type of F-16,

and GENDYN did not maintain an inventory of unsold aircraft.      The

F-16 aircraft were to be constructed on an ongoing basis pursuant

to the specifications required by the contract and set by the Air

Force.

     The manufacture of F-16's under multiyear contracting was a

complex process.   From the procurement of long-lead items through

final assembly and testing, it took GENDYN 2-1/2 to 3 years to

build the first aircraft.    Fabrication and assembly took

approximately 13 months.    At least 1 year before the first

aircraft could be built, GENDYN had to establish the production

configuration from which it would develop the drawings and bills

of materials.   The plant then had to develop and test the

production tools and otherwise complete production planning.

GENDYN would then issue purchase orders for the major subsystems

and components, including radars, computers, screens, and

sensors.    GENDYN would then purchase the raw materials (e.g.,

aluminum) necessary to fabricate the different parts of the

aircraft.

     The aircraft were fabricated using a modular approach on a

production line nearly 1 mile long.     Pieces of the airframe,

including the forward fuselage, inlet, center fuselage, aft

fuselage, stabilizing tail assembly, and wings, were designed and

fabricated separately and then joined together on the line.       Some
                                - 22 -


of the key subsystems incorporated in the F-16 were developed and

produced by GENDYN itself.    Other subsystems were procured from

vendors and subcontractors.    Approximately 115 components were

provided by the Air Force as Government-furnished equipment.

     GENDYN was generally responsible for integrating all of the

various subsystems into the F-16 while guaranteeing that the

aircraft performed according to specification.    GENDYN could

procure equipment for the F-16 only from suppliers that had been

“qualified” by the Air Force.    The process by which a supplier

becomes “qualified” is difficult and time-consuming, usually

lasting about 3 years.   Under Contract 2034, GENDYN bore the risk

that a subcontractor would go out of business or default on its

subcontract.   If a single-source subcontractor defaulted due to

technological difficulties or otherwise, GENDYN would be required

to absorb the time and expense of qualifying an alternative

source of supply without any relief from the price and schedule

provisions of Contract 2034.

     To meet its delivery schedule with the Air Force, GENDYN had

to coordinate the production and delivery schedules of all of its

suppliers and subcontractors.    Due to the extensive coproduction

of various components, the F-16 program under Multiyear I became

the most complicated aircraft assembly and production program

ever undertaken.   Notwithstanding that GENDYN had manufactured

F-16's before, numerous problems arose during the performance of

the multiyear contract, many of which were entirely unforeseen.
                              - 23 -


In late October 1983, just 6 months after GENDYN began delivering

aircraft under the multiyear contract (2034), cracks began

appearing in a critical structural element of the airframe known

as the 446 bulkhead (so designated because it is located 446

inches from the nose of the aircraft).    The 446 bulkhead is a

large aluminum ring that encircles the aircraft's engine and

supports the engine's weight, thrust, and torque.    The 446

bulkhead also bears some of the loads created by the tail wing

and the fuel tanks, and the cracks could expand with catastrophic

consequences.

     When the cracks appeared, the Air Force began to inspect the

aircraft following every 25 hours of flight time to ensure the

cracks had not reached a critical length.    The Air Force issued a

notice of deficiency to GENDYN and began withholding progress

payments.   After extensive engineering analysis, GENDYN developed

a new design for the 446 bulkhead which GENDYN believed would

prevent the cracking.   Developing this solution took more than 1

year, much longer than GENDYN expected.

     Minor problems in performance were common, and most aircraft

delivered to the Air Force under Contract 2034 were accepted with

deviations from and waivers of various aspects of the aircraft's

specification.   Depending upon the nature and seriousness of the

deviation, the Air Force might accept or refuse a nonconforming

aircraft.   In some cases, the Air Force would accept the aircraft

but withhold some portion of the consideration due GENDYN until
                              - 24 -


the deviation was cured.   In other cases, the Air Force would

accept the aircraft “as is” but require an adjustment of the

price.

     Throughout the performance of Contract 2034, the F-16

underwent significant technological evolution.     Aircraft

manufactured later in time included the incorporation of systems

and features that were not available on earlier aircraft.     To

distinguish aircraft with different capabilities and

configurations, GENDYN designated each F-16 as belonging to a

particular “block”.   The first production F-16's belonged to

Block 1.   The higher the block number, the newer and more

sophisticated the aircraft.   Design changes within a block of

F-16's sometimes resulted in the designation of “miniblocks”.

Even within miniblocks, however, few F-16's, perhaps only two or

three, were virtually identical.

     The aircraft sold to the Air Force under Contract 2034

belonged to Blocks 15, 25, and 30.     In Block 15, GENDYN

redesigned certain components of the F-16 to accept the advanced

electronics and avionics systems that were then being developed

under MSIP.   The changes that were introduced in Block 15 were so

significant that aircraft manufactured as part of the immediately

preceding Block 10 could not be upgraded to the Block 15

capability.   One of the major changes in Block 15 was a redesign

of the F-16's wiring and cooling systems to support a new, more

advanced radar system that was still under development.
                              - 25 -


     Another change in the Block 15 aircraft was the introduction

of inlet hard points which are used to hang weapons and sensors.

The inlet hard points were necessary for a low-altitude,

nighttime, infrared navigation and targeting system that was

under development.   Additionally, the size of the horizontal tail

was increased by 25 percent on Block 15 aircraft.    The larger

tail not only changed the aircraft's aerodynamics, it also

required the addition of a counterweight to the front of the

aircraft.

     The transition from Block 15 to the next production block,

Block 25, was substantial.   The Block 25 aircraft carried

advanced computers, sensors, and interface systems.    These

systems were developed under Contract 2038.    Among the systems

introduced and implemented in Block 25 were:    The AN/APG-68 fire

control radar, which could detect low-flying targets, provide

high-resolution ground maps, track moving airborne and ground

vehicles, and provide ranging data for more accurate weapons

delivery; multifunction display set, which included two video

monitors displaying a wide array of information that previously

had been supplied on separate displays; data transfer equipment

used by pilots to load navigation, target, threat, and mission

data into the aircraft's onboard computer; communication/

navigation/identification system, which essentially encompassed a

control panel and data entry display, a data entry electronics

unit, and backup and auxiliary panels, replacing individual
                              - 26 -


control panels; combined altitude radar altimeter system for

improved weapons delivery and low-altitude terrain avoidance;

enhanced fire control computer that managed fire control and

other functions; and advanced stores management subsystem that

performed the inventory, logic and control, status monitoring,

and release and jettison functions for the F-16's external weapon

stores.

     The costs of developing the new systems were charged to the

MSIP (Contract 2038) and not to Contract 2034.   Contract 2034's

profitability was affected by the success of GENDYN's development

efforts under MSIP (Contract 2038) because Contract 2034 did not

permit GENDYN relief from delay or change in price in the event

GENDYN encountered technological problems under MSIP.   GENDYN

encountered numerous technological challenges in developing and

building the Block 25 aircraft.

     Contract 2034 required GENDYN to have new software ready in

time for it to be tested and installed on the first of the Block

25 aircraft.   GENDYN failed to complete the software on time, and

in August 1983, the Air Force withheld progress payments on

Contract 2038 from GENDYN.   By the time the software was finally

completed (in December 1985), GENDYN had to retrofit the software

into completed F-16's, at GENDYN's expense.

     The Air Force delegated the day-to-day responsibilities for

administering Contract 2034 to an Administrative Contracting

Officer (ACO) who was stationed at the plant in Fort Worth,
                               - 27 -


Texas.   The ACO was the Air Force representative primarily

responsible for enforcing the terms and conditions of the

multiyear contract.   The ACO administered Contract 2034 as a

single contract for the manufacture and delivery of aircraft over

a period of years.

     The ACO approved, rejected, or deferred GENDYN's requests

for progress payments for work performed.    Progress payments to a

contractor are advances against the contract price based upon the

contractor's incurred costs.   Progress payments are essentially

loans that remain repayable to the Government unless and until

they are “liquidated” in exchange for the Government's acceptance

of a portion of the contractor's performance under the contract.

     GENDYN submitted requests for progress payments on a monthly

basis, using an official Air Force form.    In accord with the

requirements of the form, GENDYN reported all of its costs (not

broken down by program year) under the entire contract.    The only

estimate requested on the form and provided by GENDYN was an

estimate of the total cost of completing all 480 aircraft

pursuant to Contract 2034.

     Based on his determination that GENDYN was underrunning or

overrunning the contract, the ACO could also adjust the

liquidation rate that applied to progress payments.    The Air

Force liquidated progress payments using a single liquidation

rate, not separate rates by program year.
                                - 28 -


     Contract 2034 required GENDYN to furnish the ACO with

certain periodic reports, including a Quarterly Limitation of

Payment Report, which contained information regarding GENDYN's

performance under the entire contract as well as information

pertaining to each program year.    Information pertaining to

individual program years was requested and used in connection

with the available funding.   Another report that GENDYN was

required to submit on a monthly basis was the Cost Performance

Report, or “CPR”, which tracked GENDYN's projected cost at

completion versus target costs for each program year.      To derive

program year cost estimates for the CPR’s, GENDYN broke down, by

program year, its estimate of the total cost.      The cost estimate

for 1 program year was on the basis that aircraft in the other

program years would be manufactured.      CPR’s were not audited by

the Defense Contract Audit Agency.       Monthly Contract 2034 profit

estimates could become inaccurate due to later occurring events

not known at the time of the estimate.

     GENDYN also submitted, on a monthly basis, a Contract Cost

and Profit Summary or “CCPS”.    The CCPS was derived from and

contained information similar to the CPR.      Thus, the CCPS, like

the CPR, included breakdowns of GENDYN's estimated costs by

program year.   GENDYN's program office used the CCPS as one means

of assessing how well GENDYN was performing on its contracts.

The CCPS was not used, however, for financial reporting purposes.

The Air Force used the CPR’s as program management tools, not as
                               - 29 -


accounting reports.    During the performance of Multiyear I, the

“Indicated Profit” for each program year, as reflected on the

CCPS reports, varied.

     Under CCM, GENDYN treated Contract 2034 as a single, long-

term contract.   GENDYN reported all of its taxable income for

Contract 2034 in its return for 1987, the year in which the last

of the 480 F-16's was delivered.

     Contract 2038 was negotiated and entered into on April 15,

1982, separate and apart from Contract 2034.     Contracts 2038 and

2034 were not related as to the pricing in each contract.

Contract 2038 was a firm fixed-price incentive contract under

which petitioner was to provide engineering services in

connection with the F-16 aircraft.      Contract 2038 services were

set forth in eight CLIN’s and each CLIN was further separated

into numerous individually priced "sub-CLIN" items to, in part,

enable petitioner to receive interim progress payments upon

completion of sub-CLIN’s.    There were business purposes for

treating Contract 2038 separately from Contract 2034 and they

were separately funded.   The subject of Contract 2038 was

research, design, and development of new systems for the F-16

aircraft.   The new technology was first developed and perfected

under Contract 2038 and then integrated into the Contract 2034

aircraft production.    Petitioner claimed the income and

deductions in connection with Contract 2038 under CCM.
                              - 30 -


Respondent determined that Contract 2038 did not qualify for CCM

reporting for Federal income tax purposes.

     Contract 2038 is not a long term contract that would qualify

for CCM reporting of income and deductions for Federal income tax

purposes.   The relationship between Contract 2038 and Contract

2034 does not qualify Contract 2038 income and deductions to be

reported under CCM.

                              OPINION

I. Should Contract 2034 Be Severed Into Four Separate Contracts
for Reporting GENDYN’s Profit From the Production of Aircraft?

     The primary controversy requires us to interpret certain

completed contract regulations under section 4514 and to find

facts concerning GENDYN’s production of F-16 fighter aircraft.5

The parties' disagreement arises from respondent's determination

that Contract 2034, covering 4 program years, should be severed



     4
        Section references, unless otherwise noted, are to the
Internal Revenue Code as amended and in effect for the years
under consideration. Rule references are to this Court's Rules
of Practice and Procedure.
     5
        The questions raised in this opinion have been largely
obviated by the enactment of sec. 460, added by the Tax Reform
Act of 1986, Pub. L. 99-514, sec. 804(a), 100 Stat. 2085, 2358,
which, with limited exceptions, prohibits the use of the
completed contract method for the Federal tax reporting of income
and deductions of long-term contracts. Under sec. 460, most
taxpayers, especially those as large as GENDYN, are limited to
certain prescribed forms of the percentage of completion method
for long-term contracts entered into after Feb. 28, 1986. The
contracts under consideration were entered into prior to the
effective date of sec. 460. We note that GENDYN used the
percentage completion method for its financial reporting of long-
term contracts for the periods under consideration.
                              - 31 -


and treated as four separate 1-year contracts.    Contract 2034 is

a 4-program-year agreement between GENDYN (petitioner) and the

Air Force to produce 480 aircraft.     The first year was 1982, and

aircraft were produced continuously through 1987, when petitioner

delivered the 480th aircraft.6   Petitioner, under CCM, reported

the income, expenses, and profit attributable to all 480 aircraft

for the 1987 tax year.   Respondent, by determining that the

contract should be severed into four annually reportable parts of

120 aircraft, caused certain amounts of profit, allocated by

respondent, to be moved from 1987 (the year reported) to 1985 and

1986, the tax years before the Court.7

     Respondent agrees that petitioner is entitled to use CCM for

Contract 2034.   Respondent also agrees that Contract 2034 is a

long-term contract for purposes of applying CCM.    Respondent

determined that 2034 should be treated as four separate long-term

contracts for purposes of applying CCM.    In this regard,

respondent points out that the central focus of our inquiry

should be whether there has been an abuse of respondent's



     6
        Each program-year's aircraft were being delivered about
2-1/2 years after the contract inception; i.e., 1982 program-year
aircraft were delivered about 10 per month during 1984, etc.
     7
        Respondent's determination, in addition to accelerating
the time when petitioner's profits would be reported, also
results in a larger tax liability due to a differential in the
maximum corporate tax rate between the reporting year (1987) and
the 1985 and 1986 tax years in which some of the profit would be
reportable due to any severance. The maximum rate was 34 percent
for 1987 and 46 percent for the 1985 and 1986 tax years.
                                  - 32 -


discretion in requiring petitioner to segregate, account for, and

report Contract 2034 in four annualized segments.       Petitioner

does not dispute that the standard is one of abuse of discretion.

On brief, however, respondent couches the issue as follows:

       [W]hether * * * petitioner's regular method of
       accounting is being improperly applied by petitioner to
       treat Contract 2034 as a single agreement where the
       regulation expressly mandates the treatment of Contract
       2034 as several agreements so as to prevent the
       unreasonable deferral of recognition of income. * * *
       A method of accounting will only be deemed to result in
       a clear reflection of income where it approximates the
       true economic impact of the taxpayer's transactions
       during the accounting period. Ford Motor Co. v.
       Commissioner, 71 F.3d 209, 215-216 (6th Cir. 1995).
       [Emphasis added.]

       Respondent has, to some extent, mischaracterized the focus

of this case.       There is no issue concerning whether petitioner

improperly applied the completed contract method.8      In that same

vein, petitioner did not structure Contract 2034 to maximize any

deferral inherent in the completed contact method.       The question

here is not whether petitioner manipulated the completed contract

method or attempted to abuse the methodology by its particular

use.       Broadly, the question is whether petitioner has shown there

was an abuse of discretion by respondent, measured by the

regulatory standards for severance.




       8
        This is not a question of whether four separate contracts
were improperly aggregated by petitioner. In the context of this
case, we are considering a 4-year contract that respondent
determined should be severed into four reportable parts.
                                - 33 -


     Petitioner bears the burden of proof in this case.    Rule

142(a).   The regulations in question, sec. 1.451-3(e), Income Tax

Regs., provide the Commissioner with the ability to treat one

agreement as several contracts for the purpose of clearly

reflecting income.    Respondent's authority in the context of

these regulations is to be judged on an abuse of discretion

standard.    Sierracin Corp. v. Commissioner, 90 T.C. 341, 368

(1988).     That standard was described in Sierracin as follows:

          Section 446(b) and sections 1.451-3(e), 1.446-
     1(a)(2), and 1.446-1(b)(1), Income Tax Regs., vest
     respondent with broad discretion in determining whether
     a taxpayer’s contracts should be severed so as to
     clearly reflect income. “Since the Commissioner has
     ‘[m]uch latitude for discretion,’ his interpretation of
     the statute's clear reflection standard ‘should not be
     interfered with unless clearly unlawful.’” Thor Power
     Tool Co. v. Commissioner, 439 U.S. 522, 532 (1979),
     quoting Lucas v. American Code Co., 280 U.S. 445, 449
     (1930). To overcome respondent's determination,
     petitioner must establish that respondent was plainly
     arbitrary in severing petitioner's contracts * * *.
     See Reco Industries, Inc. v. Commissioner, 83 T.C. at
     920; Peninsula Steel Products & Equip. Co. v.
     Commissioner, 78 T.C. at 1046. * * * [Id.; fn. ref.
     omitted.]

To prevail here, petitioner must show that there was no adequate

basis in law and/or fact for respondent's determination, i.e.,

that respondent's exercise of the regulatory discretion was

arbitrary or capricious.     Ford Motor Co. v. Commissioner, 102

T.C. 87, 91-92 (1994), affd. 71 F.3d 209 (6th Cir. 1995).

     A. Background--Completed Contract Method

     The completed contract method of accounting for long-term

contracts first appeared in regulations issued under the Revenue
                               - 34 -


Act of 1918, ch. 18, 40 Stat. 1057.     In general, this method has

been described as “peculiarly adapted to a business fulfilling

contracts which lap over accounting periods where the ultimate

gain or loss cannot be accurately determined until the completion

of the contract.”   Fort Pitt Bridge Works v. Commissioner, 24

B.T.A. 626, 641 (1931), revd. on other grounds 92 F.2d 825 (3d

Cir. 1937); Peninsula Steel Prods. & Equip. v. Commissioner, 78

T.C. 1029, 1047 (1982).   The method “is designed to provide an

alternative to the annual-accrual method of accounting for long-

term contracts for which the ultimate profit or loss is not

ascertainable until the contract is completed.”     Spang Indus.,

Inc. v. United States, 791 F.2d 906, 908 (Fed. Cir. 1986);       RECO

Indus., Inc. v. Commissioner, 83 T.C. 912, 921 (1984).     The

completed contract method (CCM) differs from the accrual method

in that accrued income and deductions are recognized in income

when the contract is completed and not necessarily at the end of

an annual accounting period.   Fort Pitt Bridge Works v.

Commissioner, supra.

     Respondent contends that petitioner's reporting of the

entire profit in 1987 does not clearly reflect income because

“petitioner will be able to unreasonably defer for up to three

years, the recognition of substantial amounts of taxable income

that was realized upon the completion and delivery of each

program year's requirements for aircraft.”
                                - 35 -


     The term “clearly reflect income” is not statutorily

defined, and generally accepted accounting principles,

consistently applied, usually will “clearly reflect income” for

tax purposes.    See, e.g., sec. 1.446-1(a)(2), (c)(1)(ii), Income

Tax Regs.   The Commissioner, however, may reject a taxpayer’s

method if it does not clearly reflect income and substitute a

method that, in the opinion of the Commissioner, does clearly

reflect income.     Thor Power Tool Co. v. Commissioner, 439 U.S.

522 (1979).     It is important to note in this case that respondent

is not making the determination that CCM does not clearly reflect

income, but that CCM under the circumstances reported by

petitioner does not clearly reflect income.

     It should be further noted that petitioner’s income for each

of the severed years would, in any event, not be reported until

the last delivery of aircraft for that year, even after

considering respondent's severance determination.    Inherent in

CCM is delay or deferral of profit or loss beyond that

permissible under annual accounting methodology.    That delay is

permitted because in the setting of some long-term contracts, a

taxpayer is unable to determine whether it has a profit or loss

until the contract is completed.    CCM was not provided for by

Congress, but instead was sanctioned by regulation.    Ultimately,

in years subsequent to those before the Court, CCM was prohibited

by Congress (for situations such as those under consideration).
                                - 36 -


     If respondent's severance determination were sustained,

petitioner would not be required to report the income for the

1982, 1983, 1984, and 1985 contract years until the year the last

aircraft for the program was delivered in the 1984, 1985, 1986,

and 1987 tax years, respectively.    Petitioner reported Contract

2034 as a single agreement for 480 aircraft.   Reported in that

manner, the unsevered 1982 profit would be reported after 5

rather than 2 years, and the unsevered 1983 profit would be

reported after 4 rather than 2 years and so on until the 1985

year for which the profit would be reported after 2 years (1987),

irrespective of whether Contract 2034 had been severed.   Although

CCM permits reporting of income and expenses beyond the usual

annual accounting period, it is respondent's contention that the

period of delay here is inherently too long to clearly reflect

income.   There is no legal basis or factual predicate for such a

per se or ipso facto result.9

     B. The Statute and Regulations Defining and Governing the
Use of CCM


     9
        As previously noted, in limiting the use of CCM, Congress
recognized that the use of that method permitted an extended
period of deferral by long-term contractors. For larger long-
term contractors like petitioner, Congress did not attempt to
place a limit on the number of accounting periods that could be
deferred. Instead, Congress generally prohibited the use of CCM.
For long-term contracts entered into after Feb. 28, 1986, smaller
contractors (those with average annual gross receipts of less
that $10 million) may use CCM for contracts expected to be
completed within 2 years. See sec. 460(e)(1). These
limitations, however, have no direct bearing on our evaluation of
whether petitioner’s approach was correct and/or whether
respondent has been arbitrary or capricious.
                               - 37 -


     For the taxable years under consideration, section 446(b)

generally outlined the methods of accounting for Federal tax

purposes, but it did not specifically address whether taxpayers

could use CCM.   Section 1.451-3, Income Tax Regs., however,

specifically permitted the reporting of income and expenses from

long-term contracts using CCM.    Petitioner selected CCM and is

afforded some latitude in selecting a method of accounting.

Section 1.446-1(a)(2), Income Tax Regs., provides:

     It is recognized that no uniform method of accounting
     can be prescribed for all taxpayers. Each taxpayer
     shall adopt such forms and systems as are, in his
     judgment, best suited to his needs. * * *

     Respondent does not question petitioner’s selection of CCM,

but determined that Contract 2034 should be severed into four

annualized reportable portions.    Rules governing severance and

aggregation of long-term contracts were promulgated by the

Secretary and set forth in section 1.451-3(e)(1), Income Tax

Regs.10   That regulation generally provides:


     10
        These regulations were modified pursuant to the Tax
Equity and Fiscal Responsibility Act of 1982 (TEFRA), Pub. L. 97-
248, 96 Stat. 324. Sec. 229 of that Act was titled “Modification
of Regulations on the Completed Contract Method of Accounting”,
and directed the Treasury to amend the regulations governing CCM
to clarify, among other things, the rules governing severance and
aggregation of long-term contracts:
          SEC. 229(a). In General.--The Secretary of the
     Treasury shall modify the income tax regulations
     relating to accounting for long-term contracts to--
               (1) clarify the time at which a contract is
          to be considered completed,
               (2) clarify when--
                    (A) one agreement will be treated as
                                                   (continued...)
                                 - 38 -


     For the purpose of clearly reflecting income (e.g. to
     prevent the unreasonable deferral of recognition of
     income or the premature recognition of loss), it may be
     necessary in some instances for the Commissioner either
     to treat one agreement as several contracts or to treat
     several agreements as one contract. [Sec. 1.451-
     3(e)(1)(i)(A), Income Tax Regs.]

      The regulation continues by providing criteria for

severance or aggregation of contracts, as follows:

     Whether an agreement should be so severed or several
     agreements so aggregated will depend on all the facts
     and circumstances. Such facts and circumstances may
     include whether there is separate delivery or separate
     acceptance of units representing a portion of the
     subject matter of the contract, whether such units are
     independently priced, whether there is no business
     purpose for one agreement rather than several
     agreements or several agreements rather than one


     10
          (...continued)
                   more than one contract, and
                        (B) two or more agreements will be
                   treated as one contract, and
                   (3) properly allocate all costs which
              directly benefit, or are incurred by reason of,
              the extended period long-term contract activities
              of the taxpayer. [96 Stat. 493.]

The TEFRA legislative history contains the following comment:
     Congress believed that the prior rules relating to the
     completed contract method of accounting needed to be
     changed because the income of some taxpayers using that
     method of accounting was not being clearly reflected.
     * * * completion of contracts had been deferred for tax
     purposes by treating certain agreements as a single
     contract for several units rather than several
     contracts for single units, even though each unit was
     delivered or accepted separately and had been
     separately and independently priced. Congress
     believed, therefore, that Treasury should amend its
     regulations to prevent this inappropriate deferral of
     income. [Staff of Joint Comm. on Taxation, General
     Explanation of the Revenue Provisions of the Tax Equity
     and Fiscal Responsibility Act of 1982 at 150 (J. Comm.
     Print 1982).]
                              - 39 -


     agreement, and such other factors as customary
     commercial practice, the dealings between parties to
     the contract, the nature of the subject matter of the
     contract, the total number of units to be constructed,
     manufactured, or installed under the contract, and the
     contemplated time between the completion of each unit.
     [Sec. 1.451-3(e)(1)(ii), Income Tax Regs.]

     “[S]eparate delivery or separate acceptance of portions

* * * [of long-term contract items] does not necessarily require

severing”.   Sec. 1.451-3(e)(1)(iii), Income Tax Regs.

     Section 1.451-3(e)(1)(iv), Income Tax Regs., explains the

role of differing price arrangements:

     One agreement may be severed, or several agreements may
     be aggregated, based upon the pricing formula of such
     agreements. For example, in the case of a multi-unit
     agreement for several similar items, if the price to be
     paid for similar units is determined under different
     terms or formulas (for example, if some units are
     priced under a cost-plus incentive fee arrangement, and
     later units are to be priced under a fixed-price
     arrangement), then the difference in the pricing terms
     or formulas may indicate that the agreement should be
     treated as several contracts.

     Section 1.451-3(e)(1)(v), Income Tax Regs., provides:

     An agreement generally will be treated as several
     contracts where there is no business purpose for
     entering into one agreement rather than several
     agreements. A factor which may evidence that no such
     business purpose exists is that the agreement covers
     two or more subject matters, none of which readily can
     be determined to be the primary subject matter of the
     contract * * * ; such factor must be considered along
     with other factors indicating the presence or absence
     of business purpose.

     Finally, section 1.451-3(e)(1)(viii), Income Tax Regs.

provides:

     If the number of items to be supplied is increased (as
     by the exercise of an option or the issuance of a
                             - 40 -


     "change order"), the supplying of such additional items
     generally results in the agreement being changed into
     several agreements. * * *

     These regulations also include several examples that

illustrate the regulatory language.   Examples (2), (3), and (6)

of section 1.451-3(e)(2), Income Tax Regs., are of particular

relevance to this case.

     In Sierracin Corp. v. Commissioner, 90 T.C. at 369, we

emphasized that the independent pricing factor should, among the

various facts and circumstances, be given “special emphasis”.

Example (2) illustrates the independent pricing factor for

purposes of aggregating two separate contracts and involves a

shipbuilder on CCM who entered into two agreements at about the

same time to construct two submarines of the same class.    The two

agreements were the product of a single negotiation.    It was

anticipated that, because the shipbuilder had never constructed

this class of submarine before, the costs incurred in

constructing the first submarine would be substantially greater

than the costs incurred in constructing the second submarine,

which was to be delivered 1 year after the first submarine.      It

was pointed out in Example (2) that

     If the agreements are treated as separate contracts, it
     is estimated that the first contract could result in
     little or no gain, while the second contract would
     result in substantial profits. * * *

It is unlikely that the shipbuilder would have entered into the

contract to construct the first submarine for the price specified
                              - 41 -


without entering into the contract to construct the second

submarine.   In those circumstances, Example (2) contains the

conclusion that it may be necessary for the Commissioner to

aggregate the two agreements for purposes of applying the

long-term contract method.

     Example (3) is a variation of Example (2), where 1 year

after the original contracts are signed the customer issues a

“change order” providing for a third submarine of the same class

to be constructed.   The portion of the total contract price

attributable to the “change order” can reasonably be determined,

and a reasonable business person would have entered into the

agreements to construct the first two submarines for the price

specified without regard to whether a third submarine was added.

     Under Example (3) the “change order” for the third submarine

is to be treated as a separate contract for purposes of applying

the shipbuilder's CCM.   Example (3) also focuses on the

independent pricing factor for its conclusion.

     Example (6) emphasizes the importance of independent

pricing, as follows:

     T, a calendar year taxpayer engaged in the business of
     manufacturing aircraft and related equipment, enters
     into an agreement in 1982 with the B government to
     manufacture 10 military aircraft for delivery in 1984.
     It is anticipated at the time the agreement is entered
     into that B may enter into an agreement with T for the
     production and sale of as many as 300 of these aircraft
     over the next 20 years. In negotiating the price for
     the agreement, B and T take into account the expected
     total cost of manufacturing the 10 aircraft, the risks
     and the opportunities associated with the agreement and
                              - 42 -


     all other factors that the parties consider relevant,
     in such a manner that T would have entered into the
     agreement with the terms agreed upon whether or not T
     would actually enter into one or more additional
     production agreements. However, it is unlikely that T
     would have entered into the agreement but for the
     expectation that T and B would enter into additional
     production agreements. In 1984, the 10 aircraft are
     completed by T and accepted by B. In 1984, T also
     enters into an agreement with B to manufacture 20
     aircraft of the same type for delivery in 1986. In
     negotiating the price for these 20 aircraft, B and T
     take into account the fact that the expected unit costs
     for this production of 20 will be different than the
     unit costs of the 10 aircraft completed in 1984, but
     also that the expected unit costs of this production of
     20 will be substantially higher than the costs of
     future production. Because the price awarded for each
     of the two agreements takes into account the expected
     total costs and the risks expected for each agreement
     standing alone, the terms agreed upon for any one of
     the agreements are independent of the terms agreed upon
     for the other agreements. Under the facts of this
     example, the two agreements may not be aggregated into
     one contract for purposes of applying T's long-term
     contract method.

     C.   Discussion

           1. General

     Respondent correctly points out that this is not a case

where the Court must decide whether use of a particular

accounting method does or does not clearly reflect income.

Implicit in respondent's distinction is the basic principle that,

generally, CCM is accepted for Federal tax purposes as clearly

reflecting income when used by qualified taxpayers.   It should be

noted that CCM inherently permits delay in reporting income or

loss beyond that permitted by annualized methods of accounting

for Federal tax purposes.   Respondent agrees that petitioner is
                              - 43 -


entitled to use CCM.   So, the question here concerns whether, in

using CCM, petitioner correctly reported its income and

deductions from Contract 2034 after the completion and delivery

of the 480 contracted-for units or whether profit should be

segregated and reported on four separate occasions after the

completion and delivery of 120 units.

     No question of law is presented, and we focus on whether the

facts and circumstances presented in this case are sufficient to

carry petitioner’s burden of showing that respondent's exercise

of regulatory discretion was arbitrary or capricious (i.e.,

without sound basis in law and/or fact).

     2. Can Petitioner’s Profit Be Reasonably Estimated for Each
Program Year?

     The regulations do not specifically require, as a condition

to severing a contract, that the taxpayer’s profit for the

severed period be determinable with reasonable accuracy.   The

parties argue this point, however, as a threshold matter to the

question that must precede any consideration of severance.    It

should be noted, however, that the ability to reasonably compute

the amount of profit or loss attributable to each annualized 120-

aircraft allocation, does not mean that the profit or loss

predicted for each severed year would ultimately result.   In that

regard, petitioner contends that its profits for a severed period

were not reasonably determinable; e.g., due to the interdependent

pricing under the multiyear contract, petitioner could experience
                               - 44 -


a per-aircraft profit as of 1984 for the 120 aircraft from the

1982 program year completed in 1984, but after delivery of the

480th aircraft, petitioner could ultimately experience a per-

aircraft loss for all aircraft, including the batch completed in

1984.

     The parties disagree about whether a reasonably accurate

annual determination of petitioner’s Contract 2034 profit or loss

could be accomplished.   Respondent contends that petitioner was

able to determine each program year's income and expenses with

reasonable certainty.    Respondent argues that petitioner was able

to do this for financial accounting purposes and to satisfy the

Government's reporting requirements and that the Government made

payments to petitioner without hold-backs or reservations to

secure future performance.

     Petitioner contends that respondent's premise is factually

incorrect, and even if its profits could be determined by program

year with reasonable certainty, that factor would not bar its use

of CCM and/or serve as a reason necessitating severance of

Contract 2034.   We agree with petitioner that the ability to

calculate profit for a period with reasonable certainty does not

per se mandate that the period be severed.11   On the other hand,



     11
        If, for example, petitioner is able to calculate the
profit or income attributable to each aircraft, would it then be
appropriate to sever Contract 2034 into 480 reportable units?
Obviously, that is only a threshold factor and not determinative
of whether severance should be applied.
                                - 45 -


it would be difficult to sever a contract if profit for the

severed period was not determinable with reasonable certainty.

     The annualized amounts of income respondent determined in

the notice of deficiency are based on or in reference to the

projected profit for each program year reflected in the Contract

Cost and Profit Summaries (CCPS’s) prepared by petitioner on

December 31, 1984, 1985, and 1986, respectively.    CCPS’s were not

used to determine petitioner’s profit with respect to Contract

2034, either for tax or for financial accounting purposes.12

CCPS’s were derived from, and contained essentially the same

information as, the Cost Performance Reports (CPR’s) required to

be provided to the Air Force.    The Air Force used the CPR’s as

program management tools, not as accounting reports.    There was

testimony to the effect that the CPR’s could not be used as cost

pricing data for negotiating subsequent contracts because the

CPR’s were not sufficiently accurate to be certified under the

Truth in Negotiations Act, Pub. L. 87-653, 76 Stat. 528 (1962).

Significantly, all progress payments made under Contract 2034


     12
        Petitioner used the percentage completion method for
financial accounting purposes. Under that method, the gross
income recognizable from long-term contracts is that proportion
which corresponds to the percentage of the total contract
completed during the taxable period. Accordingly, petitioner’s
financial income reported on the percentage completion method
would not comport with an annualized version of CCM, as
determined by respondent. As previously noted, the percentage
completion method is mandatory for petitioner’s reporting of its
long-term contracts entered into after the 1986 tax year. During
the years under consideration, however, respondent concedes that
petitioner is entitled to use CCM.
                               - 46 -


related to costs incurred on the entire contract, and were not

broken out by program year.

     Petitioner was able to annualize its costs and receipts for

reporting to the Air Force.    This reporting may have been used as

the basis for annual Government appropriations, progress

payments, and other administrative purposes underlying Contract

2034.   Petitioner, however, did not calculate or report its

profit by segregating 120 aircraft into any form of annualized

configuration.    It is important to understand that irrespective

of its annualized reporting of costs and receipts to the Air

Force for administrative contract purposes, petitioner’s profit

or loss from Contract 2034 was interdependent and depended on the

receipts and costs for all 480 deliverable units.

     The annualized income for 120 aircraft is more easily and

reasonably computed retrospectively; i.e., after delivery of all

480 aircraft under Contract 2034.    The estimation of the profit

or loss for 120 aircraft becomes less accurate and hence less

reasonable the more that it precedes the delivery of the 480th

aircraft.   This is so because the production of the F-16 aircraft

under Contract 2034 was a progression of continually more

sophisticated and complex machines.     In that same vein, the

aircraft are interdependently priced, and the final "definitized"

price and any profit or loss thereon were dependent on risks that

may not have existed or been discovered until delivery of the

480th aircraft.   Accordingly, it would have been difficult to
                              - 47 -


make in 1984, after delivery of 120 aircraft, an accurate

determination of the 1982 program year profit, inasmuch as there

then remained to be delivered the vast majority of aircraft

called for under Contract 2034.

     3.   Independent Pricing Factor

     In evaluating Contract 2034, respondent suggests that four

relevant facts and circumstances, as set forth in section 1.451-

3(e)(1)(ii), Income Tax Regs., are to be considered.   Those

factors concern whether:   (1) There was separate delivery and/or

acceptance of aircraft; (2) the aircraft were independently

priced; (3) there was a business purpose for several or a single

contract; and (4) there were various other customary commercial

practices involving the production of aircraft.   Respondent, by

grouping the factors together, attempts to place independent

pricing on par with other factors.13   However, as decided in

Sierracin Corp. v. Commissioner, 90 T.C. 341 (1988), the

independent pricing aspect is particularly significant.


     13
        Respondent in an Action on Decision acquiescing in
Sierracin Corp. v. Commissioner, 90 T.C. 341 (1988), made the
following comment about our emphasis on independent pricing in
that case:
           The court's undue emphasis on independent pricing
     restricts the application of the regulations in other
     cases and is not controlling. For example, in a
     situation in which there are significant time intervals
     between the delivery dates of items under a multi-unit
     contract, the Service is not precluded from asserting
     that the contract should be severed notwithstanding the
     absence of independent pricing. [Action on Decision
     1990-016 (May 18, 1990), 1990-1 C.B. 1.]
                               - 48 -


     The parties approach the independent pricing factor from

differing perspectives.   Respondent emphasizes that Contract 2034

is funded on an annual basis and is more like an annual option

contract.    Respondent also points out that the number of aircraft

under Contract 2034 was, at some point, increased beyond the

original 480.   Respondent contends that these attributes make

Contract 2034 more like the option-type agreement referenced in

section 1.451-3(e)(1)(viii), Income Tax Regs., which, in relevant

part, provides:

     If the number of items to be supplied is increased (as
     by the exercise of an option or the issuance of a
     “change order”), the supplying of such additional items
     generally results in the agreement being changed into
     several agreements. See § 1.451-3(e)(1)(i).

The cross-reference indicates that subdivision (viii) is to be

interpreted consistent with the facts and circumstances test of

section 1.451-3(e)(1)(ii), Income Tax Regs.

     Petitioner contends that Contract 2034 was a fixed-price

incentive contract with a single pricing formula for the 480

aircraft in question.   Petitioner points out that the final price

could not have been determined until after the 480th aircraft was

delivered.   Petitioner faced significant and continuing risks

during the performance of Contract 2034 that could have increased

its costs and affected the projected profit of already delivered

aircraft.    As the delivery of the last or 480th aircraft

approached, however, the potential risk and the likelihood of

such an occurrence were reduced.    As production and delivery of
                              - 49 -


the aircraft approached the 480th unit, the possibility and

potential for significant impact from design and production

problems must lessen.   We have no difficulty, however, finding

that the 480 aircraft to be manufactured under Contract 2034 were

interdependently priced.

     Contract 2034 imposed a binding obligation on the Air Force

to fund successive program years, except in the event that

Congress failed to appropriate funds or the Air Force terminated

the contract for convenience or default.   The successive funding

of each fiscal year did not constitute a new order or exercise of

an option.   In Beta Sys., Inc. v. United States, 838 F.2d 1179,

1183 n.2 (Fed. Cir. 1988), the court explained the operation of a

multiyear contract and the effect of funding as follows:

     When the government enters into a multi-year
     procurement, as here, the negotiated terms apply to the
     full procurement whether or not funding has been
     approved for all years of the contract. This contract,
     like all governmental undertakings, contains the
     panoply of clauses by which the government can
     terminate the contract, or authorize the stepwise
     progression of its performance over its multi-year
     term. These assorted termination rights do not relieve
     either the government or the contractor of its
     obligations as set forth in a multi-year contract that
     is not terminated. Otherwise, rational multi-year and
     long-lead procurement would be impossible. [Citation
     omitted.]

     A multiyear contract obligates the Government to complete

the funding for the entire contract absent a valid basis for

canceling the contract:

          The fact that the requirements for the years after
     the first year in a multi-year procurement are unfunded
                                - 50 -


     does not make a multi-year contract an option contract.
     * * *

     The contract binds the Government to purchase the
     entire multi-year procurement quantity and to fund the
     successive Program Years.[14] * * * [Beta Systems v.
     United States, 16 Cl. Ct. 219, 228 (1989).]

 The Claims Court also noted:

     Multi-year procurement contracts are, in essence,
     single, indivisible entities. As a result, an
     equitable adjustment following termination of a multi-
     year contract must be based upon the entire contract.
     [Id. n.11; citation omitted.]

     Respondent argues that the Air Force reserved a unilateral

annual right to procure the next program year's projected

requirements.   Respondent's position overstates the Government's

rights with respect to multiyear Contract 2034.     The Air Force

did not have the unlimited right to cancel any future year.

Contract 2034 was a multiyear contract which could have ended if

Congress failed to fund the F-16 program or if a Government

determination was made that there was no need to acquire any

remaining F-16's under the contract.

     Respondent also focuses and relies upon language in CLIN

0001 of Contract 2034, which states:     “ITEMS 0002 THROUGH 0015

ARE NEITHER PRICED NOR FUNDED NOR IS THE GOVERNMENT UNDER ANY

OBLIGATION TO SUBSEQUENTLY ACQUIRE SAID ITEMS.”     Petitioner

counters that the CLIN 0001 language denotes that 2034, like all

     14
        Petitioner also argues that the Government may not
cancel any part of a multiyear contract on the ground that the
terms of the contract are disadvantageous, citing Appeal of Varo,
Inc., 70-1 B.C.A. (CCH) par. 8,099 (1969).
                               - 51 -


multiyear contracts, was not fully funded at its inception, and

that the Government retained the right to cancel unfunded

portions of Contract 2034 in certain circumstances.   We find

petitioner’s interpretation to be correct and consistent with the

analysis of the above-quoted cases holding that the Government’s

ability to cancel a multiyear contract is not discretionary, but

is limited to situations in which Congress fails to appropriate

funds for the goods ordered under the contract, or the Government

no longer has a need for the goods ordered under the contract.

     Contract 2034 obligated the Air Force to fund each program

year under the contract as long as Congress continued to

appropriate funds and the Air Force continued to need the F-16's

ordered under Contract 2034.   If, for example, costs of

petitioner’s performance dramatically declined during the term of

Contract 2034, the Air Force was not entitled to cancel Contract

2034 or require petitioner to produce the remaining F-16's at a

lower price.

     The Air Force’s ability to cancel prior to full funding of

all 4 fiscal years was sufficiently limited as a matter of

Government contracting law so as to deplete the substance of

respondent's claim that the funding of each successive fiscal

year was merely an increase in order quantity.   The Air Force did

not have unqualified or unlimited legal power to cancel, and the

480 aircraft procured were interdependently priced.
                              - 52 -


     One significant foundation of respondent’s argument on brief

is the premise that “the total number of F-16 aircraft and

support equipment to be manufactured and delivered by petitioner

under the contract was increased in annual increments by

unilateral contract modifications”.    This argument assumes that

the contract modifications under which annual funding was added

were “change orders” within the meaning of section 1.451-

3(e)(1)(viii), Income Tax Regs.   Respondent's position is

weakened by the fact that any change to a Government contract,

without regard to its magnitude, required a contract

modification.   The act of modification, by itself, has no

particular meaning and does not automatically place a long-term

contract within the influence of section 1.451-3(e)(1)(viii),

Income Tax Regs.   That section is more dependent upon whether

each such addition increased the obligation for the number of

aircraft ordered under the long-term contract.

     Respondent also argues that the Air Force's rights under

terms of a multiyear contract most closely resemble those of a

priced option to acquire additional units.   The evidence does not

support respondent's contention that Contract 2034 was, in

effect, a series of option contracts.   The parties to Contract

2034 did not intend to enter into an option contract.   The cost

benefits sought and obtained by the Air Force and petitioner

under Contract 2034, in part, resulted from interdependent
                               - 53 -


pricing of all the aircraft to be manufactured and delivered over

the contract’s multiyear term.

     It should be noted that respondent did not argue that the

Air Force's right to terminate fully or partially 2034 for its

convenience rendered the contract severable.    In that regard, all

Government contracts, irrespective of their timespan (including

multiyear contracts), are subject to termination for the

Government's convenience or for a party's default.    Under

termination conditions, petitioner would be compensated based on

prescribed terms set out in the contract and established legal

requirements.15

     In this regard, all 4 program years under Contract 2034 were

partially funded from inception as to long-lead funding and EOQ

items.    Respondent's position does not adequately explain or

account for the long-term funding aspects of Contract 2034.

Additionally, as of November 1, 1984, Congress had fully funded

Contract 2034, and cancellation for lack of funding was no longer

a factor.    The question of severance of Contract 2034 into four

contracts by program year would not have become possible for tax

reporting purposes until petitioner filed its 1984 tax return.

Due to the long-term nature of aircraft production, the 1982


     15
        Petitioner also points out that because the 1982 and
1983 program years were funded simultaneously in P00 80,
respondent’s increase-in-order theory should logically result in
severance into three contracts, not four as respondent had
determined.
                               - 54 -


contract year would not be complete until the Federal income tax

reporting for the 1984 tax year.    In part, respondent’s theory

relies on any right(s) the Government may have had to cancel.      In

that regard, the Government no longer possessed an ability to

cancel for lack of funding when petitioner filed its return for

1984, the first year in which the decision to sever would have

had any consequence to petitioner’s tax returns.

     4.   Separate Delivery and Acceptance

     Respondent also argues that the aircraft were delivered by

program year and that each aircraft was separately delivered and

accepted.    The regulations provide that separate delivery or

separate acceptance of portions of the subject matter of a

contract is a factor to be considered in deciding whether to

sever.    Sec. 1.451-3(e)(1)(iii), Income Tax Regs.   Separate

delivery or acceptance does not, by and of itself, require

severance.    Example (4), section 1.451-3(e)(2), Income Tax Regs.,

does not require severing by separate delivery and acceptance

where there was a business reason for entering one contract

rather than several contracts.    In Sierracin Corp. v.

Commissioner, 90 T.C. 341 (1988), we rejected severance of long-

term contracts even though there was separate delivery under the

contracts in question.    From the perspective of Sierracin,

separate delivery was mitigated by the existence of

interdependent pricing.
                              - 55 -


     Petitioner also notes that the majority of the aircraft

produced under Contract 2034 was delivered after all 4 program

years were fully funded, and Contract 2034 was at all times

administered as one contract for 480 aircraft.   Petitioner also

points out that if separate delivery per se justified severing,

then Contract 2034 should be severed into 480 contracts for 480

separately delivered aircraft.

     Respondent contends that the Air Force and petitioner were

required to establish target costs for each program year.

Petitioner counters that the target costs were due to Congress'

annual appropriations and inability legally to obligate funds for

future years.   The use of target costs and profits broken down by

program years, however, had no bearing on petitioner’s ultimate

profit upon completion of the contract, which was determined

solely by reference to the single target cost, target profit, and

share line or ratio adopted for Contract 2034.

     Respondent also argues that the liquidation of progress

payments as each aircraft was accepted supports the attempt to

sever Contract 2034 by program year.   Respondent argues that the

liquidation of progress payments under Contract 2034 is evidence

that each of the 4 program years was independently priced.

Liquidation of progress payments, however, would not enable

petitioner to determine its profits on a program year basis with

respect to each aircraft.   Moreover, by calculating the amounts

liquidated for each aircraft identified to a program year,
                              - 56 -


petitioner would not have been able to determine its profits by

aircraft or for a particular program year.

     The parties argue about the relevance of Example (2) under

section 1.451-3(e)(2), Income Tax Regs.    Respondent focuses on

the fact that the submarine contractor was willing to enter into

a contract to build one submarine for a minimal profit because a

second submarine would produce substantial profit.    Respondent

contends that Example (2) contains a situation where the price is

truly dependent, whereas the price in Contract 2034, at least

initially, was not.   Respondent’s contention is factually flawed

because the ultimate price for the 480 aircraft was

interdependent, and petitioner did not agree to a fixed price for

the first year only and/or subsequently negotiate a price for

later program years under Contract 2034.

     Petitioner also counters that respondent's argument is

dependent on “average pricing” and that there is no mention in

Example (2) of “average pricing”.   Petitioner instead construes

the key facts in Example (2) as being:    “These agreements are the

product of a single negotiation” and that “A reasonable business

person would not have entered into the agreement to construct the

first submarine for the price specified without entering into the

agreement to construct the second submarine.”    Following through,

petitioner contends that all 480 aircraft were priced in one

single negotiation, which resulted in one pricing formula for all

480 aircraft.   No reasonable person would have agreed to build
                               - 57 -


the first 120 aircraft at the price implicit in Contract 2034

without a binding agreement to build the remaining 360.

     The record here supports petitioner’s reasoning on this

point.   Petitioner made several proposals for price, depending on

whether there would be multiyear or annual contracts.    In

addition, the Air Force and petitioner stood to enjoy meaningful

cost savings under a multiyear contract as opposed to four annual

contracts.

     The parties next debate the significance of Example (6), of

section 1.451-3(e)(2), Income Tax Regs., which presents an

aggregation situation.    Respondent argues that the price terms

within Contract 2034 are almost on all fours with the facts set

forth in Example (6).    Petitioner counters that the most

significant factor in Example (6) precluding aggregation of the

two aircraft contracts is that

     In negotiating the price for the agreement, B and T
     take into account the expected total cost of
     manufacturing the 10 aircraft, the risks and the
     opportunities associated with the agreement, and all
     other factors that the parties consider relevant, in
     such a manner that T would have entered into the
     agreement with the terms agreed upon whether or not T
     would actually enter into one or more additional
     production agreements. * * * [Sec. 1.451-3(e)(2),
     Example (6), Income Tax Regs.; emphasis added.]

We agree with petitioner’s analysis that neither the taxpayer in

the example nor petitioner would have accepted the price terms

agreed to in the multiyear contract as the basis for an annual
                               - 58 -


commitment.    Without the long-lead purchase and EOQ savings,

petitioner would have been at a substantial cost disadvantage.

       Example (6) instructs that two orders of goods are not

interdependently priced if prices are determined independently

for the two contracts in separate negotiations.    It follows that

the existence of a single-price negotiation for all items ordered

under a contract is a strong indicator that all items under the

contract are interdependently priced, as was the case with

Contract 2034.

       Respondent, in effect, argues that in a fixed-price

incentive contract where actual costs of any program year's

requirements exceeded the point of total cost absorption for that

program year, profits realized in performance of other program

years could be reduced.    Respondent, on brief, asks us to find

that

       The “point of total cost absorption” is when, under
       share ratio set by the incentive price revision clause,
       it is the point at which the costs have reach[ed] the
       ceiling cost, and the profit of the contractor is being
       impacted and the contractor starts to incur a loss on
       the contract.

Petitioner counters that

       The “point of total cost assumption” is the point at
       which the contractor bears 100% of the cost overruns;
       this point occurs before the contractor reaches the
       ceiling price. * * * In other words, at the point of
       total assumption, for every dollar of overrun, the
       contractor's profit is reduced by a dollar; the
       contractor, however does not start to incur a loss on
       the contract until the contractor's costs exceed the
       ceiling price. * * * In addition, whenever the
       contractor is overrunning the contract (i.e., the
                              - 59 -


     contractor's costs exceed the target cost), its profits
     are being impacted, even prior to reaching the point of
     total cost assumption. Prior to reaching the point of
     total cost assumption, however, the contractor bears
     its share of the cost overrun as provided for by the
     share line. In [Contract 2034], petitioner would have
     borne 40 cents of every dollar of cost overruns up to
     the point of total cost assumption at which point it
     would have borne 100% of the cost overruns. [Citations
     omitted.]

     We agree with petitioner that the point of total cost

assumption in a fixed-price incentive contract is determined by

the relationship between the target cost, the target profit, and

the share line.   Contract 2034 had only one share line and,

accordingly, only one point of total cost assumption.     Thus,

respondent's argument is not borne out by the facts.

     Respondent has also asked us to find that

     Under the provisions of Contract 2034, as definitized
     by * * * [P00 80], when a final determination is made,
     if no single program year exceeds its ceiling, then the
     profits on the other three program years, would not be
     affected.

     We agree with petitioner that respondent's requested finding

is misleading because there is only one ceiling price and one

incentive price revision for the entire contract; there are no

separate program year ceilings or price determinations.

     In a similar vein, respondent also argues that the

dependency of price terms among the program years under the

incentive provisions might be entitled to some weight in the

determination to treat Contract 2034 as several agreements if

there was a significant probability that the cost overruns
                               - 60 -


incurred in performance of a program year's requirements might

reach the point of total cost absorption.   This argument must

also fail because Contract 2034 did not have separate points of

total cost assumption for individual program years.    On the

contrary, petitioner faced very significant risks in performing

Contract 2034 because of the sophistication and integration

aspects of the models of the F-16 to be produced.    An example of

such a risk was the incident involving the cracks that developed

in the 446 bulkhead.16   In addition, petitioner relied upon

numerous subcontractors, many of whom manufactured complex parts.

It should also be noted that Contract 2034 was the first

multiyear procurement of a major weapons system, and petitioner

bore substantially more risk than it would have borne under four

annual contracts.   Petitioner necessarily assumed the risks of

its subcontractors because petitioner would have incurred

significant costs had a subcontractor failed to perform

satisfactorily.

     5.   Business Purpose

     Respondent stipulated that both petitioner and the Air Force

had valid business purposes for entering into a multiyear

contract, as opposed to four separate contracts.    There is no

     16
        Petitioner also cited the example involving Sierracin
Corp., which manufactured many of the transparencies used in the
F-16's produced under Contract 2034. Petitioner went on to note
that this Court found that Sierracin’s Sylmar division was
subject to substantial risk in producing such transparencies.
Sierracin Corp. v. Commissioner, 90 T.C. 341, 348-349 (1988).
                             - 61 -


question that relatively substantial savings were experienced

through the multiyear feature of Contract 2034.    The cost savings

constituted the Air Force’s principal motive for seeking a

multiyear contract.

     Petitioner believed it could achieve substantially higher

profit rates under a multiyear contract than it could otherwise

achieve under four annual contracts.   Petitioner also believed it

could achieve substantially higher sales volume of the aircraft

under the multiyear approach of Contract 2034.    Petitioner’s

agreement to a multiyear contract instead of continuing annual

contract procurement was also dependent upon expectations that it

would obtain increases in the sales volume of aircraft to

customers other than the U.S. Government.   Finally, petitioner

viewed the multiyear form of procurement as providing stability

to its F-16 production and operations over the term of a 4-year

contract.

     6. The Customary Business Practices of the Air Force and
Petitioner

     Respondent argues that, in negotiating Contract 2034, the

Air Force and GENDYN (hereinafter the parties) made a concerted

effort to adjust the rates of periodic progress payments and

liquidations so as to provide petitioner with the same economic

results as it would have realized had Contract 2034 been four

separate procurement contracts.
                               - 62 -


      Petitioner argues that the Air Force and Congress

established that substantial cost savings would be accomplished

using the multiyear form of procurement in place of the previous

annual contracts.    Petitioner hoped to benefit from this by

earning a higher profit rate than it had earned under annual

contracts.

     Petitioner concedes that the Air Force and petitioner

tracked costs by program year and that each aircraft ordered was

identified in connection with a program year.      Petitioner also

agrees with respondent that billing prices could be adjusted to

reflect petitioner’s performance under Contract 2034.

Petitioner, however, argues that it is equally clear that

Contract 2034 was one contract, with one pricing formula, and,

regardless of amounts advanced to petitioner during the course of

the contract, all 480 aircraft ordered by Contract 2034 were

interdependently priced, and petitioner’s profit was not

determinable until Contract 2034 was completed.

     The customary business practices of the parties had not been

to enter into multiyear contracts.      Instead, annual price

negotiation and funding were the customary practice.      The parties

retained some of the prior practices such as reliance on the

annual Government budget process.    The parties also departed

significantly from the prior practices by their entry into a 4-

year commitment.    Each side stood to benefit by the extended

period, and each exposed itself to certain risks by undertaking
                              - 63 -


the long-term approach.   Although the parties remained subject to

certain features of the annual appropriation process, their long-

term commitments, in many respects, changed the way they did

business.

     Both petitioner and respondent make valid points concerning

the business exigencies and customs, but ultimately the Air Force

and petitioner were subject to a long-term contract with

interdependent pricing of all the aircraft deliverable under

Contract 2034.

     7.   Conclusion and Summary--Contract 2034

     In the final analysis, respondent asks that we focus on

attributes of Contract 2034 that represent only a few of the

criteria contained in the regulations for deciding whether a

long-term contract should be severed or aggregated.   Petitioner,

however, meets the most significant as well as the majority of

the regulatory criteria for its reporting the income and expenses

for all 4 years of Contract 2034 as a single long-term contract

under CCM.

     The main thrust of respondent's argument is that

petitioner’s use of CCM to report the income and expenses of

Contract 2034 does not clearly reflect income unless the contract

is severed into 4 contracts each for the manufacture and delivery

of 120 aircraft.   As petitioner has shown, however, Contract 2034

was a 4-year commitment for which pricing and resultant profit

were dependent on the fabrication and delivery of all 480 units.
                              - 64 -


     It is true that each aircraft was individually delivered by

petitioner and accepted by the Air Force, and that completion of

the contract was dependent upon annual congressional

appropriations.   In sum and substance, however, this was a single

multiyear contract for the delivery of 480 aircraft.    Financially

and legally, Contract 2034 was no different from a long-term

contract to build a structure composed of 480 parts.    In either

event, the contract would not be completed until the 480th part

was completed and put in place or placed in service with the

other 479 parts to complete the delivery and/or form the final

structure.   In both situations, the first, last, and parts in

between, bear on the profitability of the contract.    Contract

2034 was a financial and technological continuum for a 4-

contract-year period.   Instead of a series of 1-year contracts

which take 2-1/2 years each to complete, it was a 4-year contract

that took almost 7 years to complete.   Contract 2034 was a long-

term contract of the type for which CCM is a permissible method.

     We recognize respondent's argument that petitioner’s

reporting of any profit on the first group of aircraft would be

accelerated if Contract 2034 were severed into four separate

contracts.   However, we do not find that petitioner in any manner

distorted or abused CCM.   As a matter of principle, we must

accept that CCM permits deferral beyond that which would be

permitted under the accrual method.    We are unable to find that
                                - 65 -


the delay alone in these circumstances prevented petitioner’s

income from being clearly reported and reflected.

     It may be that use of CCM, per se, does not clearly reflect

income, but it is a method that petitioner was entitled to use

for the period under consideration.      Congress, for years after

1986, has practically banned the use of CCM for large contractors

and limited its use to 2-year contracts for certain smaller

contractors who meet specific requirements.      In that regard, the

legislative history, coupled with the structure of the post-1986

statute, make it obvious that CCM was not believed to clearly

reflect income in general.   That proscription, however, does not

apply to the years before us.

     In addition, we are not confronted with the type of “gross

distortion” discussed in Ford Motor Co. v. Commissioner, 102 T.C.

at 100-101.   In that case, the taxpayer deducted the total cost

of structured settlements in the year the settlement was reached

and made annual payments over an extended period of years, far in

excess of the period of deferral in this case.      Also, as earlier

noted, the difference between petitioner’s reporting and

respondent's determination in terms of the amount of delay

becomes nominal and then disappears as the deliveries approached

the fourth program year of Contract 2034.      There was no

difference between respondent's and petitioner’s approaches as

they applied to the 1985 year, other than the question of

severance, because in either case income and deductions would be
                               - 66 -


reported for 1987.   Finally, Contract 2034 was fully funded

before the first severed annualized reporting period matured for

tax reporting purposes.

     Accordingly, under the regulation by which the question of

severance and/or aggregation of long-term contracts is to be

judged, we find that respondent's determination that Contract

2034 must be severed was without sound basis in law and/or fact

and, thus, was arbitrary or capricious.

II. Should Contract 2038 Be Treated as a Long-term Contract and
Reported Under the Completed Contract Method?

     Respondent determined that Contract 2038 is not a long-term

contract within the meaning of section 1.451-3(a), Income Tax

Regs.    Petitioner does not contend that Contract 2038 qualified

on its own as a long-term contract.     Nor does petitioner contend

that the services performed under Contract 2038 (the MSIP

contract) were of benefit solely to Contract 2034.    Instead,

petitioner argues that the services performed under the MSIP

contract were incidental to and necessary for performance of

Contract 2034 and should be accounted for as part of Contract

2034 under petitioner’s completed contract method of accounting.

Even though Contract 2038 is substantial and completely separate

from Contract 2034, petitioner seeks to treat Contract 2038 as

though it consisted of incidental indirect costs attributable to

a long-term contract as described in various regulations cited

below.
                             - 67 -


     A “long-term contract” is defined in section 1.451-

3(b)(1)(i), Income Tax Regs., as a building, installation,

construction, or manufacturing contract which is not completed

within the taxable year in which it is entered into.    Contract

2038 does not meet that definition.    Contract 2038 provided for

services under MSIP, an engineering and development program, viz,

it was in essence a contract for the performance of services.

     Petitioner’s argument, in essence, is that Contract 2038 is

incidental to and necessary for performance of Contract 2034.

Petitioner relies on a labyrinth of related regulation sections

involving CCM, section 1.451-3(a)(1), 1.451-3(d)(5)(i) or (6)(i),

1.451-3(d)(5)(iii), 1.451-3(a)(3), and 1.451-3(d)(5), Income Tax

Regs., in support of its position.    Petitioner contends that

certain indirect costs and expenses attributable to long-term

contracts, including direct labor costs and direct material costs

that are incidental to and necessary for the performance of a

long-term contract, should be allocated to that contract.

     Based on the above regulations, petitioner argues that

respondent has sanctioned petitioner’s position by interpreting

section 1.451-3(d)(5), Income Tax Regs., in a manner that would

permit research expenses that are incidental to and necessary for

the performance of a long-term production contract to be

allocated to and accounted for with a long-term contract.

Petitioner directs our attention to the following language from
                                  - 68 -


G.C.M. 39803 (Nov. 16, 1989) (citing section 1.451-3(d)(9)(x)(E),

Income Tax Regs.):

          Income and expenses attributable to * * * services
     that directly benefit or are performed by reason of a
     taxpayer's long-term contract should be accounted for
     as part of the long-term contract that is benefited
     and, thus, should be accounted for under taxpayer's
     method of accounting for the subject matter of the
     long-term contract.

            *        *       *       *       *      *      *

     engineering and design costs that are incidental to and
     necessary for the performance of non-extended period
     long-term contracts are allocable contract costs.

     Respondent counters that section 1.451-3(d)(9), Income Tax

Regs., concerns “extended period long-term contracts” and that

neither Contract 2034 nor Contract 2038 fits within that

category.       Respondent also notes that the contracts would have

qualified as extended period long-term contracts under another

regulation section, but the referenced section is applicable for

long-term contracts entered into after December 31, 1982, so that

Contracts 2034 and 2038 do not qualify.       See sec. 1.451-3(g)(1),

1.451-3(d)(6), Income Tax Regs.       Next, respondent points out that

section 1.451-3(d)(9), Income Tax Regs., is limited in

application to those contracts to which section 1.451-3(d)(6),

Income Tax Regs., applies.       Finally, respondent admits that after

all of the above analysis there is an exception provided for in

section 1.451-3(d)(9)(x)(E), Income Tax Regs., which section is

applicable to all long-term contracts.       Respondent, however,

contends that section 1.451-3(d)(9)(x)(E), Income Tax Regs.,
                              - 69 -


contains the further caveat that costs properly accounted for are

not otherwise to be allocated in accord with the section formula.

     The regulations and other authority cited by petitioner in

support of treating Contract 2038 as part of Contract 2034 for

CCM reporting are directed at specific income, expenses and/or

costs which are incidental or inconsequential to a long-term

contract.   Although the services performed under Contract 2038

were necessary for the performance of Contract 2034, respondent

did not err by disallowing petitioner’s approach of treating

Contract 2038 as part of a long-term contract for income tax

reporting purposes.   Petitioner must fail here because Contract

2038 is a separate and substantial agreement for which a separate

accounting is required.   Contract 2038, as a separate contract,

is only partially related to Contract 2034.   Petitioner reports

its income for Federal tax purposes under differing methods of

accounting, depending on the type of contract it is performing.

In that regard, Contract 2038 is not a long-term contract and

does not separately qualify for the completed contract method of

tax accounting.   As noted above, the income and expenses

attributable to services under Contract 2038 are the substance of

a separate and substantial contract for services, separate and

apart from Contract 2034, and should not be treated as incidental

or inconsequential to Contract 2034.   Contract 2038 is a

separately reportable contract and does not merely constitute

indirect costs and expenses attributable to a long-term contract.
                             - 70 -


The regulations and G.C.M. relied on by petitioner are not

intended to reach the result petitioner seeks.

     To reflect the foregoing,

                                      An appropriate order will be

                                 issued.
