United States General Accounting Office

GAO Report to the Honorable

Russell D. Feingold, U.S. Senate

December 1998 DEFENSE TRADE

U.S. Contractors

Employ Diverse

Activities to Meet

Offset Obligations

GAO/NSIAD-99-35

GAO United States

General Accounting Office

Washington, D.C. 20548

National Security and

International Affairs Division

B-297767 

December 18, 1998

The Honorable Russell D. Feingold

United States Senate

Dear Senator Feingold:

This report provides information you requested on the types of activities

undertaken by U.S. contractors to meet offset obligations associated with

the sale of defense equipment to various foreign governments. Offsets are

the entire range of industrial and commercial benefits that are provided to

foreign governments as inducements or conditions for the purchase of

military goods and services. They include, for example, coproduction and

subcontracting, technology transfers, in-country procurements, marketing

and financial assistance, or joint ventures.

Our review examined offset transactions of six major U.S. defense

contractors. We obtained and analyzed data for over 100 offset

transactions on defense weapon system procurements by countries in the

Middle East, Europe, and Asia. The transactions were primarily from

ongoing or recently completed offset programs reflecting both high and

low dollar procurements and tied to foreign military sales (FMS) contracts.

Although the sample is not statistically valid, contractors have indicated

that these transactions are representative of their offset activities.

Results in Brief Companies undertake a broad array of activities to satisfy offset

requirements. Under offset programs, U.S. contractors commonly award

subcontracts for components and subsystems to firms in purchasing

countries, and in a few cases, have made longer term commitments

covering foreign firm participation in the event of future sales of weapon

systems. This activity has been accompanied by technology transfers, for

example, providing manufacturing technology needed to produce a

component. Placing contracts overseas has resulted in the emergence of

additional contractors that are qualified to participate in weapon system

development and production. However, the long-term supplier

relationships that develop may result in reduced business opportunities

for some U.S. firms. Nonetheless, the value of the export sale, in the

transactions examined, greatly exceeded the amount of work placed

overseas. For procurements not directly related to weapon systems, U.S.

prime contractors enlisted their major subcontractors, their suppliers, and

other foreign entities to help meet offset obligations.

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B-297767 

U.S. contractors also undertook a wide variety of activities that could be

labeled business development. These activities are similar to those that an

economic development ministry performs. Contractors provided technical

assistance to foreign firms across a wide range of technologies and

industries and assisted foreign firms in marketing their products in export

markets using the expertise of the contractors’ own organizations or

consultants. In a few cases, U.S. contractors advocated a foreign firm’s

product to the Department of Defense (DOD) or suppliers. In isolated cases,

offset transactions involved financial assistance to subsidize particular

export sales. These transactions were limited to foreign markets and

therefore did not involve improper incentive payments under U.S. law.

U.S. contractors also facilitated or established joint ventures with firms in

the offset country. While a country’s economic development ministry

might perform similar activities, the offset program allowed the country,

or firms in the country, to leverage the expertise and know-how of major

U.S. multi-national firms.

Background The ever increasing costliness of defense equipment, the limited defense

budgets, the concerns about employment levels, and the importance of

industrial competitiveness in a global economy have led governments to

leverage their imports of major weapon systems so as to yield benefits for

their domestic economies. Offsets are one way to achieve these benefits.

Such programs are often an essential part of a weapons procurement and

allow the purchasing government to build public support for large

expenditures of public funds. It is difficult to accurately measure the

impact of offsets on the overall U.S. economy and on specific industry

sectors.1

Military equipment is sold to foreign governments either by DOD through

the FMS program or by defense contractors as direct commercial sales.

These sales are accompanied by offset agreements that are established

between U.S. defense contractors and purchasing governments. Although

the U.S. government is a party to FMS agreements and issues licenses for

technology transfers as needed, it is not a party to offset agreements and

assumes no liability pursuant to the agreements.

In the past, contractors had to absorb the costs of offset implementation

against their negotiated profit margins. In 1992, however, DOD recognized

that contractors incurred such costs by allowing their recovery under FMS

1

Offset requirements are discussed in more detail in our 1996 report entitled Military Exports: Offset

Demands Continue to Grow (GAO/NSIAD-96-65, Apr. 12, 1996).

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B-297767 

contracts. Today, U.S. defense contractors may recover administrative

costs incurred to implement their offset agreements under certain

circumstances by charging such costs to the purchasing foreign

government through the FMS contracts. Figure 1 illustrates the U.S.

government’s “hands-off” policy on offsets and the offset relationships

between a U.S. contractor and a country purchasing FMS.

2

Figure 1: Offset Relationships

Foreign

Military

Sale

LOA

FAR

Purchasing

Country

Offset Offset Commercial

Munitions

Contract

Agreement Agreement Contract

License

Direct

Commercial

Sale

DOD

Offset

Administrative

Costs

U.S. Contractor 

Legend:

 LOA - Letter of Offer and Acceptance

 FAR - Federal Acquisition Regulations

Source: The Management of Security Assistance, Defense Institute of Security Assistance

Management, 17th Edition, May 1997, p. 303.

2

FMS acquisition, offsets, and offset relationships are discussed in chapter 11 of the Defense Institute’s

Security Assistance Management, 17th Edition, May 1997.

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B-297767 

Offset agreements ordinarily specify the level of offset required, normally

expressed as a percentage of the sales contract, and the types of activities

that are eligible for offset credits. Negotiating an offset credit is an

important part of implementing offset agreements because countries can

encourage companies to undertake highly desirable offset activities by

granting additional offset credit through multipliers. For example, a

country may grant an offset credit for advanced technology or training

activities based on what the country would have paid to procure or

develop the training or technology itself. Countries may also offer large

multipliers to encourage desired activities.3

Wide Spectrum of

Activities Contained

in Offset Agreements

Offset agreements contain a wide spectrum of activities that U.S.

contractors agree to undertake to satisfy their obligations. Offset

agreements tend to be specific in stating requirements and ways they are

to be satisfied. Offset activities can be grouped into the following

categories: coproduction and subcontracting related to defense items,

technology transfers, in-country procurements, marketing assistance,

financial assistance, and investments or joint ventures. Activities can fall

into more than one category. For example, coproduction activity may also

include the transfer of technology needed to improve production

processes. As another example, a contractor can buy carpet and display it

prominently in its executive lobby—a combination of in-country

procurement and marketing assistance activities. In addition, there are

other activities that do not fit within any of these categories.

Coproduction and

Subcontracting,

Technology Transfers, and

In-country Procurements

Are Widely Used

Coproduction tied directly to a weapons sale, subcontracting for

defense-related products, and technology transferred as part of those

arrangements, or separately, are transactions commonly found in the

agreements we reviewed. Procurements of goods and services not related

to the weapon system sales—indirect offset activities—were also

frequently used.

Coproduction and

Subcontracting

Coproduction occurs when defense companies located in offset countries

receive contracts to assemble, build, or produce articles for the weapon

system sale. Subcontracting occurs when a U.S. contractor procures

defense-related components and subsystems for export from suppliers in

countries where the contractor has offset obligations. Foreign

subcontracts are either competed within the purchasing country or

3

A multiplier is used to increase the value of an offset project when determining offset credit. For

example, if a company helped facilitate a $10,000 export of a product with particular importance, the

country could offer a multiplier of five, thereby increasing the amount of offset credit to $50,000.

Page 4 GAO/NSIAD-99-35 Defense Trade
B-297767 

directed to an entity within that country. Regardless, per the agreements,

U.S. contractors normally insist that the foreign companies meet certain

contract standards for price, quality, and delivery to become qualified

subcontractors. One U.S. contractor stated that foreign companies must

meet the same contract standards as those used to select qualified U.S.

subcontractors. Placing contracts overseas has resulted in additional

contractors who are qualified to participate in weapon system

development and production. However, the long-term supplier

relationships that develop may result in reduced business opportunities

for some U.S. firms. In the transactions we reviewed, coproduction and

subcontracting activities ranged from 2.5 percent to 66.7 percent of the

total offset obligation.

The following examples describe coproduction and subcontracting

activities. A U.S. contractor used two foreign defense companies to

assemble an aircraft and produce some of its components and parts.

Together, the U.S. contractor and foreign country determined that these

particular components and parts were compatible with the foreign

companies’ manufacturing processes and concluded they could be

produced at a lower cost by the foreign companies than by the U.S.

contractor.4

 These activities equated to about 8.8 percent of the total offset

obligation. According to the contractor, although the contractor did not

solicit any U.S. companies to compete for the contract, it determined that

the two foreign companies were competitive in their price, quality, and

delivery. An Asian government, per the offset agreement, specified that it

would select industry participants to manufacture airframe spares. This

would allow all four of the Asian country’s aerospace companies to

participate and achieve a proportionate share of the spares manufacture.

U.S. contractors have established longer term relationships covering

foreign firm participation in future sales of the weapon system and beyond

their commitment in the purchasing country. In many cases, the foreign

subcontractor will become a longer term supplier to the U.S. contractor

for that item being produced. For example, an American defense

contractor subcontracted a European defense company to assemble the

tail section for a particular aircraft system sold worldwide. The

manufacturing know-how was transferred to the company through a

Department of State approved manufacturing license. In another

illustration, a U.S. contractor subcontracted with a European company to

manufacture test sets for a weapon system sold worldwide.

4

We did not attempt to verify this conclusion because it was outside the scope of our review.

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Technology Transfers Technology transfer is widely used to fulfill offset obligations and often

accompanies coproduction and subcontract activities. It, however, is also

used in areas unrelated to defense procurements. From the contractors’

perspective, technology transfers are often a relatively inexpensive way to

earn offset credit because, in some cases, the contractors already possess

the technology the foreign government desires. In most cases, the value of

the technology transfer is negotiated between the U.S. contractor and the

foreign government. The negotiated value of the technology is often based

on the contractor’s prior investment in research and development, the

market value of the technology, or the cost to the foreign government for

developing the technology itself. Multiples of the negotiated value are also

used, depending on the value the foreign government places on certain

types of technology. For example, in one European country, the multiplier

for this activity varied between 1 and 20, depending on the benefits

received by that country’s industries. Recognizing the difficulty in

determining the value of technology transfer, an Asian country and a U.S.

contractor agreed to negotiate in good faith the mutually acceptable offset

credit amount based on such factors as the market value, the license fees

and royalties appropriate for such technology, the costs to transfer the

technology, the sale or benefits resulting from the transfer, or the

development costs of the technology.

Many of the purchasing countries prefer projects that require technology

transfers because the transfers generally provide manufacturing skills and

technical assistance that can be used to help the economic development

within the countries. For example, a European government wanted to

develop an in-country capability by using indigenous labor that would

perform flightline and special repair activity maintenance. Thus, a U.S.

defense contractor provided one of the country’s defense companies a

comprehensive technology transfer and training program that permitted

the foreign company to train its country’s Air Force personnel to operate,

maintain, and repair a weapon system in accordance with appropriate U.S.

military and manufacturer standards. The State Department permitted this

technology to be transferred by approving the technical assistance and

manufacturing license agreements between the two parties. The U.S.

contractor received an offset credit when the training program was

established, and it expects to earn future credit once the European

company trains other countries with this technology. In another example,

an Asian government, per the offset agreement, indicated a strong desire

to infuse technology into the country’s business in order to increase its

commercial business capabilities. To satisfy this desire, a U.S. contractor

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B-297767 

provided an Asian commercial company with technology and training in

the area of commercial component manufacture.

In-country Procurements In-country procurement is an indirect offset activity that entails purchases

of goods and services not related to the foreign weapon system sale. In

addition to the U.S. contractors making purchases, they also employ other

parties such as major subcontractors, suppliers, and foreign entities to

help meet their offset obligations. In a few cases, U.S. contractors

advocated a foreign firm’s product to DOD or suppliers. Suppliers will often

purchase items from foreign countries in which a U.S. contractor has an

offset obligation in an effort to strengthen relationships with the prime

contractor or to establish new relationships with other customers that will

eventually lead to future contracts. According to U.S. contractors, some of

these items are purchased because of need and at competitive prices,

others mainly to help satisfy an offset obligation.

Contractors often encourage their suppliers to participate in satisfying

their offset obligations. For example, one U.S. defense contractor uses its

supplier rating or performance evaluation system to encourage

participation. The system measures factors such as the affordability, the

quality, and the responsiveness (including offset cooperation as a

subfactor) of the supplier and the supplier’s goods. Depending on the

overall rating, a supplier may receive an increased percentage of

additional work from the contractor or recognition from other customers.

Another contractor holds periodic conferences or places a clause within

purchase orders as a means to inform suppliers of its offset obligations

with foreign countries.

Our review indicated U.S. suppliers purchased items that included a

recovery boiler, a batching system for producing float glass, satellite

hardware, a pulsed laser deposition system, a pressurized filtration device,

a turret punch press, a paper variability analyzer, an overhead crane

system, transformer equipment, communications equipment, and

ergonomic computer workstations. Foreign entities purchased 3-axle

trailers, ferries, and automobile parts.

Offset Transactions

Include Business

Development Activities

U.S. contractors also undertook a wide variety of activities that could be

labeled business development and are similar to those performed by an

economic development ministry.

Page 7 GAO/NSIAD-99-35 Defense Trade
B-297767 

Marketing Assistance Marketing assistance is defined as a U.S. contractor helping foreign

companies penetrate and develop U.S. and/or non-U.S. markets by

analyzing the market for the exporter’s product or assisting the exporter in

responding to a request for proposals. To help in this area, a U.S.

contractor often pays brokers or consultants a fee to provide such

services. For example, a U.S. defense contractor paid a U.S. broker to

coordinate the transfer of oil and gas refining technology from a European

oil company to an Indian oil company. The deal provided the opportunity

for the European company to penetrate a new market. In another case, a

U.S. contractor helped an Asian defense company that was performing

modification work for the U.S. Air Force in that region. Similarly, a U.S.

contractor paid a U.S. firm for helping a European company develop a

competitive proposal for a U.S. military contract. One final example of

marketing assistance involved a U.S. contractor funding a European

organization’s U.S. operations. The European organization promoted

products in the United States, made by its country’s small-sized, high

technology businesses. The U.S. contractor received credit for the initial

financial support, and it will receive credit for all future sales made to U.S.

buyers by the small European companies.

Financial Assistance Financial assistance is not as frequently used as others that we reviewed.

Financial assistance is defined as providing funds to a foreign company in

the country where the offset obligation exists to facilitate an export.

Financial assistance can be in the form of incentive payments and success

or service fees.5

 For example, a U.S. defense contractor paid a foreign

bank a service fee to provide financing assistance to a European

shipbuilding company so it could manufacture container ships. The funds

were used to complete the manufacturing of two vessels sold to a U.S.

shipping company. Another example involved a European automotive

parts manufacturer, a subsidiary of a U.S. automotive company, which

acquired 100 percent of a foreign automotive component company that

was going out of business. A U.S. defense contractor provided funds to the

foreign company to help defray the acquisition cost. The U.S. contractor

received an offset credit for assisting with the expenses. In another case, a

contractor sponsored and underwrote a portion of the expenses for a

European orchestra concert tour and industry export trade promotion

show held in the United States.

Investments and Joint Ventures Investments and joint ventures are occasionally used to satisfy offset

obligations. An investment or joint venture occurs when a U.S. contractor

5

In 1994, Congress passed the Feingold Amendment prohibiting incentive payments to induce U.S.

persons or companies to purchase foreign goods or services to satisfy offset agreements (section 733

of P.L. 103-236). These transactions do not fall within the coverage of the Feingold Amendment.

Page 8 GAO/NSIAD-99-35 Defense Trade
B-297767 

serves as a facilitator to bring parties together, provides start-up costs to

develop a new entity, or makes an equity investment in the foreign

country. For example, a U.S. defense contractor and a European defense

company negotiated a teaming agreement. Jointly, the team will develop

an upgraded weapon system that will generate worldwide sales. The U.S.

contractor, in turn, will receive an offset credit for its involvement in the

venture. In another case, a U.S. contractor and a European software

manufacturer established a joint development program to build software

links between a systems integrator and the software architecture.

Other Activities A few activities did not clearly fit into any of the other categories. For

example, U.S. contractors may generate potential offset credits through

activities that occur prior to contract award; a process called “banking”. In

one case, a successful contractor used banked offset credits to help satisfy

its offset obligation. In another case, a successful contractor bought the

unsuccessful contractor’s banked offset credits.

Agency Comments We requested comments on a draft of this report from the Departments of

Defense, Commerce, and State and U.S. contractors. DOD and State

officials responded that they did not have any comments. Commerce

stated the details of the report complemented its legislatively mandated

report on offsets (see app. I). The U.S. contractors did not provide written

comments but generally agreed with our description of offset activities.

Scope and

Methodology

To assess the activities undertaken by U.S. contractors to satisfy offset

obligations, we analyzed over 100 transactions contained in 19 ongoing or

recently completed offset programs by 6 major U.S. defense companies

with 12 purchasing countries. We selected the countries based on their

geographic locations and their purchases of foreign military equipment.

The purchasing countries were Finland, France, Germany, Greece, Korea,

Malaysia, Netherlands, Norway, Saudi Arabia, Switzerland, Turkey, and

Taiwan. The defense companies were chosen based on their roles as prime

contractors and subcontractors that provided offset services. The

companies were Boeing, General Electric, Lockheed Martin, Northrop

Grumman, Pratt & Whitney, and Raytheon.

We reviewed contractors’ records for tracking offset activities and offset

implementation costs charged to FMS contracts. We visited and interviewed

company officials to obtain detailed data describing the offset activities.

We examined supporting documentation for selected charges in order to

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B-297767 

develop a description of offset activities undertaken for each program. We

then summarized the activities by placing them into offset categories. The

contractors reviewed and agreed with our definitions of the offset

categories discussed previously. But, due to the proprietary nature of the

offset agreements and programs, we were limited in our ability to present

specific information on activities in these categories. In addition, we

reviewed offset data reported to the Department of Commerce6

 as well as

foreign subcontracting data reported to DOD.

7

We conducted our review from October 1997 to November 1998 in

accordance with generally accepted government auditing standards.

As agreed with your office, unless you publicly announce its contents

earlier, we plan no further distribution of this report until 30 days from the

date of this letter. At that time, we will send copies to interested parties

and make copies available to others upon request.

6

Under the Defense Production Act amendments of 1992, 50 U.S.C. app. 2099, U.S. firms entering into

contracts for the sale of defense articles or services to foreign countries or firms that are subject to

offset agreements exceeding $5 million in value are required to furnish certain information to the

Department of Commerce regarding such agreements. Since 1995, U.S. firms have been required to

report to the Bureau of Export Administration, on June 15 of each year, offset transactions that receive

offset credits of $250,000 or more claimed from a foreign country.

7

A U.S. firm that is performing or is bidding on a DOD contract exceeding $10 million is required by 10

U.S.C. 2410g to notify DOD if the firm or a first-tier subcontractor plans to perform more than $500,000

of the contract outside the United States and Canada and the work could be performed inside the

United States or Canada. DOD also administratively requires U.S. firms to submit a notification for

contracts exceeding $500,000, when any part that exceeds $100,000 will be performed outside the

United States.

Page 10 GAO/NSIAD-99-35 Defense Trade
B-297767 

Please contact me at (202) 512-4841 if you or your staff have any questions

concerning this report. Major contributors to this report were

Karen S. Zuckerstein, Lauri A. Kay, and Richard E. Burrell.

Sincerely yours,

Katherine V. Schinasi

Associate Director

Defense Acquisitions Issues

Page 11 GAO/NSIAD-99-35 Defense Trade
Appendix I 

Comments From the Department of

Commerce

(707306) Page 12 GAO/NSIAD-99-35 Defense Trade
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