Defense Acquisitions: Historical Analyses of Navy Ship Leases (Letter
Report, 06/25/1999, GAO/NSIAD-99-125).

The Navy recently proposed long-term leasing rather than outright
purchase of 12 auxiliary dry cargo ships. Historically, the Navy has
bought its combat ships and relied on long-term and short-term leases to
acquire some auxiliary vessels for supply and other support functions.
Although it now appears that the Navy will purchase the dry cargo ships,
its still considers long-term leasing an alternative to buying auxiliary
vessels. This report provides an historical analysis of the Navy's
decisions to lease Sealift tankers, Maritime Prepositioning Ships, T-5
replacement tankers, and Chouest specialized support vessels. GAO (1)
determines the basis and the support for the Navy's lease decisions, (2)
reviews past concerns about those decisions, and (3) identifies
legislative and regulatory changes that affect current and future
leasing decisions. This report updates an April 1999 testimony before
Congress. (See xxx/T-NSIAD-99-141.)

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  NSIAD-99-125
     TITLE:  Defense Acquisitions: Historical Analyses of Navy Ship
	     Leases
      DATE:  06/25/1999
   SUBJECT:  Military cost control
	     Leases
	     Naval procurement
	     Cost effectiveness analysis
	     Decision making
	     Military vessels
	     Comparative analysis
IDENTIFIER:  Navy Industrial Fund
	     T-5 Tanker
	     TAKX Maritime Prepositioning Ship
	     Sealift Tanker
	     U.S.S. Cory Chouest

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GAO United States General Accounting Office

Report to Congressional Requesters

June 1999 DEFENSE ACQUISITIONS

Historical Analyses of Navy Ship Leases

GAO/NSIAD-99-125

GAO/NSIAD-99-125

Page 1 GAO/NSIAD-99-125 Defense Acquisitions United States General
Accounting Office

Washington, D. C. 20548 National Security and International
Affairs Division

B-281374 Letter June 25, 1999 The Honorable John Warner Chairman,
Committee on Armed Services United States Senate

The Honorable Olympia Snowe Chairwoman The Honorable Edward
Kennedy Ranking Minority Member Subcommittee on Seapower Committee
on Armed Services United States Senate

To acquire 12 Auxiliary Dry Cargo vessels, the Navy recently
proposed using long- term leasing rather than outright purchase. 1
Historically, the Navy has purchased its combat ships, but it has
used long- and short- term leasing arrangements to acquire certain
auxiliary vessels to perform supply

and other operational support functions. Although it now appears
that the Navy will purchase the dry cargo vessels, it still
considers long- term leasing an alternative to purchasing
auxiliary vessels.

This letter responds to your request for a historical analysis of
the Navy's decisions to lease Sealift tankers, Maritime
Prepositioning Ships, T- 5 replacement tankers, and Chouest
specialized support vessels. Specifically, we (1) determined the
basis and support for the Navy's lease decisions, (2) reviewed
past concerns regarding those decisions, and

(3) identified legislative and regulatory changes that affect
current and future leasing decisions. On April 21, 1999, we
testified on some historical insights into Navy ship leasing. This
report updates the information

provided in that testimony. 1 In 10 U. S. C. 2401, a long- term
lease is defined as a lease, charter, service contract, or
conditional sale agreement that lasts for a period of 5 years or
longer (including options to renew or extend the initial term of
the lease), for a period of more than one- half the useful life of
the vessel, or for a period of 3 years or longer (including
options to renew or extend the initial term of the lease) when
certain investment tax credits or depreciation are claimed by the
lessor. For the purposes of this report, a short- term lease is
any lease, charter, or service contract that does not meet the
definition of a long- term lease provided in 10 U. S. C. 2401.

B-281374 Page 2 GAO/NSIAD-99-125 Defense Acquisitions

Results in Brief The primary reason the Navy decided to use long-
term leases to acquire auxiliary vessels in the early 1970s and
early 1980s was the ability to

acquire the vessels without a large, up- front obligation of
procurement funds, which were being used to purchase combat ships
and meet other Navy procurement priorities. The Navy also cited
readiness and industrial base concerns as reasons for entering
into the long- term lease

arrangements. Cost- effectiveness was not the primary factor in
the Navy's decisions. The Navy complied with then- existing
requirements to perform lease versus purchase cost analyses, and
its analyses concluded that leasing was more cost- effective than
purchasing. When the Navy entered into these long- term leases,
concerns arose regarding (1) the budget authority needed to make
such large, long- term funding commitments and (2) the cost-
effectiveness of such commitments. After entering into the long-
term arrangements of the early 1980s, the Navy

expressed concerns about the total amount it should record as a
firm obligation in the Navy Industrial Fund. 2 Congress was also
concerned about whether the Navy Industrial Fund could adequately
cover the total obligations that would accrue from these leases.
To address these concerns, the Navy requested and received
congressional authorization to

carry out the acceptance provisions of the long- term leasing
contracts and incur obligations in advance of appropriations. The
cost- effectiveness of these long- term commitments was also
questioned. At the time, there were limited guidelines for
conducting lease versus purchase analyses. As a result, cost
studies used different assumptions and methodologies in

analyzing the alternatives and drew different conclusions about
the cost- effectiveness of leasing. In 1983, our report and a
congressional staff study questioned the validity of the
assumptions used in the Navy's studies and their conclusions. 3
Had the Navy's studies used assumptions that more fully reflected
the government's total costs, they would have concluded that
purchasing was the cheaper alternative.

Since the long- term leasing decisions of the early 1970s and
early 1980s, a number of changes in oversight and cost analyses
have occurred that will 2 At that time, the Navy Industrial Fund
was a revolving fund that provided products and services, and it
was reimbursed for those products and services by its customers
out of operation and maintenance appropriations.

3 Improved Analyses Needed to Evaluate DOD's Proposed Long- Term
Leases of Capital Equipment (GAO/PLRD-83-84, June 28, 1983) and
Tax Aspects of Federal Leasing Arrangements, Staff of the Joint
Committee on Taxation JCS 3- 83 (Feb. 25, 1983).

Lett er

B-281374 Page 3 GAO/NSIAD-99-125 Defense Acquisitions

affect current and future long- term lease decisions. Through
legislation, Congress has increased its control over leases
lasting 5 years or more and made the leasing decision more
transparent. Additionally, budget- scoring guidelines have
increased the emphasis on up- front budget authority by providing
Congress with a mechanism to assess the cumulative impact of long-
term leasing decisions prior to the obligation of funds. Finally,
tax benefits, which made leasing an attractive option to the Navy,
have been reduced, and more detailed guidelines now require that
the Navy perform lease versus purchase analyses that better
reflect the government's total cost of long- term leasing
arrangements.

Background The Military Sealift Command is responsible for
administering the Department of Defense's (DOD) leases of
auxiliary vessels. In the early 1970s and early 1980s, the Navy
used long- term leases, called charter and build arrangements, to
acquire Sealift tankers, Military Prepositioning Ships (MPS), and
T- 5 replacement tankers. Under these arrangements, the private
sector lessors arranged for the construction, long- term
financing, and delivery of the vessels. In return, the lessors, as
owners of the ships, receive a return on their investment from the
Navy's lease payments, tax

benefits, and the residual value of the vessels at the end of the
leases. The Navy leased the vessels for 20 to 25 years and agreed
that it would pay scheduled termination costs if it canceled the
leases. The termination

costs ensure that lessors will recover their investment plus a
specified rate of return.

In 1972, the Navy entered into contracts with two contractors for
the long- term lease of nine Sealift tankers. These tankers were
put into service in 1974 and 1975, but are no longer being leased.
In 1982, the Navy awarded 13 separate contracts (based on offers
received from 3 different companies) for the long- term lease of a
total of 13 MPS vessels. Each contract was awarded to a separate
special purpose corporation. The first of these 13 vessels was
delivered to the Navy in September 1984, and all remain under
lease. Also in 1982, the Navy awarded contracts for the long- term
lease of five newly constructed T- 5 replacement tankers. The
first of these tankers was delivered in June 1985, and all remain
under

lease. The Navy has used a different type of lease arrangement to
acquire the specialized support services of vessels owned and
operated by Edison Chouest Offshore. Since 1988, the Navy has used
the small- to medium- sized Chouest vessels for transportation
services and special

B-281374 Page 4 GAO/NSIAD-99-125 Defense Acquisitions

missions, such as oceanographic surveillance and research.
Generally, these vessels have been leased through short- term
leases that consist of a fixed period of 17 months or less
followed by multiple option periods of 17 months or less that,
when combined, do not exceed 5 years. With 30- days notice, the
Navy can cancel these short- term leases during the option period
without incurring termination costs. In addition to these short-
term leases, the Navy entered into a 5- year, long- term lease for
the Cory Chouest in 1998. For the long- term lease of the Cory
Chouest, the

Navy's termination costs are limited to redelivering the vessel to
its owner in its original condition, with normal wear and tear
excepted. Under both the short- and long- term leases of the
Chouest vessels, the Navy's lease payments cover the services of
the vessel, crew, and its operation and maintenance on a daily use
basis.

Since 1969, a DOD instruction has required DOD components to
perform economic analyses of lease versus purchase decisions. 4
Following the long- term leasing decisions of the early 1980s,
Congress enacted statutory provisions that require specific
analyses or determinations to be made prior to entering into
certain types of leasing arrangements. These statutes and other
guidelines do not apply to the short- term leases of Chouest
vessels, and as a result, the Navy is not required to perform
lease versus

purchase analyses prior to entering into these short- term
arrangements. Basis and Support for Lease Decisions

Cost- effectiveness was not the primary reason for the Navy's
decisions to lease auxiliary vessels in the early 1970s and early
1980s. According to Navy officials, the primary reason for
proposing long- term lease( s) was the

need to devote procurement funds to higher priority combat ships.
Long- term leasing allowed the Navy to meet its support
requirements without a large, up- front obligation of procurement
funds. Had the Navy

purchased these vessels, funds would have been obligated from the
Navy's Shipbuilding and Conversion procurement appropriation;
payments would have been required prior to delivery over the
relatively short construction phase; and auxiliary ships would
have had to compete with combat ships for procurement funds. By
leasing the vessels, the Navy believed it could spread payments
over the length of the leases and use its annual Operation and
Maintenance appropriations to fund them without incurring an up-
front obligation of the total lease amount.

4 Since 1969, this instruction (DOD Instruction 7041. 3) has been
revised twice, in 1972 and 1995.

B-281374 Page 5 GAO/NSIAD-99-125 Defense Acquisitions

Readiness was an additional factor cited in the Navy's decision to
enter into long- term leases for auxiliary vessels. For example,
the Navy believed that the MPS vessel program could not fulfill
its mission effectively unless all 13 vessels could be acquired in
a short period. However, available procurement funds were
insufficient to purchase enough MPS vessels to fulfill the
Marines' requirement for prepositioned equipment and supplies in
three strategic locations around the world. Through the long- term
leasing arrangement, the Navy acquired all 13 vessels by 1986 4
years after the contracts were awarded.

Industrial base concerns were another factor in the decision to
lease the MPS vessels and T- 5 replacement tankers in the early
1980s. At that time, the commercial shipbuilding sector was in
decline. A Navy official stated in a 1983 hearing that projects
such as the MPS and T- 5 replacement tanker programs were needed
to prevent the potential closing of several commercial shipyards
and to protect the nation's industrial base. 5

Cost- effectiveness was not the primary reason for the Navy's
lease decisions, but the Navy maintained that long- term leasing
was a cost- effective way of acquiring the services of auxiliary
vessels. Cost studies provided by the Navy, together with
historical references to Navy analyses in our 1973 report 6 and in
congressional hearings in 1982 and

1983, 7 indicate that the Navy complied with DOD requirements to
perform lease versus purchase cost analyses in support of its
long- term leasing decisions for the Sealift tankers, MPS vessels,
and T- 5 replacement tankers. The Navy's analyses showed that
long- term leasing would be cheaper than purchasing. Flexibility
and cost- effectiveness are cited as the primary reasons for
leasing the Chouest vessels. According to a Military Sealift
Command official, flexibility is important because the military
requirements for

5 Federal Leasing Practices Hearing before the Subcommittee on
Oversight of the Committee on Ways and Means, House of
Representatives, 98 th Congress, First Session, February 28, 1983.
6 See Build and Charter Program for Nine Tanker Ships (B-174839,
Aug. 15, 1973). 7 See Hearing on Contract Awards for Charter and
Conversion of the TAKX Pre- Positioning Ships Program before the
Readiness Subcommittee of the Committee on Armed Services, House
of

Representatives, 97 th Congress, Second Session, September 17,
1982; Federal Leasing Practices Hearing before the Subcommittee on
Oversight of the Committee on Ways and Means, House of
Representatives, 98 th Congress, First Session, February 28, 1983;
and Governmental Lease Financing Reform Act Hearing before the
Committee on Finance, U. S. Senate, 98 th Congress, First Session,
July 19, 1983. The TAKX program is now commonly referred to as the
MPS program.

B-281374 Page 6 GAO/NSIAD-99-125 Defense Acquisitions

special mission vessels, as well as the funding for these
requirements, are frequently uncertain. The lease arrangements for
the Chouest vessels provide military users the flexibility to
obtain commercial vessels for

short- term, specific technological and design needs. Military
users like short leases because they can return the vessel to its
owner rather than retain an asset that they no longer need once a
mission is completed or that they can no longer afford once
funding is discontinued. While lease versus purchase analyses were
not required for the short- term leases of the Chouest vessels,
such an analysis was performed before the Navy entered into a 5-
year, long- term lease for the Cory Chouest. This analysis
concluded that it was in the government's best interest to lease
this vessel instead of purchasing a similar vessel. The Navy found
that the

government would save approximately $3 million to $15.4 million by
leasing the Cory Chouest from 1998 through 2003 rather than
purchasing a comparable vessel. Concerns About

Budget Authority and Supporting Analyses

The Navy's decisions to enter into long- term leases raised
concerns about whether (1) the Navy had sufficient budget
authority to cover the total cost of the leases, especially
termination costs if the leases were canceled and (2) the Navy's
lease versus purchase analyses adequately reflected the
government's costs.

Concerns Regarding Budget Authority

Under the Navy's ship leasing programs, the leases were to cover a
base period of 5 years, renewable up to 20 or 25 years at 5- year
intervals, with substantial termination costs for failure to
renew. After entering into the long- term leasing arrangements
with the contractors in the early 1980s, the Navy became concerned
about the total amount it should record as a firm obligation in
the Navy Industrial Fund once the lease period started, and it
requested our legal opinion. Following the request, Congress
expressed

concern about the adequacy of the Navy's budget authority to cover
the total long- term obligations that would accrue from these
leases. We 8 concluded that once the Navy, through acceptance of
vessel delivery, agreed to commence the lease, it must record the
leases as firm obligations in an amount sufficient to cover lease
payments for the 5- year base period plus the gross termination
expenses should the leases not be renewed at the end of the 5
years. If the Navy Industrial Fund did not have an existing

8 62 Comp. Gen. 143, B-174839 (Jan. 28, 1983), Navy Industrial
Fund: Obligations in Connection with Long- Term Vessel Charters.

B-281374 Page 7 GAO/NSIAD-99-125 Defense Acquisitions

unobligated balance sufficient to cover these costs at the time of
the delivery of all the vessels, it would be in violation of the
Antideficiency Act. 9 The opinion contained suggested actions the
Navy could take to increase its funding authority and avoid such a
violation. One option was to obtain specific contract authority
from Congress. The Navy subsequently requested and received such
authority from Congress to proceed with the leasing arrangements
in the absence of an appropriation

covering the total potential termination liability. 10 The
following year, Congress provided the Navy additional contract
authority, which allowed the Navy to proceed with the leasing
arrangements in the absence of an appropriation or existing
unobligated balance sufficient to cover the total

lease payments for all 5 years of the 5- year base period. 11
Specifically, under these authorities granted by Congress, the
Navy was only required to record annually against its industrial
fund an amount equal to the estimated lease payments for the then
current lease year for the MPS and T- 5 replacement tanker leases.
With respect to the termination liability, the authority required
that the Navy record against its then current fiscal

year Operation and Maintenance appropriation an amount equal to
only 10 percent of the gross termination costs that would be due
for failure to renew the leases. Without these authorities, the
Navy would have been required to record the full amount of the
gross termination costs and the full amount of the estimated lease
payments for the first 5- year base period of the leases. A study
conducted on the Navy's behalf in 1983 determined that the highest
termination values for the MPS program occurred during the first 5
years; the termination liability for failing to renew the lease
after this period was estimated to be 128.1 percent of the
lessor's cost to acquire

the ship. Concerns Regarding Cost- Effectiveness of Leasing

The Navy complied with DOD requirements to perform lease versus
purchase cost analyses in support of its long- term leasing
decisions in the early 1970s and early 1980s. However, guidelines
for such analyses at that time were neither detailed nor specific.
As a result, the outcomes of these analyses were influenced by the
methodologies and assumptions used in

9 The Antideficiency Act, codified in 31 U. S. C. 1341, prohibits
authorizing or incurring obligations or expenditures in excess of
amounts available in an appropriation or fund unless authorized by
law. 10 Supplemental Appropriations Act of 1983 (P. L. 98- 63).

11 Appropriations Act of 1985 (P. L. 98- 473).

B-281374 Page 8 GAO/NSIAD-99-125 Defense Acquisitions

each study. Although the methodologies and assumptions the Navy
used showed leasing to be cheaper, our 1983 review of the Navy's
decision and a study by the Joint Committee on Taxation used
different methodologies and assumptions and found purchasing to be
the cheaper alternative. Specifically, the Navy's lease versus
purchase cost comparison for the MPS vessels concluded that the
government would save $29.3 million per ship by leasing the 13 MPS
vessels. However, the MPS study conducted by the

Joint Committee staff concluded that outright purchase would be
cheaper by $20.8 million per ship. Our 1983 report concluded that
it would cost between $11.9 million and $38 million more per ship
to lease the MPS

vessels. The differences between the studies' conclusions are a
result of different methodologies and assumptions regarding (1)
tax revenues, (2) residual values, and (3) discount rates.

The majority of the differences between the Navy study and the
congressional staff study were attributed to differing assumptions
regarding how to account for tax revenue. The Navy study reduced
the total cost of the lease to the government by the taxes that
would be paid on interest income received by the lenders that
financed a portion of the ship's acquisition. The committee
staff's methodology did not include these taxes

as a source of government revenue. The methodologies and
assumptions used in both studies were acceptable under then
existing guidelines; however, in our June 1983 report, we
supported the committee staff study's decision not to consider
these taxes because the Treasury would receive taxes on the income
earned from either a lease or a purchase. Another key difference
between the Navy and committee staff studies was the treatment of
residual values. The residual value of a vessel is an estimate
measure in present value terms of what that vessel could be sold
for at the end of the lease term. The Navy's study of the MPS
program assumed that the vessels would have no residual value at
the end of their 25- year leases, whereas the committee staff
assumed that the residual value of the ships would be nearly 60
percent of the original cost of the ships. While it is not clear
if a residual value of 60 percent was appropriate, a residual
value of zero was not consistent with Internal Revenue Service
(IRS) requirements at the time. Had the residual value been
assumed to be 20 percent, which would be consistent with the
minimum IRS requirements at the time, the cost advantage of
leasing identified in the Navy's study

would be reduced. In our 1983 review of these studies, we agreed
with the staff study's assumption that the vessels would have a
residual value at the end of the lease terms.

B-281374 Page 9 GAO/NSIAD-99-125 Defense Acquisitions

Determining whether leasing is more economical than purchasing
also depends on the discount rate used to adjust the total value
of lease payments to recognize the time value of money the lost
opportunity to invest the money and earn interest. A lower
discount rate makes purchasing a more economical option, while a
higher rate makes leasing more economical. When the lease versus
purchase analyses were performed for the long- term leasing
arrangements of the early 1970s and

early 1980s, there was some flexibility regarding what discount
rate to use in the analysis. In prior reports, we expressed
concern regarding the discount rates used in the Navy's lease
versus purchase analyses. For example, in a 1973 report on the
Navy's analysis of the Sealift tanker program, we found that the
Navy had inappropriately selected a high discount rate. 12 Had the
Navy used the lower and more appropriate rate, it would have found
that the cost of leasing exceeded the purchase cost. In our 1983
report, we questioned whether the prescribed Office of Management
and Budget (OMB) discount rate was realistic, and in our analysis,
we used a discount rate based on the average yield on marketable
Treasury obligations, which we believed was a better reflection of
the

government's true cost of borrowing funds. Actual lease payment
and ship purchase cost data for the MPS vessels, T- 5 replacement
tankers, and Chouest vessels are provided in appendix I.

Changes That Influence Lease Decisions

Since the long- term leasing decisions of the early 1970s and
early 1980s, a number of changes have occurred that will affect
current and future long- term leasing decisions by increasing
oversight and improving cost analyses. Through legislation,
Congress has increased its control over these types of decisions
and made them more transparent. Additionally, scoring guidelines
now provide Congress with a mechanism to assess the

cumulative impact of long- term leasing decisions prior to the
obligation of funds. Reductions in tax benefits and changes in how
these benefits are treated in lease versus purchase analyses
minimize the loss of tax revenue and ensure that such a loss of
revenue is more fully considered in the decision. Finally, as part
of the decision- making process, more detailed

guidelines require that government agencies perform lease versus
purchase analyses that better reflect the government's total cost
for long- term leasing arrangements.

12 Build and Charter Program for Nine Tanker Ships (B-174839, Aug.
15, 1973).

B-281374 Page 10 GAO/NSIAD-99-125 Defense Acquisitions

Changes to Increase Congressional Control and Lease Decision
Transparency

Concerns about the budgetary impact of the leases' long- term
funding commitments and uncertainties about their cost-
effectiveness led Congress to establish a number of statutory
conditions and requirements for entering

into long- term leases as part of the fiscal year 1984 Department
of Defense Authorization Act (P. L. 98- 94) in September 1983.
These requirements, now codified in 10 U. S. C. 2401, increased
congressional control over certain lease decisions, made lease
decisions more transparent, and provided for the development of
more detailed guidelines for conducting lease versus

purchase cost comparisons. In general, 10 U. S. C. 2401 requires
that 13  DOD's long- term leases or charters of vessels and
aircraft, or leases or

charters with substantial termination liabilities, be specifically
authorized by law;  notice of intent to issue a solicitation for
such a lease or charter be given

to the Committees on Armed Services and on Appropriations of the
Senate and House of Representatives;  a detailed description of
the terms of the lease and a justification for entering into the
lease rather than purchase of the vessel be provided to

Congress;  an analysis comparing the costs of leasing to those of
purchasing be

submitted to Congress with any request for authorization of such a
lease;  such analysis be evaluated by OMB and the Treasury
Department; and  OMB and Treasury jointly issue guidelines for
determining under what

circumstances DOD may use lease arrangements rather than use
direct procurement. Additionally, Congress established statutory
requirements for certain leases lasting less than 5 years. Under
these requirements, now codified in 10 U. S. C. 2401a, a Secretary
of a military department cannot (1) enter into a leasing
arrangement that exceeds 18 months or (2) extend or renew such an
arrangement for a term of 18 months or more until the Secretary
has considered all costs of such a lease, including the estimated
termination

13 This statute did not apply to any lease or charter agreement
entered into before December 1, 1983. The Joint Explanatory
Statement of the Committee of Conference stated that nothing in
this section shall impede or affect the ability of the Secretary
of the Navy to proceed to acquire the use of thirteen T- AKX class
Maritime Prepositioning Ships and the use of five new T- 5 tankers
in accordance with the long term charter arrangements negotiated
by the Navy before the date of enactment of this Act. House
Conference Report No. 98- 352, p. 246.

B-281374 Page 11 GAO/NSIAD-99-125 Defense Acquisitions

liability. The Secretary must also determine in writing that the
contract is in the best interest of the government. Increased
Emphasis on Up- Front Budget Authority

At the time the Navy entered into the long- term leases in the
early 1970s and early 1980s, Congress' ability to assess the
cumulative impact of such arrangements prior to the obligation of
funds was limited. Since the Navy entered into these leases,
mechanisms for requesting budget authority have been more clearly
established, which increases the transparency of these

arrangements. The Balanced Budget and Emergency Deficit Control
Act of 1985 (P. L. 99- 177), as subsequently amended, 14
established statutory limits on federal government spending by
creating spending caps on discretionary spending. To track
progress against and compliance with budget enforcement
requirements and spending caps, budget scorekeeping

guidelines have been established for lease- purchases, capital
leases, and operating leases. 15 If the Navy were to now enter
into the types of leases it entered into in 1972 and 1982, the
current scorekeeping rules would require

that the Navy request up- front budget authority for the estimated
net present value of the government's total estimated legal
obligations over the life of the contract. Changes That Eliminate
Tax

Incentives Under leasing arrangements for the Sealift tankers, MPS
vessels, and T- 5

replacement tankers that were entered into prior to 1984, the
lessors qualified for special tax benefits. These benefits
included accelerated depreciation of the ship's cost and
deductions on interest payments that lowered the shipowners'
taxes. Consequently, shipowners passed some of

these benefits to the Navy in the form of lower lease payments,
which made leasing a more attractive option to the Navy. However,
these tax benefits also represented a loss of tax revenue to the
U. S. Treasury. The Deficit Reduction Act of 1984 (P. L. 98- 369)
modified tax laws and eliminated the benefits available to the
owners of assets leased to government entities; the act did not,
however, affect prior Navy leasing arrangements.

14 The Balanced Budget Act of 1997 (P. L. 105- 33) extended the
discretionary spending caps to 2002. 15 Preparation and Submission
of Budget Estimates, OMB Circular A- 11 (July 1, 1998).

B-281374 Page 12 GAO/NSIAD-99-125 Defense Acquisitions

More Detailed Guidelines Will Influence Future Cost Analyses

In October 1984, OMB and Treasury issued joint guidelines for
DOD's leases. These guidelines required that any special tax
benefits conveyed to the shipowner be added to the cost of a lease
in a lease versus purchase

analysis. 16 Additional OMB guidance was issued in 1992 to prevent
lease versus purchase analyses from understating the government's
total cost of leasing. Specifically, this guidance, which is to be
applied

government- wide, prescribes that analyses (1) should add special
tax benefits to the cost of leasing and (2) should not subtract
the normal payment of taxes on the lessor's income derived from
the leases from the

total lease costs. 17 Had this guidance been in place when the
Navy conducted its analyses of the MPS and T- 5 replacement tanker
lease programs, the analyses would have concluded that purchasing
was cheaper than leasing. OMB's 1992 guidance also addressed the
issue of discount rates. This

guidance prescribes that lease versus purchase analyses are to use
discount rates that reflect the Treasury's borrowing rate. OMB now
annually updates the discount rates to be used in the analyses.
Current

discount rates as prescribed in the OMB guidance are lower than
those used in the past analyses, and lower rates tend to make
leasing less attractive today.

Conclusions The Navy's decisions in the early 1970s and early
1980s to enter into long- term ship leases were based primarily on
the decision to acquire ships

without a large up- front obligation of procurement funds. The
Navy also believed leasing was more cost- effective than
purchasing the ships. These decisions were supported by certain
assumptions that were used in the absence of clear guidance.
Different economic assumptions would have supported purchasing,
rather than leasing, these ships. Our legal opinions

clarified requirements for such leases, and current budgetary
legislation and scoring guidance now emphasize up- front budgeting
for such leases. The elimination of tax advantages for leasing,
together with more detailed guidelines for conducting lease versus
purchase analyses, will make it more difficult to support long-
term leasing on a cost- effectiveness basis.

16 Joint OMB and Treasury Guidelines to the Department of Defense
Covering Lease or Charter Arrangements for Aircraft or Naval
Vessels (Oct. 31, 1984). 17 Guidelines and Discount Rates for
Benefit- Cost Analysis of Federal Programs, OMB Circular A- 94
(Oct. 29, 1992).

B-281374 Page 13 GAO/NSIAD-99-125 Defense Acquisitions

Scope and Methodology

To determine the basis and support for the Navy's decisions to
lease instead of purchase selected auxiliary vessels, we
interviewed and requested documents from Military Sealift Command,
Naval Sea Systems Command, Office of the Assistant Secretary of
the Navy (Financial Management Comptroller), Office of the Deputy
Chief of Naval Operations (Logistics),

and the Center for Naval Analyses officials in Washington, D. C.
We also interviewed officials from Edison Chouest Offshore in
Galliano, Louisiana; Avondale Industries, Inc., in New Orleans,
Louisiana; and the American Shipbuilding Association in
Washington, D. C. We also reviewed congressional hearings and
previous reports by us, Navy contractors, and others regarding the
leasing of vessels by the Navy, and we examined applicable laws
and regulations.

To review past concerns regarding the leasing decisions of the
early 1970s and early 1980s, we primarily relied upon
congressional hearings conducted in the early 1980s and previous
reports. We also interviewed Navy and Military Sealift Command
officials. To identify legislative and regulatory changes that
affect current and future long- term leasing, we examined
applicable laws, legislative histories, and regulations. We also
interviewed Military Sealift Command and industry officials.

We did not verify the reliability of the lease payment data
provided by (1) the Military Sealift Command from its contract
files and accounting systems and (2) in select cases, Edison
Chouest Offshore. The Military Sealift Command was unable to
provide lease payment data relating to the

Sealift tanker program. According to agency officials, the Sealift
tanker contracts had been closed out and specific payment records
sent to storage, and they could not be located and retrieved
within the time constraints of our review. The Military Sealift
Command also informed us that because of accounting changes, it
would be virtually impossible to obtain a complete and accurate
record of how much has been spent on technical or regulatory
upgrades and insurance on the four categories of auxiliary vessels
covered by our review. Therefore, we did not attempt to

replicate the Navy's prior lease versus purchase analyses. We
performed our review between November 1998 and March 1999 in
accordance with generally accepted government auditing standards.

Page 14 GAO/NSIAD-99-125 Defense Acquisitions

Agency Comments and Our Evaluation

DOD did not provide written comments. However, in oral comments on
a draft of this report, DOD did not take issue with the
information presented in it. DOD suggested certain technical
clarifications, and we have incorporated them in the text where
appropriate.

We are sending copies of this report to Senator Robert Byrd,
Senator Carl Levin, Senator Joseph Lieberman, Senator Ted Stevens,
Senator Fred Thompson, Representative Dan Burton, Representative
David R. Obey, Representative Ike Skelton, Representative Floyd D.
Spence, Representative Henry A. Waxman, and Representative C. W.
Bill Young in their capacities as Chairmen or Ranking Minority
Members of Senate and

House Committees. We are also sending copies of this report to the
Honorable William S. Cohen, Secretary of Defense; the Honorable
Richard Danzig, Secretary of the Navy; Rear Admiral Gordon S.
Holder, Commander, Military Sealift Command; and the Honorable
Jacob J. Lew, Director, Office of Management and Budget. Copies
will be made available

to others upon request. If you or your staff have any questions
concerning this report, please call the contacts listed in
appendix II.

James F. Wiggins Associate Director Defense Acquisitions Issues

Page 15 GAO/NSIAD-99-125 Defense Acquisitions

Page 16 GAO/NSIAD-99-125 Defense Acquisitions

Appendix I Lease Payment and Ship Cost Data Appendi x I

As requested by the Subcommittee, this appendix summarizes actual
lease payment data for the Military Prepositioning Ships (MPS)
vessels, T- 5 replacement tankers, and selected Chouest vessels.
For the MPS vessels and T- 5 replacement tankers, the lessors'
original cost to acquire the ships is also provided; such data are
not available for the Chouest vessels.

MPS Vessels and T- 5 Replacement Tankers

Actual lease data are available for the MPS vessels and the T- 5
replacement tankers, but such data are not available for the
Sealift tankers. The data identify the lessors' cost to acquire
the ships the capitalized costs and

the total lease payments of the lease period. 1 However, the data
do not reflect all the costs that would be considered in a lease
versus purchase analysis. Table I. 1 shows the present value as of
fiscal year 2000 of the capitalized costs, the total lease
payments, and their difference for the MPS vessels and T- 5
replacement tankers.

Table I. 1: Present Value of Total Lease Payments and Capitalized
Costs for MPS Vessels and T- 5 Replacement Tankers (in constant
fiscal year 2000 dollars)

a Calculation of total lease payments assumes that the leases will
not be terminated prior to the completion of their 20- and 25-
year terms.

b To do the present value calculations, we used an Office of
Management and Budget (OMB) prescribed rate of 2.9 percent. All
values have been rounded. Source: GAO analysis of Military Sealift
Command contract data.

Based on this present value analysis, the total lease payments for
both the MPS vessels and T- 5 replacement tankers are less than
the capitalized costs of the ships, which suggests that it was
cheaper for the Navy to lease these vessels. However, an analysis
that only considers lease payments and

1 The capitalized cost of a vessel is determined upon the delivery
of that vessel and represents the acquisition costs incurred by
the vessel's lessor. Included within these acquisition costs are
the construction price, interest on interim financing, and other
costs associated with the construction and

delivery of the vessel.

Type of ship Numberof ships Length of

leases a Presentvalue

of total lease payments b

Present value of total capitalized costs Difference

MPS vessels 13 25 years $4.7 billion $5.1 billion $474 million T-
5 replacement

tankers 5

20 years $655 million $736 million $81 million

Appendix I Lease Payment and Ship Cost Data

Page 17 GAO/NSIAD-99-125 Defense Acquisitions

capitalized costs does not fully account for the government's
total costs. Under the leasing arrangements for these ships, the
owners qualified for tax benefits, including accelerated
depreciation rates, interest deductions

on the long- term debt, and amortization deductions for certain
elements of vessel cost. These tax benefits, along with the lease
payments and residual value, provide the owners with a net return
on investment. A portion of these tax benefits was passed on to
the Navy in the form of reduced lease payments, which made leasing
more attractive to the Navy. These lower lease payments do not
fully offset the loss of tax revenue to the U. S. Treasury. The
government's total cost for these lease arrangements, therefore,
consists of not only the lease payments, but also the loss of tax
revenue as a result of the tax benefits that were available to the
lessors as shipowners.

Chouest Vessels Since 1988, the Navy has used short- term leases
to acquire the services of 19 Chouest vessels. While the Navy has
leased some of these Chouest vessels for a total of 5 or more
years under a series of short- term leases, each short- term lease
was awarded pursuant to separate, fully competed solicitations.
Lease payments for Chouest vessels include not only the services
of these vessels, but also their crew, operations, maintenance,
and other costs; these costs are not broken out separately. Table
I. 2 shows the approximate total lease payments for selected
Military Sealift Command short- term leases of Chouest vessels
from the inception of the initial leases through fiscal year 1998.
2 For example, the Laney Chouest was first leased

in 1988 for 17 months with two 17- month extension options, then
leased again under a new contract in 1992 for the same length of
time, and then under a third contract beginning in 1997 for 15
months. In 1998, the Laney Chouest was returned to its owner; it
is the only vessel in table I. 2 that is no longer leased by the
Navy. During the 10- year period that the

Navy leased the Laney Chouest under consecutive, separate short-
term contracts, it paid the contractor approximately $42.6 million
in lease payments.

2 Beginning in 1994, the Navy has also leased harbor tugs from
Edison Chouest Offshore. Currently, 13 Chouest tugs are operating
under Navy leases in California, Florida, and Georgia.

Appendix I Lease Payment and Ship Cost Data

Page 18 GAO/NSIAD-99-125 Defense Acquisitions

Table I. 2: Total Short- Term Lease Payments for Chouest Vessels
Through Fiscal Year 1998

a Lease payment data for the Laney Chouest were available for only
fiscal years 1989 through 1998. b At the start of fiscal year
1999, the Navy's long- term lease of the Cory Chouest commenced.
This table does not present the payments associated with this
long- term lease. Source: GAO analysis of Military Sealift Command
and contractor accounting data.

On October 1, 1998, the Military Sealift Command commenced a new
long- term contract to charter the Cory Chouest an oceanographic
surveillance vessel used as a platform for the Surveillance Towed
Array Sensor System (SURTASS) and Low Frequency Active (LFA)
acoustic detection system. The Cory Chouest will be chartered
through the year 2003 because of delays in the delivery of the
Navy's new T- AGOS 23 vessel, The Impeccable. The Cory Chouest is
currently performing the mission

that The Impeccable is expected to perform upon its completion. In
addition, the Cory Chouest will substitute for other surveillance
vessels as they are retrofitted with LFA. The Cory Chouest total
estimated lease (charter hire) payments for the 5- year contract
that commenced on October 1, 1998, range from $24 million to $27
million in constant fiscal year 2000 dollars (based on price
economic adjustments). These payments are based on daily rates by
fiscal year and do not include estimated port charges, fuel, use
of satellite communications, meals for government personnel, and
reimbursable items as listed in the contract.

Dollars in millions (constant fiscal year 2000) Vessel Fiscal year
of

initial lease Number of

subsequent short- term leases Total lease

payments

Laney Chouest 1988 a 2 $42. 6 Cory Chouest 1989 2 b 45. 4 Dolores
Chouest 1990 1 12. 9 Carolyn Chouest 1994 0 15. 0 Kellie Chouest
1996 0 10. 1 Margaret B. Chouest 1996 0 14. 6

Page 19 GAO/NSIAD-99-125 Defense Acquisitions

Appendix II GAO Contacts and Staff Acknowledgements Appendi x I I

GAO Contacts James F. Wiggins, 202/ 512- 4530 Robert J. Stolba,
202/ 512- 8963

Acknowledgements In addition to those named above, Johana R.
Ayers, Rosa M. Johnson, Stephanie J. May, and Charles W. Perdue
made key contributions to this

report.

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