Article by Nancy Bowen, Andrius Kontrimas, William Lee, Robert C. Morris and Shawn O'Brien

The IRS is aggressively targeting foreign companies and the U.S. companies that hire them to perform offshore services for the oil and gas industry on the Outer Continental Shelf in the Gulf of Mexico. The IRS takes the position that these foreign companies and their foreign workers have U.S. source income and may be engaged in a U.S. trade or business. Consequently, the IRS contends that these foreign companies and their foreign workers have obligations to file U.S. tax returns and pay the U.S. taxes due on amounts earned from these offshore services. Furthermore, the IRS contends that the U.S. companies that hired and paid these foreign companies should have withheld and remitted to the IRS 30% of the amounts paid to the foreign companies.

In addition to the often substantial taxes and interest that the IRS is seeking to recover, the IRS has also signaled its intent to assert a variety of penalties against the foreign companies, their workers, and the U.S. companies that hire them. The IRS recently designated Foreign Withholding a Tier One Compliance Issue, and issued an Industry Directive dated October 28, 2009, specifically targeting activities on the Outer Continental Shelf in the Gulf of Mexico. Tier One Compliance Issues are generally the IRS's highest priority, and receive the most scrutiny by IRS auditors.

U.S. Source Income and U.S. Trade or Business

Amounts paid to foreign companies that perform services in the United States are considered "U.S. source income," and the companies performing those services may have engaged in a U.S. trade or business. Foreign companies that engage in a U.S. trade or business are generally subject to U.S. income and employment taxes, are required to file Form 1120-F (U.S. Income Tax Return of a Foreign Corporation), and may also be required to file Form 941 (Employer's Quarterly Federal Tax Return) and Form 940 (Employer's Annual Federal Unemployment Tax Return) for payments made to their workers.

Absent certain exemptions, a U.S. company that pays U.S. source income to a foreign party must withhold U.S. income tax from the payments at a 30% rate. The U.S. company generally is required to withhold and deposit the withholding taxes with the IRS, and also to report the payments on Form 1042-S and file a Form 1042 by March 15 of the year following the payments. The U.S. company's obligations to withhold and deposit 30% and to file Forms 1042-S and 1042 for the amounts paid arise so long as the amounts paid to the foreign company are considered "U.S. source income," whether or not the foreign company is engaged in a U.S. trade or business, unless the foreign company files certain forms claiming exemption from or reduced withholding.

What is the United States?

The linchpin of whether foreign companies and their workers have U.S. source income and/or are engaged in a U.S. trade or business is whether the services were performed or the income was earned in the United States. The Internal Revenue Code's definition of the "United States" is extremely broad for personal services that relate to the "exploration and exploitation" of natural resources under section 638. Under this broad definition, those performing personal services on the Outer Continental Shelf that relate to the "exploration and exploitation" of natural resources are considered to be within the "United States" for federal tax purposes.

IRS Broadly Defines "Exploration and Exploitation"

The IRS has broadly defined the services that relate to the "exploration and exploitation" of natural resources in its recently issued Industry Directive and in a 2008 private letter ruling. For example, in the Industry Directive, the IRS summarily concludes that (1) contractors that perform services on the Outer Continental Shelf (such as seismographic testing, drilling, repair, and salvage work); (2) vessel operators that merely transport supplies and personnel between U.S. ports and locations on the Outer Continental Shelf; and (3) owners and/or operators of foreign vessels that bareboat or time charter to persons that perform offshore services, are all engaged in activities related to the "exploration and exploitation" of natural resources within the United States for federal tax purposes.

The IRS's position that vessel operators who merely transport supplies and personnel on the Outer Continental Shelf are performing activities related to the "exploration and exploitation" of natural resources was first set forth in a 2008 private letter ruling. In Priv. Ltr. Rul. 200823005 (Mar. 3, 2008), the IRS applied its broad definition of "exploration and exploitation" to foreign vessel owners that transported divers across the Outer Continental Shelf. Although the foreign vessel owners did not provide the divers, and although the divers undertook repair and remediation of oil and gas pipelines and equipment rather than the drilling of oil and gas wells, the IRS nevertheless determined that the transportation services provided by the foreign vessel owners were related to the "exploration and exploitation" of natural resources and gave rise to U.S. source income.

In the Industry Directive, the IRS articulates an even broader definition of "exploration and exploitation" than in the private letter ruling. The IRS asserts in the Industry Directive that a foreign vessel owner that merely provides a vessel under a bareboat charter arrangement to contractors that then engage in activities that may relate to the "exploration and exploitation" of natural resources has U.S. source income.

It is unclear whether the IRS's expansive view of "exploration and exploitation" would survive a court challenge. Assuming that the divers in the private letter ruling and the contractors in the Industry Directive are engaged in "exploration and exploitation" activities, the IRS must attribute the activities of the divers/contractors to the captain, crew, and owners of the vessel to assert they are subject to U.S. tax. A court may find that such a connection is too remote under the rationale of Ocean Drilling & Exploration Co. v. United States, 24 Cl. Ct. 714 (1991), aff'd, 988 F.2d 1135 (Fed. Cir. 1993). In that case, the Claims Court concluded that providing insurance on mobile drilling rigs that operated on the Outer Continental Shelf was not related to the "exploration and exploitation" of natural resources, and did not give rise to U.S. source income. The court's ruling is directly contrary to an example in the Treasury Regulations under section 638.

Information Already Available to IRS on Vessels Operating on the Outer Continental Shelf

The IRS is able to determine what vessels have been operating on the Outer Continental Shelf through U.S. Coast Guard and U.S. State Department records. Extensive information must be submitted to the U.S. Coast Guard to obtain approval for foreign vessels to be operated in U.S. waters by foreign nationals. The necessary information includes the names and nationalities of the members of the crew, the bareboat charter agreements (including amounts paid), and information and documents about the owners of the vessels and their officers and directors. Additionally, all foreign nationals working on the vessels in U.S. waters must obtain a B1 visa from the U.S. State Department before they work on the Outer Continental Shelf. The information that must be submitted to the U.S. Coast Guard and U.S. State Department for foreign vessels and foreign workers to operate on the Outer Continental Shelf allows the IRS to check whether tax returns were filed by the vessel owners and crew members that operated on the Outer Continental Shelf.

IRS Has Begun Contacting Foreign Companies that Operate Vessels on the Outer Continental Shelf

The IRS has already sent letters to several hundred foreign vessel owners that the IRS believes have operated on the Outer Continental Shelf. The IRS letter requests that the vessel owner file U.S. tax returns and pay any tax and interest due, or provide a reason why the vessel owner believes that U.S. tax returns are not required. The IRS letter requires that the foreign vessel owner respond to the IRS's request within 30 days.

The IRS will undoubtedly follow up with the foreign vessel owner to determine and target the U.S. company that hired the vessel owner. Unless the U.S. company has obtained from the foreign vessel owner appropriate documentation (Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding, Form W-8BEN, or Certificate of Foreign Person's Claim That Income Is Effectively Connected With the Conduct of a Trade or Business in the United States, Form W-8ECI) claiming exemption from withholding or reduced treaty withholding before a payment is made to the vessel owner, the IRS will assert that the U.S. payor should have (1) withheld and deposited tax from the amounts paid at the rate of 30%, and (2) filed Form 1042 and Form 1042-S to report such payments. The IRS may also assert penalties against the U.S. payor, including penalties for failure to file tax returns or pay tax, failure to file correct information returns, and failure to furnish correct payee statements, as well as the accuracy-related (negligence) penalty under section 6662.

U.S. Companies and Foreign Vessel Owners Should Prepare Now

In light of the IRS enforcement initiative, both foreign vessel owners and the U.S. companies that hire them should be prepared for potential IRS inquiries. Responding to such IRS inquiries would include analyzing the specific facts involved in light of the U.S. tax laws; making any necessary challenges to the IRS's sometimes overly broad definition of what constitutes "exploration and exploitation" of natural resources; raising any available exceptions to or exemptions from U.S. tax return filing or withholding requirements; asserting available tax treaty exemptions or reductions; and seeking the waiver or reduction of any penalties the IRS may assert. Foreign vessel owners and the U.S. companies that hire them may also consider adjusting their tax compliance procedures going forward.

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