IRS is targeting foreign work vessels operating on the Outer Continental Shelf

Andrius Kontrimas
Fulbright & Jaworski LLP
Houston

An increasing number of vessels are entering into US waters in the Gulf of Mexico on the Outer Continental Shelf to engage in work related to the exploration for or exploitation of natural resources. On Oct. 28, 2009, the Internal Revenue Service's Large and Midsize Business Division issued an Industry Directive specifically targeting activities on the Outer Continental Shelf. The IRS also recently designated Foreign Withholding a Tier One Compliance Issue. Tier One Compliance Issues are generally the IRS's highest priority, and receive the most scrutiny by IRS auditors.

The Industry Directive states that the IRS analysis indicates that a significant number of foreign vessels permitted to work on the Outer Continental Shelf do not comply with their US federal tax filing obligations. The IRS is focusing on three categories of foreign taxpayers that are engaged in activities related to the exploration for, or exploitation of, natural resources in the Outer Continental Shelf:

• Contractors that perform services on the Outer Continental Shelf including drilling, repair, salvage work, and seismographic testing;
• Operators that transport supplies and personnel between US ports and locations on the Outer Continental Shelf; and
• Owners or operators of foreign-registered vessels that bareboat or time charter vessels to persons engaged in activities related to the exploration for, or exploitation of, natural resources on the Outer Continental Shelf.

The Industry Directive further says that the natural resources and construction industry group of the IRS has established an issue management team and identified IRS technical advisors specifically for shipping issues, natural resource issues, withholding tax, and employment tax issues.

The IRS takes the position that these foreign companies and their foreign workers have US source income and may be engaged in a US trade or business. Consequently, the IRS contends that these foreign companies and their foreign workers have obligations to file US tax returns and pay the US taxes due on amounts earned from these offshore services. Furthermore, the IRS contends that the US 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 US companies that hire them.

It's not just the IRS that believes that there has been significant noncompliance in the federal tax arena. Some industry groups and owners of US flag vessels have questioned low charter and service rates and have attributed such low rates to their belief that foreign vessel owners have not been paying US taxes. The Industry Directive is viewed by these groups as leveling the playing field from a competitive standpoint.

The importance of US source income or US trade or business activity

Amounts paid to foreign companies that perform services in the United States are considered "US source income," and the companies performing those services may have engaged in a US trade or business. Foreign companies that engage in a US trade or business are generally subject to US income and employment taxes, are required to file IRS Form 1120-F (US Income Tax Return of a Foreign Corporation), and may also be required to file IRS 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 US company that pays US source income to a foreign party must withhold US income tax from the payments at a 30% rate. The US 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 US 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 "US source income," whether or not the foreign company is engaged in a US trade or business, unless the foreign company files certain forms claiming exemption from or reduced withholding.

Is the OCS considered part of the US for federal tax purposes?

The linchpin of whether foreign companies and their workers have US source income and/or are considered to be engaged in a US 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 on the Outer Continental Shelf under section 638. Under this broad definition, those performing personal services on the OCS 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 for, or exploitation of" natural resources in its recently issued Industry Directive and in a 2008 IRS private letter ruling. For example, in the Industry Directive, the IRS summarily concludes that (1) contractors that perform services on the OCS related to the oil and gas business; (2) vessel operators that merely transport supplies and personnel between US ports and locations on the OCS; 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 OCS 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 OCS. 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 US 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 US 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 US 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 OCS was not related to the "exploration and exploitation" of natural resources and did not give rise to US source income. The court's ruling is directly contrary to an example in the Treasury Regulations under section 638 of the Internal Revenue Code.

Info is readily available to the IRS on foreign vessels operating on the OCS

The IRS is able to determine what vessels have been operating on the OCS through US Coast Guard and US State Department records. Extensive information must be submitted to the US Coast Guard to obtain approval for foreign vessels to be operated in US 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 US waters must obtain a B1 visa from the US State Department before they work on the OCS. The information that must be submitted to the US Coast Guard and US State Department for foreign vessels and foreign workers to operate on the OCS allows the IRS to check whether tax returns were filed by the vessel owners and crew members that operated on the OCS.

IRS has begun contacting foreign companies that operate vessels on the OCS

The IRS has already sent letters to several hundred foreign vessel owners that the IRS believes have operated on the OCS. The letter requests that the vessel owner file US tax returns and pay any tax and interest due, or provide a reason why the vessel owner believes that US 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 US company that hired the vessel owner. Unless the US 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 US 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 US 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.

What should US companies and foreign vessel owners do to prepare now?

In light of the IRS Industry Directive and the launch of this new enforcement initiative, both foreign vessel owners and the US 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 US 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, US 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 US companies that hire them may also consider adjusting their tax compliance procedures going forward.

Here is a link to the IRS Industry Directive: www.irs.gov/businesses/article/0,,id=214906,00.html

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