The OCS Tax Trap: U.S. and Foreign Companies Beware!
Stepped-up IRS enforcement activity on the U.S. Outer Continental Shelf spells potential trouble for foreign vessel operators and service providers
By Joseph T. Gulant and Jennifer L. Bell
In the aftermath of Hurricane Katrina and the Deepwater Horizon spill, an increasing number of foreign vessels and businesses have engaged in construction and repair activity on the U.S. Outer Continental Shelf (OCS) in the Gulf of Mexico. In response, the Internal Revenue Service (Service) has fired a shot across the bow of these businesses in an attempt to eliminate perceived competitive advantages (i.e., lower tax rates) over U.S.-owned businesses.
Pursuant to a new Service Directive, the Service is aggressively increasing its enforcement activities with respect to foreign taxpayers engaged in certain activities on the OCS. The results are often unanticipated and counter-intuitive, and the Service has identified the following categories of foreign taxpayers as engaged in activities related to the exploration for, or exploitation of, natural resources on the OCS (Covered Activities) that it believes fall into the U.S. tax net:
• contractors that perform services on the OCS (such as testing, drilling, repair and salvage work);
• vessel operators that transport supplies and personnel between U.S. ports and locations on the OCS; and
• owners and/or operators of foreign-registered vessels that time or bareboat charter vessels to persons that are engaged in Covered Activities.
The purpose of this article is to alert vessel owners and operators, foreign contractors, foreign service providers, and other foreign entities conducting business on the OCS that they may unwittingly be subjecting their businesses to taxation in the U.S.
Income Tax Considerations
For U.S. federal income tax purposes, the OCS is generally treated as geographically within the U.S. to the extent that the activities on the OCS relate to Covered Activities. The Service has applied an expansive view of the scope of these rules, and the Service is likely to take the position that even activities that are only tangentially related to the exploration and exploitation of natural resources (e.g., oil pipeline repairs, use of vessels for transportation or other construction support services, oil platform construction and engineering-related activities, etc.) may be subject to U.S. tax.
A foreign corporation that derives income from transporting cargo and crew to locations on the OCS (to the extent that such activities are Covered Activities) may derive U.S.-source income if the transportation begins and ends within the U.S. As a result, the foreign corporation may be subject to U.S. federal income tax at a flat rate of 30 percent of the gross amount of its U.S.-source passive investment income (in the absence of a reduction or exemption pursuant to a comprehensive income tax treaty (Treaty) that is not effectively connected with a trade or business in the U.S. As discussed in greater detail below, the foreign corporation will likely also be subject to income tax withholding.
Alternatively, the foreign corporation may be engaged in a U.S. trade or business, provided its activities are regular and continuous; consequently, it may be subject to tax in the U.S. on its net income and may have U.S. tax return filing obligations. If the foreign corporation does not file its U.S. tax return, it will generally be denied otherwise allowable deductions for expenses related to the generation of that income (i.e., vessel depreciation and amortization deductions, operating expenses, etc.). In addition, a second tax at a 30 percent rate would generally be imposed upon the net income of the foreign corporation in the U.S. (the branch profits tax) which is not reinvested in assets in the U.S.
A foreign corporation that charters vessels on either a time or bareboat charter basis also generally derives income from activities within the scope of these rules for the period of time during which the vessels are engaged in Covered Activities. It is the Service’s position that revenue from time and bareboat charters should be characterized as rental income and, therefore, should be sourced for federal income tax purposes based on where the vessel is used. It is also the Service’s view that such income should be U.S. source income for the period of time during which the activities are performed domestically and/or on the OCS since the OCS is treated as part of the U.S. for these purposes. Both time charterers and bareboat charterers must keep potential U.S. income taxes in mind when negotiating the terms of their charters. For example, it may be appropriate for such entities to negotiate tax gross-up provisions in their leasing arrangements to cover the potential incidence of U.S. taxation and thereby preserve their anticipated after-tax economic returns from the leases.
Income Tax Withholding Considerations
It is vital to understand that the incidence of taxation with respect to foreign entities operating on the OCS does not only fall on foreign corporations. Because the U.S. would have a host of administrative and jurisdictional issues involved in chasing foreign corporations for taxes, the Internal Revenue Code (Code) requires certain U.S. taxpayers to withhold tax on payments made to foreign corporations.
In general, if a vessel is utilized in connection with purely domestic transport, the U.S. company that hires and pays a foreign corporation would have an obligation to withhold tax at a 30 percent rate on the gross amount of payments made to non-U.S. vessel owners (in the absence of an available Treaty reduction or exemption), and such U.S. company could be held liable for the tax in the event of a failure to withhold. For example, in the case of a time charter or bareboat charter, a time or bareboat charterer would be responsible to withhold U.S. income tax at the 30 percent rate on lease or rental payments made to the vessel owner/operator (in which case the time or bareboat charterer would be liable for a failure to withhold). However, a U.S. company is generally not required to withhold such amounts if such vessel owner/operator provides to the U.S. company certain IRS Forms which evidence either (a) an exemption from taxation under an applicable Treaty (Form W-8BEN), or (b) an exemption from withholding based on the fact that the income is “effectively connected with a U.S. trade or business” (ECI) (Form W-8ECI).
It should be noted that generally no withholding payments are required with respect to certain types of shipping-related income if a vessel is utilized in international transport, but purely domestic transport is not subject to this taxing regime.
Employment Tax Considerations
An employer of a foreign individual that may wittingly or unwittingly become a U.S. tax resident as a result of work performed in the OCS over an extended period may also be liable for certain U.S. employment taxes.
If an employee performing services on the OCS is treated as a U.S. resident alien for U.S. federal tax purposes (e.g., by reason of extended presence on the OCS), this individual may be subject to U.S. income tax on income from all sources, including sources outside the U.S., at the same rates and in the same manner as a U.S. citizen. Regardless of residency status, wages of a foreign employee with respect to services performed on the OCS may also become subject to tax in the U.S., and an employer may have an obligation to withhold such taxes from the employee’s wages. In addition, other service-providing entities (e.g., construction and engineering companies) operating on the OCS would generally also be subject to tax in the U.S. on their ECI, and their employees may become subject to U.S. tax on their wages as well.
An employer and/or a foreign employee may also be subject to employment taxes under the Federal Insurance Contributions Act (FICA) and/or the Federal Unemployment Tax Act (FUTA). Under FICA, an employer is generally required to withhold Social Security taxes from wages paid to an employee during the year, and the employer must also match the amount of tax withheld from the employee’s wages. In addition, FUTA generally imposes a tax on any employer who paid at least $1,500 in wages during any calendar quarter in the current or preceding calendar year. An employer subject to either income tax withholding or Social Security taxes, or both, is generally required to file a quarterly federal tax return or, if eligible, an annual return.
Be Prepared
In light of the recent sabre-rattling by the Service relative to tax enforcement activities with respect to Covered Activities and the related uptick in U.S. protectionist tax policies, the tax risks raised by the above-mentioned rules are likely to become much more than a theoretical concern. In fact, the Service has already begun contacting certain foreign companies with respect to these issues, and its activity is likely to increase as a result of the creation of an OCS Task Force. U.S. and foreign companies engaged in activities related to the exploration for, or exploitation of, natural resources on the OCS would be well advised to have their operations reviewed to determine whether they are in compliance with these onerous and counter-intuitive tax provisions. – MarEx
Joseph T. Gulant is a partner at Blank Rome LLP and the practice group leader of the Business Tax Group. Jennifer L. Bell is a tax associate in the New York office of Blank Rome LLP. This article is prepared and published for informational purposes only and should not be construed as legal advice.
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To ensure compliance with IRS Circular 230, you are hereby notified that any discussion of federal tax issues in this article is not intended or written to be used, and it cannot be used by any person for the purpose of: (A) avoiding penalties that may be imposed on them under the Code, and (B) promoting, marketing or recommending to another party any transaction or matter addressed herein. This disclosure is made in accordance with the rules of Treasury Department Circular 230 governing standards of practice before the Service.