Are there any reasons I can't issue options to foreign contractors?

My company is a U.S. C-Corp and we have recently created a stock option plan that allows for both ISO and NSO option grants. We have a foreign contractor located in China who does work for the company and we would like to issue her a number of NSOs. Is there any problem with issuing NSOs to a foreign contractor?

Issuing alone is not a problem, but there are tax complications involved. Your corporation is required to withhold on the employee's stock option compensation upon exercise depending on whether your company is "engaged in trade or business within the United States" (ETBUS), which it presumably is.

Employers generally withhold on portion of spread allocable to ETBUS (Rev. Rul. 69-118 and §864(c). The spread is measured from grant date to exercise date. When it is unclear whether this sourcing is correct (as compensation may be for periods prior to grant), you may have to withold the entire amount and have the shareholder file for a refund from the IRS.

Also note that IRC Section 409A may be applicable and complicate witholding.

Please see: http://www.docstoc.com/docs/53154153/American-Bar-Association-Section-of-Taxation-Committee-on-US Please also see:
Exercises of Employee Stock Options by Non-resident Aliens

In short, non-resident aliens who receive compensatory income from the
exercise of United States stock options are taxable, at graduated
rates, to the extent that the income is attributable to services
provided in the United States. This look-back rule applies regardless
of whether the non-resident alien was a former resident of the United
States - at least, that is the IRS's position. The look-back rule does
not retroactively subject former residents to tax on their worldwide
income.

An employer whose employee exercises a non-statutory stock option
withholds under Section 3402. The employer need not withhold under
Section 1441, because the regulations exclude from Section 1441
withholding any ETBUS income subject to withholding under Section
3402.(36) Withholding on a non-resident alien's wage income is nonetheless more complicated than withholding on the wage income of a
US citizen or resident. Theoretically, the employer should withhold
only on US source compensation, but an employer which must withhold
from non-resident alien employees may not know how much of the
employees' income is attributable to US sources. Employers may not
always track their employee's US and non-US business days in each pay
period. Regulations applicable to Section 1441 withholding provide
that when a payer "does not know at the time of payment the amount
that is subject to withholding because the determination of the source
of the income" depends on unknown facts, the employer must withhold on
the entire amount.(37) This rule is generally applicable to wage
withholding as well. Thus, an employer facing this conundrum is
permitted to withhold on the entire amount, leaving the non-resident
alien employee to claim a refund.(38)

In general, capital gain from the sale of securities by a non-resident
alien is foreign source income;(43) as such, it is not taxable to a
non-resident alien as either "fixed and determinable" income under
Section 871(a) or ETBUS income under Section 871(b). Therefore, if the
non-resident alien realizes capital gain by selling the stock
underlying the option (as opposed to income from the exercise of the
option), the capital gain is foreign source income and non-taxable.