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

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.

Withholding under Section 1441 Non-statutory stock options**

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)

Capital gains

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.

If you're feeling light-headed as result of reading this, then it's probably time to consult a tax lawyer. Disclaimer: This is merely personal research and not legal advice and does not constitute an attorney-client relationship.