Cross-Border Tax Newsletter

January February 2003 Email Edition.

Cross-Border Tax Insight

Editor: Joseph Soussan

Note our new business address and telephone number:

411 Duplex Avenue, Suite 1205

Toronto, Ontario, M4R 1V2

Tel: 416-567-1829

E-mail: jsoussan@usatax.ca

www.usatax.ca

This newsletter is generally published several times a year and is distributed only by e-mail. Refer to www.usatax.ca for current and past editions of the newsletter. To receive this newsletter regularly send an e-mail request to jsoussan@usatax.ca. “Subscribe to Newsletter” should be in the subject line of such e-mail request. For more information on the tax services provided by North American Tax Services or Joseph Soussan, see section entitled “About North American Tax Services” appearing immediately after the below article. Your comments and questions are always appreciated.

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U.S. Tax Treatment of Gambling Winnings for Canadians and U.S. Residents

In the following article, I wish to shed some light on the taxability of gambling income in the U.S. for both residents and non-residents of the U.S. The topic is quite technical and elaborate but perhaps the basics will suffice, to provide the Canadian tax practitioner with an introduction to this topic.

Firstly, unlike the U.S., lottery and gambling winnings in Canada are not taxable.

Gambling in the U.S.

In the U.S., individuals whom gamble on a professional basis, may be permitted to deduct gambling expenses, to the extent such expenses are connected to a trade or business.

Taxpayers who pay or incur an expense in a given taxable year need to examine the expense and the circumstances under which it arose, to determine whether it meets the statutory tests for a deductible trade or business expense.

In order for expenses paid or incurred by a taxpayer to be deductible trade or business expenses, three tests must be met. First, the expenses must be related to a trade or business. Second, the expenses must be ordinary and necessary. Third, the expenses must be paid or incurred in carrying on a trade or business.

Some limitations are placed on the deductibility of trade or business expenses. First, a deduction for certain expenditures which might otherwise qualify as trade or business expenses is denied if the expenditures violate public policy. Second, a deduction for an expense paid or incurred in connection with a trade or business is denied in the taxable year in which paid or incurred if the expense is a capital expenditure.

Example - Full-Time Gambler

Dick is a full-time gambler who engages in gambling activity every day and relies on this activity as his means of earning a living. In 2002, Dick incurred $10,000 of gambling losses. Dick's gambling constitutes a trade or business, and the expenses are connected with the trade or business. If the ordinary and necessary test and the carrying on test are met, the losses are deductible trade or business expenses.

Example - Occasional Gambler

Rob, a U.S. resident, is an accountant who likes to go to the racetrack once a month and bet on the horses. In 2002, Rob lost $500 gambling at the racetrack. Rob's casual gambling activity is not a trade or business. The $500 is not a deductible trade or business expense. Note, however, that Rob can deduct his losses as an itemized deduction, to the extent of his winnings (see below).

Gambling or Wagering Losses for the Non-Professional

A taxpayer's gambling or wagering losses for a year are deductible only to the extent that the taxpayer has gambling or wagering gains for that year[1]. Thus a net loss may not be created in such circumstances.

The limitation applies regardless of whether the taxpayer is a casual gambler or a professional gambler who pursues gambling as a trade or business. Thus, a gambling loss need not be incurred in a trade or business to be deductible to the extent of gambling gains. Nonetheless, non-resident aliens of the U.S. (casual gamblers) may not be permitted to deduct such losses against their gambling gains. See below for more on this.

Example - Gambling Losses Must Offset Gambling Gains

Tom visited the race track once during the year and lost $1,000 gambling on horses. Tom had no other gambling transactions for the year and no gambling winnings. The loss is not deductible.

Example - Gambling Losses Used as an Offset

Tom purchased a lottery ticket for $100 and won $50,000 for the taxable year. He paid $500 during the year for lottery tickets that did not win. The $500 loss can be used to offset net winnings of $49,900.

Gambling income is reported on a taxpayer's Form 1040, but the gambling losses must be reported as an itemized deduction on Schedule A[2].

Where a Joint Return is Filed by U.S. Residents

In the case of a husband and wife who file a joint return, their combined losses from wagering will be deductible to offset their combined gains[3].

Example - Joint Return May Combine Losses and Gains

During the year, H won $1,000 at a casino; while W lost $2,000 at the casino. If H and W file a joint return, H's $1,000 gain will be included in gross income while $1,000 of W's loss will be deductible.

Withholding on Gambling Winnings

U.S. payors of gambling winnings which are subject to withholding are required to withhold tax at source as follows[4]:

(1) 28% of such payments if the amounts are paid on or before August 6, 2001; or

(2) if the amounts are paid after August 6, 2001, an amount equal to the product of the third lowest tax rate imposed on unmarried individuals (other than surviving spouses and heads of households) i.e., 27.5% in 2001 after August 6, 2001, 27% in 2002 and 2003, 26% in 2004 and 2005, and 25% in 2006 and later and such payments. 588

Winnings which are subject to withholding are as follows[5]:

• Proceeds over $5,000 from a wagering transaction, if the amount of such proceeds is at least 300 times as large as the amount wagered.

• Proceeds over $5,000 received from a state lottery.

• Proceeds over $5,000 from wagers placed in (1) a sweepstakes, wagering pool, or non-state conducted lottery; or (2) a wagering transaction in a pari-mutuel pool with respect to horse racing, dog racing, or jai alai if the amount of is 300 times as large as the amount wagered.

Note that withholding is not required if the payee is a nonresident alien or a foreign corporation already subject to withholding under §1441 or §1442. Under §1441 of the Internal Revenue Code, 30 percent tax is withheld on various types of payments made to U.S. nonresident aliens. Recall, by definition, such persons, are not U.S. citizens or residents.

Also to note, withholding is not required for winnings from slot machines, bingo, and keno in accordance to §3402(q)(5) of the IRC. Nonetheless, Form W2-G may be required to report gross amounts paid to the recipients in the event certain thresholds are exceeded.

Gambling Winnings and Non-Resident Aliens

Nonresidents of the U.S. may not be permitted to deduct such gambling losses against gambling gains, where such gains are considered “fixed or determinable” income, and tax has been withheld at source, pursuant to §1441 of the IRC. As mentioned above, 30 percent tax will be withheld from such winnings, and no recourse is available to make use of such related losses[6]. Thus in such a case, the treatment of a U.S. resident is preferable to that of a non-U.S. resident.

Fixed or determinable income is described as being "fixed" when it is to be paid in amounts that can be definitely predetermined. It is "determinable" when there is a basis for calculation by which the amount to be paid can be ascertained.

Note, non-resident aliens are effectively exempt from tax and the usual 30 percent withholding tax (under IRC §1441) for winnings from blackjack, baccarat, craps, roulette, or big-6 wheel[7].

Keep in mind, that prizes and awards are also taxable in the U.S.

About North American Tax Services.

Joseph Soussan founded North American Tax Services in 1998. Since 1997, he is a member of the Certified General Accountants’ Association of Ontario. He completed the CICA In-Depth Tax Course in 2000, and obtained CPA certification in 1998 from the state of Delaware. His firm is dedicated to providing both U.S. (primarily) and Canadian tax expertise (as applicable to international tax situations), tax–related educational services, and technical writing assistance to Canadian accounting and law firms. Joseph speaks frequently to organizations and companies on cross-border tax matters.

He currently practices exclusively in the areas of both cross-border corporate and personal taxation. He has, to date, provided extensive consulting and compliance services to the following firms in Toronto and Montreal: Deloitte and Touche, Ernst and Young, I.T.S.G, Cross-Border Tax Services, Horwath Orenstein LLP, and other local CA firms.

Cross-Border Tax Insight is published by North American Tax Services as an information service to clients and friends of the firm. This publication should not be used as substitute for professional advice. Qualified professional tax or legal advice should be sought prior to applying tax or other types of law to a particular set of facts. Comments and questions are welcome.

[1] Refer to §165(d) in the Internal Revenue Code “IRC”.

[6] See Barba v. U.S., 83-1 USTC ¶9404 (Cl. Ct. 1983) in which a nonresident alien won $62,000 in Keno games at a U.S. gambling casino and also had $400,000 in gambling losses in the same taxable year. The casino withheld tax at the 30% rate and the taxpayer sued for a refund. The court upheld withholding on the grounds that gross gambling proceeds were fixed or determinable income subject to tax under §871(a)(1)(A). Because the nonresident alien was not engaged in a U.S. trade or business, he could not offset his gambling losses against his gross gambling winnings.