In most cases, income earned by non-U.S. residents in the United States (U.S.) is taxed according to the mandates of tax treaties, if any, between the U.S. and the foreigner’s country of nationality. If a non-resident plays the lottery while in the U.S. and wins, is she/he subject to income tax in the U.S.? The following case shows how the Internal Revenue Service (IRS) considered proceeds from a California lottery won by an Israeli national, under the U.S.-Israel Income Tax Treaty.
The U.S. and Israel signed the Income Tax Convention (U.S./Israel ITC) in 1975. Two protocols amended this convention: the 1980 and 1993 Protocols. The U.S./Israel ITC aimed at preventing double taxation and tax evasion. Taxes subject to this convention includes (1) U.S. federal income taxes imposed by the IRS, excluding social security taxes, and the tax on insurance premiums paid to foreign insurers; (2) taxes imposed by the Israeli Income Tax ordinance, by the Land Appreciation Tax Law, by the Income Tax Law, and other taxes on income administered by the Israeli Government, including income taxes and profits from banking and insurance companies; and (3) taxes similar to those described above imposed by the above authorities after this convention.
In Ismat M. Abeid v. Commissioner, Docket No. 10441-02 (2004), the U.S. Tax Court was to decide whether the proceeds from a California lottery won by an non-U.S. resident, Israeli national were taxable income in the U.S. Petitioner was an Israeli national who won the California Lottery in 1992. Consequently, petitioner was entitled to 20 annual payments of $722,000. Petitioner was residing in the U.S. in 1992; however, he was residing in Israel during 1997, 1998, and 1999. Petitioner filed his federal income tax return for these three years, and claimed the lottery proceeds for these years were not subject to income taxation according to the U.S./Israel ITC. The IRS, however, determined that Petitioner’s lottery proceeds were subject to U.S. income tax under Sec. 871(a)(1)(A), I.R.C. (Internal Revenue Code). Petitioner did not agree. He claimed that the lottery annual payments constituted “annuities” within the meaning of the Par. 5, Art. 20 of the U.S./Israel ITC, and, therefore, exempt from U.S. tax. Article 20 of the convention established that annuities shall be taxable only in the jurisdiction in which the recipient resides. The Tax Court held that lottery payments are not annuities as the term annuities is defined in the treaty; thus, they were subject to U.S. tax.
The IRS claimed that Sec. 871(a)(1)(A) of the IRC establishes that "interest. . ., dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income" received by non-residents from sources within the U.S. and not effectively connected to U.S. trade or business are subject to a 30 percent tax. Also, the IRS claimed, proceeds from lottery winnings paid to non-residents fall within this IRC provision as established in Barba v. United States, 2 Cl. Ct. 674 (1983), with some limited exceptions. This is because annual payments under lottery winnings are treated as gambling winnings. Rusnak v. Commissioner, T.C. Memo. 1987-249; “see also sec. 3402(q)(3)(B) (treating certain proceeds from wagers in State-conducted lotteries as gambling winnings).”
In contrast, Petitioner claimed that the California lottery proceeds were annuities within the meaning of the U.S./Israel ITC, and, therefore, exempt from U.S. tax. The U.S./Israel ITC defines the term “annuities” as “a stated sum paid periodically at stated times during life, or during a specified number of years, under an obligation to make the payments in return for adequate and full consideration (other than services rendered).
The Tax Court considered important to find the definition of the phrase “in return for adequate and full consideration” to solve this case. The court first noted that the treaty did not define this phrase. Thus, according to Article 2(2) of the U.S./Israel ITC, the term "shall, unless the context otherwise requires, have the meaning which it has under the laws of the Contracting State whose tax is being determined." Therefore, the phrase had to be defined according to U.S. law. The phrase “in return for adequate and full consideration” is commonly used in the IRC to connote “a purchase or exchange of property that is bona fide and at an arm's- length price, as distinguished from a gift or other transfer of property between persons who do not transact at arm's length.” Thus, the term means “consideration of equivalent amount to the property transferred.”
The court held that Petitioner did not pay adequate and full consideration in this case and therefore the lottery payments did not constitute annuities within the meaning of the convention. The court rejected Petitioner’s arguments that the ticket payments made by other players constituted the full and adequate consideration in this case. The court also rejected Petitioner’s alternative argument that the US$1 ticket constituted full and adequate consideration. The court held this was not a reasonable adequate consideration for 20 payments of $722.000.
Well, foreigners who win the lottery in the U.S. and receive annual payments may have to pay its share to Uncle Sam.