Decisions will be entered under
P, a South Korean national and nonresident alien, had U.S. gambling winnings and interest income that was not effectively connected with a U.S. trade or business.
136 T.C. 569">*570 COHEN,
The issues for decision are: (1) Whether petitioner's 2006 and 2007 gambling winnings are subject to tax under
These cases were submitted fully stipulated under
Petitioner works as a full-time, high-ranking business executive for a large chemical company in South Korea. Petitioner's employer pays for petitioners' son to attend school in the United States and for petitioners to travel to the United States to visit their son. Petitioner wife also has other family living in the United States.
During the years in issue, petitioners traveled to the United States for vacation and to visit family a number of times. Petitioner enjoys gambling, and during these trips he frequented the Pechanga Resort & Casino (Pechanga) in Temecula, California, to play the slot machines. 2011 U.S. Tax Ct. LEXIS 30">*33 Petitioner gambled at Pechanga on 20 of the approximately 68 days that he was in the United States in 2006 and on 11 of the approximately 46 days that he was in the United States in 2007. With respect to the gambling activity, petitioner did not have a business plan and did not keep books and records. Petitioner did not use for gambling money that was needed to support his family. Petitioner wife had no involvement in any gambling or gaming activities.
In 2006, petitioner won 138 slot machine jackpots of $1,200 or more, with total gambling winnings of $431,658. Pechanga withheld 30 percent of the winnings for payment of Federal income tax on three of those jackpots (two jackpots of $50,000 and one of $1,600), for a total of $30,480 withheld for taxes. A report prepared by Pechanga showed that petitioner had losses that exceeded his 2006 winnings by $4,663.
On February 18, 2007, petitioner provided his Social Security number to Pechanga and signed a Form W-9, Request for Taxpayer Identification Number and Certification, certifying that he was not subject to backup withholding and that 136 T.C. 569">*572 he was a U.S. person (including a U.S. resident alien). In 2007, petitioner won 43 slot machine jackpots 2011 U.S. Tax Ct. LEXIS 30">*34 of $1,200 or more, with total gambling winnings of $103,874. Pechanga withheld 30 percent of the winnings for payment of Federal income tax on three jackpots (jackpots of $2,620, $1,440, and $1,380), for a total of $1,632. A report prepared by Pechanga showed that petitioner had losses that exceeded his 2007 winnings by $45,130.50.
Petitioner received from sources within the United States other income that was not effectively connected with a U.S. trade or business in 2006: (1) Interest income of $6,585; (2) capital gain income of $52,792; and (3) dividend income of $7,471 (taxable at a rate of 15 percent under the Convention for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect To Taxes on Income and the Encouragement of International Trade and Investment, U.S.-S. Kor., art. 12, par. (2)(a), June 4, 1976,
Petitioners filed a Form 1040, U.S. Individual Income Tax Return, for 2006 as married filing jointly, prepared by a bookkeeping service. Petitioners did not report any gambling winnings or any associated expenses. They did report petitioner's other U.S. source 2011 U.S. Tax Ct. LEXIS 30">*35 income. The payer of the interest income was listed as Bank of America.
In 2007, petitioner also received from sources within the United States income that was not effectively connected with a U.S. trade or business: (1) Interest income of $11,830 and (2) dividend income of $3,046 (taxable at a rate of 15 percent under the U.S.-Korea income tax treaty, art. 12, par. (2)(a)).
Petitioner filed a Form 1040 for 2007 and reported the interest and dividend income from sources within the United States, but he did not report the gambling income or any associated expenses. The payer of $11,662 of interest income was listed as "FEDL HOME LOAN BK CONS DISC". Petitioner's 2007 return was prepared by a certified public accountant.
Pechanga reported petitioner's jackpot winnings of $1,200 or more to the Internal Revenue Service (IRS) on completed Forms W- 2G, Certain Gambling Winnings, for 2006 and 2007. The IRS examined the 2006 and 2007 tax returns and determined that petitioner received unreported gambling income of $431,658 in 2006 and $103,874 in 2007. The IRS 136 T.C. 569">*573 did not receive reporting from third parties with respect to the interest income of $6,585 and $11,662, as reported on the 2006 and 2007 2011 U.S. Tax Ct. LEXIS 30">*36 tax returns respectively. However, the IRS made adjustments to the interest income as reported on the 2007 return to reflect information reported from third parties: (1) $4 less $1 withholding from Wells Fargo Bank, N.A. (a U.S. national bank chartered and regulated by the Office of the Comptroller of the Currency) and (2) $165 from First Clearing, L.L.C. The IRS sent a notice of deficiency to petitioners on March 23, 2009, for determined deficiencies and an accuracy-related penalty with respect to 2006. On November 9, 2009, the IRS sent a notice of deficiency to petitioner for determined deficiencies and an accuracy-related penalty with respect to 2007.
The parties agree that petitioners are nonresident aliens and that for both 2006 and 2007 Forms 1040 were erroneously filed instead of Forms 1040NR, U.S. Nonresident Alien Income Tax Return.
Gambling winnings, including slot machine winnings, are gross income. See
Generally, a recreational or casual gambler's gross income from a wagering transaction should be calculated by subtracting the bets placed to produce the winnings, not as a deduction in calculating adjusted gross income or taxable income but as a preliminary computation in determining 136 T.C. 569">*574 gross income. See
A nonresident generally cannot deduct or offset gambling losses against gambling winnings. See
When gambling winnings of $1,200 or more from a bingo game or slot machine play are paid, the payer is required to inform the IRS of the payments. See
136 T.C. 569">*575 For nonresident aliens,
The tax and withholding requirements apply to U.S. source gambling winnings of nonresident alien individuals unless the proceeds are exempt under provisions not relevant here or a treaty provision applies. See
When interpreting a treaty, we begin with the text of the treaty and the context in which the written words are used.
The 2011 U.S. Tax Ct. LEXIS 30">*41 U.S.-Korea income tax treaty entered into force on October 20, 1979. Article 4, paragraph (1) of this treaty provides: A resident of one of the Contracting States may be taxed by the other Contracting State on any income from sources within that other Contracting State and only on such income, subject to any limitations set forth in this Convention. For this purpose, the rules set forth in Article 6 (Source of Income) shall be applied to determine the source of income.
Article 6, paragraph (9) of the U.S.-Korea income tax treaty provides that income not otherwise addressed, as is the case with gambling income, shall be determined by each of the Contracting States in accordance with its own law. 136 T.C. 569">*576 The U.S.-Korea income tax treaty does not establish an exemption from tax for South Korean residents with respect to U.S. gambling income, and there is no provision permitting South Korean residents to deduct gambling losses or to otherwise net gambling losses against gambling winnings. Accordingly, petitioner's gambling winnings are taxable under
Petitioners do not argue that petitioner's gambling income is not taxable under 2011 U.S. Tax Ct. LEXIS 30">*42 the U.S.-Korea income tax treaty, but they contend that the Treaty of Friendship, Commerce and Navigation, U.S.-S. Kor., art. XI, Nov. 28, 1956,
The FCN treaty is one of a series of Friendship, Commerce and Navigation Treaties that the United States signed with various countries after World War II. The treaties were initially negotiated for the purpose of encouraging American investment abroad but also secured reciprocal rights that granted protection to foreign businesses and individuals operating in the United States. See
Article XI, 2011 U.S. Tax Ct. LEXIS 30">*43 paragraph 3 of the FCN treaty provides: Nationals and companies of either Party shall in no case be subject, within the territories of the other Party, to the payment of taxes, fees or other charges imposed upon or applied to income, capital, transactions, activities or any other object, or to requirements with respect to the levy and collection thereof, more burdensome than those borne by nationals, residents and companies of any third country.
Within the same article, paragraph 5(b) applies reservations to this most-favored-nation provision: Each Party reserves the right to: (a) extend specific tax advantages on the basis of reciprocity; (b) accord special tax advantages by virtue of agreements for the avoidance of double taxation or the mutual protection of revenue; and (c) apply special provisions in allowing, to non-residents, exemptions of a personal nature 2011 U.S. Tax Ct. LEXIS 30">*44 in connection with income and inheritance taxes.
Petitioners maintain that because residents of certain third countries would not be subject to tax on gambling winnings from within the United States under bilateral income tax treaties that those countries have entered with the United States, the most-favored-nation provision of FCN treaty article XI, paragraph 3, entitles them to Federal income tax exemption. Petitioners refer to IRS Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Entities, and the section addressing "Other Income", which states: Gambling income of residents (as defined by treaty) of the following foreign countries is not taxable by the United States: Austria, Czech Republic, Denmark, Finland, France, Germany, Hungary, Ireland, Italy, Japan, Latvia, Lithuania, Luxembourg, Netherlands, Russian Federation, Slovak Republic, Slovenia, South Africa, Spain, Sweden, Tunisia, Turkey, Ukraine, and the United Kingdom.
Respondent asserts that the reservations of FCN treaty article XI, paragraph 5(b) apply to preclude application of the most-favored-nation provision of FCN treaty article XI, paragraph 3, and that petitioner's U.S. gambling income is subject 2011 U.S. Tax Ct. LEXIS 30">*45 to U.S. income tax.
Certain foreign countries, including Japan, have entered into income tax treaties with the United States that have treaty benefits excluding U.S. gambling income from the Federal taxable income of their residents. See Convention for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion With Respect to Taxes on Income, U.S.-Japan, Nov. 6, 2003, Tax Treaties (CCH) par. 5201 (U.S.-Japan income tax treaty). The Senate report from the Committee on Foreign Relations stated that the principal purposes of the U.S.-Japan income tax treaty are to reduce or eliminate double 136 T.C. 569">*578 taxation of income earned by residents of either country from sources within the other country, to prevent avoidance or evasion of the taxes of the two countries, to promote close economic cooperation between the two countries, and to eliminate possible barriers to trade and investment caused by overlapping taxing jurisdictions of the two countries. See Senate Comm. on Foreign Relations, S. Exec. Rept. 108-9, at 1-2 (2004).
Article 21, paragraph 1 of the U.S.-Japan income tax treaty provides: Items of income beneficially owned by a resident of a Contracting State, wherever arising, not dealt 2011 U.S. Tax Ct. LEXIS 30">*46 with in the foregoing Articles of this Convention * * * shall be taxable in that Contracting State. Examples of items of income covered by Article 21 include income from gambling, punitive (but not compensatory) damages, covenants not to compete, and income from certain financial instruments to the extent derived by persons not engaged in the trade or business of dealing in such instruments * * *.
FCN treaty article XI, paragraph 5(b), expressly reserved the right to extend specific tax advantages on the basis of reciprocity and accord special tax advantages by virtue of agreements for the avoidance of double taxation or the mutual protection of revenue. This reservation encompasses the more favorable treatment with respect to Federal income tax of U.S. gambling winnings, as extended to Japan and other relevant countries through the bilateral income tax treaties. The most-favored-nation provision under article XI, paragraph 3 of the FCN treaty is thus not available when the reservations of paragraph 5(b) apply.
We conclude that the 2011 U.S. Tax Ct. LEXIS 30">*47 plain language of the FCN treaty does not extend to petitioners the more favorable treatment--Federal income tax exemption--with respect to gambling winnings as provided for in the relevant bilateral income tax treaties between the United States and other countries.
Petitioners argue that if a treaty provision does not exempt the gambling winnings from income tax, then the income is from personal services of petitioner and taxable as income effectively connected with a U.S. trade or business.
Income of a nonresident alien individual that is effectively connected with the conduct of a trade or business in the United States is generally subject to tax in the same manner and at the same rates as that of a U.S. person. See
Petitioners rely on
The issue in
Petitioner exhibited no such use of personal skills or strategies when 2011 U.S. Tax Ct. LEXIS 30">*49 he played the slot machines. Thus, petitioners' reliance on
Petitioners did not initially argue that petitioner's gambling activity constituted a trade or business, but respondent addressed this issue in his opening brief. In their reply brief petitioners argued that petitioner's gambling activities were a trade or business because petitioner had a profit motive in playing slot machines and petitioner was willing to commit the capital necessary to carry out his gambling activity.
To be engaged in a trade or business within the meaning of
Whether the taxpayer engages in an activity with the primary purpose of making a profit is a question of fact to be resolved on the basis of all the facts and circumstances in a particular case.
Petitioners do not address the factors of
The parties have stipulated that petitioners earned U.S. source interest income in 2006 and 2007 that was not effectively connected with a U.S. trade or business. Petitioners contend that the interest income is excludable from tax as simple interest on deposits under
Respondent requested information from petitioners to demonstrate that 2011 U.S. Tax Ct. LEXIS 30">*52 the interest income was from bank deposits to be considered "earnings from deposits", as petitioners contend. In their brief, petitioners state that they "are still attempting to provide this evidence, but it is quite apparent from the face of the tax return that this is bank interest and nothing more." Respondent asserts that petitioners have failed to present credible evidence regarding the type of interest income received in 2006 and 2007. Respondent concedes that article 13, paragraph (2) of the U.S.-Korea income tax treaty provides for a reduced tax rate of 12 percent on the interest income for 2006 and 2007, but respondent contends that it is not excludable from Federal income tax.
For purposes of paragraph (2), the term "deposit" means amounts which are-- (A) deposits with persons carrying on the banking business, (B) deposits or withdrawable accounts with savings institutions chartered and supervised as savings and loan or similar associations under Federal or State law, but only to the extent that amounts paid or credited on such deposits or accounts are deductible under section 591 (determined without regard to sections 265 and 291) in computing the taxable income of such institutions, and (C) amounts held by an insurance company under an agreement to pay interest thereon.
Petitioners reported interest income on the 2006 and 2007 tax returns that was not reported to the IRS by the payers listed on the returns. In the 2007 notice of deficiency, respondent adjusted the interest income to reflect reporting from third parties that had not been reported on the tax returns, including interest income that was reported to the IRS by Wells Fargo, N.A., a U.S. national banking institution.
Although petitioners did not supply evidence with respect to the interest 2011 U.S. Tax Ct. LEXIS 30">*54 income from Wells Fargo, N.A., it was the bank that directly reported the interest income to the IRS. The interest income from Wells Fargo, N.A., was erroneously included by respondent in the adjusted amount because it is excludable as deposits with persons carrying on the banking business. See
Interest income for 2007 was reported from another third party, First Clearing, L.L.C., but this entity is not a U.S. chartered national bank, and petitioners have not shown that this interest income qualifies for an exception from tax. See
Petitioners have been unable to supply documentation with respect to the interest income they reported on the tax returns to demonstrate the reported interest income is from deposits as defined in
The 2006 and 136 T.C. 569">*583 2007 interest income, except the excludable 2007 interest income from Wells Fargo, N.A., is subject to income tax at 2011 U.S. Tax Ct. LEXIS 30">*55 the rate of 12 percent according to the provisions of the U.S.-Korea income tax treaty.
Petitioners contest the imposition of accuracy-related penalties for the years in issue.
There is a substantial understatement of income tax if the amount of the understatement exceeds the greater of 10 percent of the tax required to be shown on the 2011 U.S. Tax Ct. LEXIS 30">*56 return or $5,000.
Under
Respondent has met the burden of production by showing that petitioners' failure to report gambling and interest income for the years in issue resulted in understatements of their income tax for the years in issue by more than $5,000 and by more than 10 percent of the tax required to be shown on the returns.
136 T.C. 569">*584 The accuracy-related penalty under
Petitioners 2011 U.S. Tax Ct. LEXIS 30">*58 contend that they could reasonably rely on Pechanga to follow the law and on the tax preparer to properly report the gambling winnings income. Pechanga did not withhold the 30-percent tax from all of petitioner's gambling winnings and reported the winnings on Forms W2-G. However, petitioner signed a Form W-9 in 2007 that erroneously represented his status for withholding purposes. Petitioners have failed to provide any evidence concerning information provided to or advice received from their tax return preparers and/or other professionals.
Petitioner was educated in the United States and is a high-ranking executive at a large chemical company. These factors tend to weigh against petitioners' claim of reasonable cause and good faith with respect to all or part of the underpayments.
136 T.C. 569">*585 We conclude that petitioners' underpayments of Federal income tax were the result of negligence or disregard of rules or regulations under
We have considered all arguments of the parties, and to the extent not mentioned they are moot or without merit. To reflect concessions and our conclusions stated above,