Consulting Firm Follows Up on Meeting With Treasury on Guidance on Exemption for Winnings of Foreign Persons Wagering Outside U.S.

From: Barbara Angus [angus@angusnickerson.com]

It was good to talk with you this afternoon. We want thank you and Carl again for meeting with us on our request for guidance regarding procedural and administrative matters with respect to the exemption provided in new Code section 872(b)(5).

As we discussed, the attached document is to follow up on our meeting. Following up on the questions discussed at the meeting, the document provides a description of the mechanics with respect to pari-mutuel wagering covered by the exemption provision. It also provides a description of the guidance requested with respect to the implementation of the new provision. The requested guidance is needed to ensure that the statutory provision accomplishes its intended objectives.

If you all have any questions or if there is any further information that would be useful, please let us know.

New Code section 872(b)(5), enacted in 2004, provides an exemption from U.S. tax for amounts derived by a foreign person from a wagering transaction initiated outside the United States in a pari-mutuel pool with respect to a live horse or dog race in the United States. This specific statutory exemption providing certainty regarding the treatment for U.S. tax purposes of these transactions is critically important to the ability of the U.S. horse racing industry to export its product -- races run in the United States -- to foreign markets. Clear and explicit guidance regarding procedural and administrative matters with respect to the application of this exemption is needed to ensure that the statutory provision accomplishes its intended objectives.

Background

Set forth below is a detailed description of what happens when a foreign person places a wagering transaction at a foreign track or other foreign location (a "foreign wagering site") in a pari-mutuel pool with respect to a U.S. horse race, including an explanation of the relationship between the foreign wagering site and its local customers and the relationship between the U.S. track where the race is run and the foreign wagering site.

As an initial matter, it should be noted that in pari-mutuel wagering, the individual is not "betting against the house," as is the case with certain casino-style games. Rather, in pari-mutuel wagering, the odds and payouts for a particular race are determined by all the "net betting dollars" that are wagered on that race by individual patrons. The net betting dollars are determined by subtracting from the amount of the patrons' wagers an amount, typically referred to as "the takeout," which is a specified percentage (generally 20%) of the amount of wagers placed and which the wagering site uses to pay its taxes and associated fees, to fund the horsemen's purses (which are used to pay the trainer, jockey and owner of the horse), and to cover its own operational expenses. The track where the race is run (the "host track") is responsible for managing the pari-mutuel pool, collecting the information about the bets that have been placed on a particular race at all locations and determining the odds and payouts based on that information. The host track then makes the payouts on the wagers it has accepted from its patrons and authorizes all other participating wagering sites to make payouts to their local patrons on the same basis.

A foreign person that wishes to wager in a pari-mutuel pool on a U.S. horse race may do so by placing a bet at a foreign wagering site that broadcasts and accepts wagers on races run in the United States. The foreign wagering site broadcasts the U.S. races under a simulcast agreement with the U.S. host track where the races are run. The simulcast agreement also authorizes the foreign wagering site to accept wagers on the U.S. races. Under the simulcast agreement, the U.S. host track is responsible for performing the data integration function necessary to calculate the odds and payouts for each race. Thus, the U.S. host track collects the data on the bets that are placed on a race at all participating locations and provides the resulting odds and payout calculations to all the U.S. and foreign wagering sites accepting bets on the race. The data provided by each participating location to the U.S. host track is provided on an aggregate basis showing the total amount bet at that location on each potential outcome; information regarding individual bets placed is never transmitted. Similarly, the information provided by the U.S. host track to the participating locations is on an aggregate basis showing the odds and payouts for each possible outcome. The foreign wagering sites use this aggregate information to determine the payouts to be made on the wagers they accepted from their individual patrons. The foreign wagering sites pay a "host fee" to the U.S. host track for the services and rights received under the simulcast agreement.

When a foreign person enters into a wagering transaction outside the United States in a pari-mutuel pool on a U.S. horse race, that person will deal exclusively with the foreign wagering site that broadcasts the U.S. race and is authorized to accept pari-mutuel wagers on the race. The person places a bet on the race, makes payment to the foreign wagering site for that bet typically in cash, and receives a pari-mutuel ticket reflecting the amount and type of the bet or bets he places. If the bet is a winning bet, the person will present the ticket at the foreign wagering site for payment of the proceeds, also typically in cash. Both steps -- the placing of the bet at the foreign wagering site and the payment of proceeds by the site -- typically occur within a very short period of time surrounding the running of the race. Payment of proceeds is conditioned exclusively on the presentation of a ticket reflecting a winning bet.

The foreign wagering site will quote odds and make payouts on bets it accepts based on the calculations made with respect to the aggregate of all bets placed at all sites on the particular race. The foreign wagering site uses the funds it receives from the bets placed with it, less the applicable takeout, to pay proceeds on winning bets placed with it. The foreign wagering site is solely liable for payment of proceeds on winning bets placed with it and the winning bettor's sole recourse for amounts owed to him is against the foreign wagering site.

In addition to the host fee paid under the simulcast agreement by the foreign wagering site to the U.S. host track where the race is run, funds are transferred between the U.S. host track and the foreign wagering site only when necessary to balance any difference between the total bets accepted and the total payouts on winning bets on a location by location basis. Such a transfer of funds, which occurs occasionally, is referred to as a "money room adjustment." A money room adjustment arises when the total payout due on winning bets at one location is different from the total amount collected for bets placed there; such a difference at one location is offset by a comparable offsetting difference at one or more other locations. The situation of an excess at one location and offsetting deficit at another location can arise because the odds and payouts at each individual location are based on the bets placed at all locations. An excess total amount of winning bets, when compared with the wagers placed, at the foreign wagering site would give rise to a transfer of funds from the U.S. host track to the foreign site; similarly, an excess total amount of wagers placed, when compared with winning bets, at the foreign wagering site relative to the U.S. host track would give rise to a transfer of funds from the foreign wagering site to the U.S. host track. Under no circumstances will the U.S. host track make any payments directly to a foreign person who placed a winning bet at the foreign wagering site.

Proposed Guidance

New Code section 872(b)(5) makes clear that foreign persons who place bets outside the United States in a pari-mutuel pool with respect to a U.S. horse race are not subject to U.S. tax on any winnings on such bets. Clear and explicit guidance regarding the procedural and administrative aspects of this exemption will ensure that the statutory provision operates as intended.

Guidance should address the following key points:

Set forth below is a more detailed discussion of each of the key points on which explicit guidance should be provided in order to ensure the intended implementation of the new statutory provision.

1. No Obligation to Withhold U.S. Tax

New Code section 872(b)(5) provides an exclusion from gross income for amounts derived by a foreign person from a wagering transaction initiated outside the United States in a pari-mutuel pool with respect to a live horse or dog race in the United States. Section 872(b)(5) further provides that such an amount is exempt from U.S. income taxation. The broad exemption provided in section 872(b)(5) covers all taxes otherwise imposed under subtitle A of Title 26, which includes the 30% tax imposed under Code section 871 on certain amounts paid to certain foreign persons.

Under Code section 1441, an obligation to deduct and withhold the 30% tax under section 871 is imposed on persons or entities that make payments of certain items of fixed or determinable, annual or periodical income to foreign persons, to the extent the items constitute gross income from sources within the United States. Because of the exclusion from gross income that is provided in new Code section 872(b)(5), amounts derived from a pari-mutuel wager initiated outside the United States on a U.S. horse or dog race do not constitute gross income. Therefore, payment of such amounts is not subject to an obligation under Code section 1441 to deduct and withhold tax.

Explicit guidance should be provided making clear that a person or entity that makes payment of such amounts does not have any obligation to deduct and withhold U.S. tax with respect to such amounts. The guidance should provide that a payment of an amount derived from a wagering transaction initiated outside the United States in a pari-mutuel pool on a live horse or dog race in the United States is not an amount subject to withholding. Treatment of these amounts as not an amount subject to withholding would be consistent with the existing guidance applicable to proceeds from wagers placed on blackjack, baccarat, craps, roulette, or big-6 wheel. Proceeds of such wagers, like the specified amounts derived from pari-mutuel wagers, are exempt from the 30% tax by statute and the existing regulations include a specific rule excluding them from the definition of amounts subject to withholding. See Treas. Reg. section 1.1441-2(a)(4).

Alternatively, the guidance could explicitly provide that amounts derived from a wagering transaction initiated outside the United States in a pari-mutuel pool on a live horse or dog race in the United States do not constitute fixed or determinable, annual or periodical income. Such treatment would be consistent with the statutory exclusion of these amounts from gross income. Moreover, specifically providing such treatment would be consistent with the provision of the existing Treasury regulations that provides for the issuance of published guidance reflecting a determination by the Internal Revenue Service that particular items are not fixed or determinable, annual or periodical income. See Treas. Reg. section 1.1441-2(b)(2)(ii).

Amounts derived by a foreign person from a legal wagering transaction initiated outside the United States in a pari-mutuel pool with respect to a live horse or dog race in the United States are exempt from U.S. tax in the hands of the foreign recipient and therefore the payer is exempt from any withholding obligation. Explicit guidance making this clear is needed to ensure that the new statutory provision operates as intended.

2. No Obligation to Obtain Documentation regarding Recipient's Status

The exclusion from gross income and exemption from tax provided in new Code section 872(b)(5) applies to amounts derived by a foreign person from a legal wagering transaction initiated outside the United States in a pari-mutuel pool with respect to a live horse or dog race in the United States. The income exclusion and tax exemption applies to any payment that meets the specified conditions, which require that the payment be derived from a pari-mutuel wagering transaction initiated outside the United States. Eligibility for the income exclusion and tax exemption is not dependent on any special status of the foreign person who derives the amount. For example, eligibility for the income exclusion and tax exemption does not depend on the foreign person being a resident of a particular country. Because no special conditions apply for eligibility for the income exclusion and tax exemption, the payer of such amounts should not be required to obtain any special documentation regarding the status of the recipient in order to be entitled not to withhold U.S. tax on the payment.

Guidance should explicitly provide that documentation establishing foreign status is not required for purposes of the exemption from withholding. Such guidance would be consistent with the specific guidance provided in the existing regulations with respect to amounts that constitute gambling winnings from blackjack, baccarat, craps, roulette, or big-6 wheel. See Treas. Reg. section 1.1441-1(b)(4)(xx). The proceeds of such games, like the specified amounts derived from pari-mutuel wagers, are exempt from the 30% tax by statute without any requirement that the recipient have any special status or meet any special conditions. Such guidance also would be consistent with the specific guidance provided in the existing regulations with respect to several other types of payments, including, for example, payments of bank deposit interest and payments of interest on short-term obligations. See Treas. Reg. section 1.1441-1(b)(4)(ii) and (iv). Again, like the specified amounts derived from pari-mutuel wagers, these amounts are exempt from the 30% tax by statute without any special requirements with respect to the recipient.

Alternatively, the guidance could explicitly provide that such amounts are not amounts subject to withholding and therefore are not subject to any documentation requirement for purposes of eligibility for the withholding exemption. This would be consistent with the provision of the existing regulations that indicates that the question of potential documentation requirements is relevant only in the case of payment of amounts that are subject to withholding. See Treas. Reg. section 1.1441-1(b)(4)(xxi).

Explicit guidance making clear that the exemption from any withholding obligation on the part of a person or entity making payments of amounts derived by a foreign person from a legal wagering transaction initiated outside the United States in a pari-mutuel pool with respect to a live horse or dog race in the United States is needed to ensure that the new statutory provision operates as intended.

3. No Obligation to File Information Reporting

Under Code section 1461, an obligation to file information reporting is imposed on persons or entities making payments that are subject to a withholding obligation under Code section 1441. The reporting obligation is dependent on there being an underlying obligation with respect to withholding. Thus, payments that are exempt from any obligation with respect to withholding also are exempt from the information reporting obligation.

Explicit guidance should be provided making clear that a foreign wagering site that makes payment of amounts derived from a pari-mutuel wager initiated outside the United States on a U.S. horse or dog race is not required to file information reporting with respect to such amounts. This guidance should provide that the payments are not amounts subject to reporting because they are not amounts subject to withholding. This treatment would be consistent with the existing regulations regarding the interaction between the withholding obligation and the information reporting obligation. See Treas. Reg. section 1.1461-1(c)(2)(i). This treatment also would be consistent with the treatment of gambling winnings from blackjack, baccarat, craps, roulette, or big-6 wheel, which are excluded from the definition of amounts subject to reporting because they are not amounts subject to withholding. See Treas. Reg. section 1.1461-1(c)(2)(i)(H).

Alternatively, the guidance could provide an explicit exception to the reporting requirement for amounts derived from a pari-mutuel wager initiated outside the United States on a U.S. horse or dog race. Such treatment would be consistent with the provisions in the existing regulations providing reporting exceptions for several categories of payments, including certain bank deposit interest and interest on short-term obligations which are not subject to withholding. See Treas. Reg. section 1.1461-1(c)(2)(ii)(A) and (B).

Explicit guidance making clear that there is no information reporting obligation on persons or entities making payments of amounts derived by a foreign person from a legal wagering transaction initiated outside the United States in a pari-mutuel pool with respect to a live horse or dog race in the United States is needed to ensure that the new statutory provision operates as intended.

4. No Withholding, Documentation or Reporting Obligation with Respect to Any Money Room Adjustments

A money room adjustment is a transfer of funds to balance out the wagers placed at each wagering site with the payouts made by that site in respect of wagers placed at that site. Depending on the imbalance to be addressed, the money room adjustment can be a transfer either to the particular wagering site or from the particular wagering site.

Money room adjustments do not represent gambling winnings or other income of the recipient wagering site. As discussed above, in pari-mutuel wagering, the wagering site does not take a position with respect to a race. Also as discussed above, the amount of the proceeds retained by the wagering site, which is in the form of its takeout, is based on the aggregate amount of wagers placed with it and not on either the outcome of the race or the extent that the wagers placed with it are winning wagers. A money room adjustment that is transferred to the foreign wagering site is simply a transfer of funds necessary to make the required payments on pari-mutuel wagers placed at that site.

The only theory under which any money room adjustment transferred to a foreign wagering site could be considered to be a payment by the U.S. host track of an item of "income" is if the transfer is viewed as an indirect payment by the U.S. host track to the persons who placed winning wagers at the foreign wagering site. It should be noted, however, that the money room adjustment is based on aggregate amounts and is not associated with any particular winning wager or wagers. Even if the U.S. host track is considered to be making an indirect payment to the person or persons who placed winning wagers, the payment would be an amount derived from a wager initiated outside the United States in a pari-mutuel pool on a live horse or dog race in the United States. Payments of such amounts derived by foreign persons are excluded from gross income and exempt from U.S. tax under new Code section 872(b)(5). For all the reasons discussed above, payments of such amounts are not subject to withholding, documentation, or information reporting obligations.