Winning Big: Is Luck Tax-Free?

Photo Credit: CityNews Ottawa

All references to the ‘Act’ mean the Income Tax Act, RSC 1985, c. 1 (5th Supp.), as amended. All references to the ‘Regulations’ mean the Income Tax Regulations. The following should not be construed as legal nor tax advice. I am a tax professional, but not your tax professional. Consultation with your usual tax/legal professional is advised.

Good morning Toronto! Unfortunately, some people win more than others. Whether it's a lucky spin at the roulette wheel or hitting the grand jackpot in the lottery, not all wins are created equal, especially in the eyes of the CRA! In today's article, we discuss how lottery and gambling winnings are treated under Canadian tax law, as well as how US gambling winnings paid to non-residents are taxed.

To begin, one of the principles of the Canadian income tax system is the ‘source doctrine’, or the idea that taxable income must be traced to a source to be taxable. Such sources include (but are not limited to) employment income, business income, dividend income, capital gains, etc. In theory, if income cannot be ‘traced’ to a source, then it is not taxable. In Canada, lottery winnings are considered windfalls, which are NOT a recognized source. In determining if income is a ‘windfall’, the starting point is ‘The Queen v. Cranswick, 82 DTC 6073', argued before the Federal Court of Appeal in 1982. In this landmark decision, the court came up with eight criteria to determine if income is a windfall. These still hold true today That is;

• If the taxpayer had no enforceable claim to the payment;
• If the taxpayer made no organized effort to receive the payment;
• If the taxpayer didn’t seek the payment;
• If the taxpayer didn’t expect to receive the payment;
• If the taxpayer had no reason to expect the payment would recur;
• If the payment was from a source that is not a customary source of income for the taxpayer;
• If the payment was for goods, services or anything else provided by the taxpayer;
• If the payment was not earned by the taxpayer as a result of any activity or pursuit of gain by said taxpayer

If a taxpayer can answer ‘yes’ to any of the above factors, there is a strong possibility that the funds are NOT a windfall.

In the conventional sense, most lotteries usually offer money as prizes. In these cases, while the principal amount is neither reportable nor taxable income, any income (such as interest or investment income) generated ON that principal IS taxable

However, depending on the specifics of the lottery, physical property like cars/houses is commonly offered as prizes. While the initial value of these assets is untaxed, any appreciation/depreciation ARE subject to capital gains/loss provisions. As a reminder, capital gains/losses are added/deducted to income at a 50% inclusion rate. Homes won as part of a lottery do still qualify for the Principal Residence Exemption if the home was designated as a principal residence and inhabited by the taxpayer or a member of their immediate family. If the exemption applies, then no capital gains tax is payable.

Generally speaking, the Act treats gambling winnings the same as lottery winnings. When received as mere occurrences of chance, they are considered windfalls. However, there have been a few cases where the courts have ruled that continuous gambling can be sourced as business/professional income, and hence taxable. These factors can be summarized as below:

• If the taxpayer gambles with the intent to earn income;
• If the gambling activity is frequent and repetitive;
• If there is a structured approach taken to betting (i.e. card counting);
• If the taxpayer kept logs, spreadsheets, records, etc, of gains/losses;
• If winnings are reinvested in further gambling;
• If the taxpayer spends significant amounts of time on gambling, like a full-time job;
• If the taxpayer relies on gambling winnings as a significant source of income;
• If the game involves significant skill, and this skill is being actively exploited to win

If the income is indeed considered business income, then the taxpayer needs to report the income on Form T2125 when completing their tax return. However, as part of this process, gambling losses can be deducted from income. Likewise, expenses incurred in carrying out ‘business’ activities, such as accommodations, meals, and travel, are claimable as deductions.

Up until now, we have considered cases when the gambling/lottery winnings arise in Canada. Of course, many Canadians have travelled down South to gamble. In these cases, different rules apply. Unlike Canada, the US considers gambling winnings to be taxable. Non-US tax residents must pay a 30% tax on winnings, which are withheld by the casino when the payment is made. However, there are two scenarios where a Canadian taxpayer can file a tax return to get a refund. That is:

• If tax was withheld from winnings from blackjack, baccarat, craps, roulette or big-6 wheel (these games are not taxed in the US) OR
• If there are gambling losses (any game but blackjack, baccarat, craps, roulette or big-6 wheel), which can reduce gambling winnings

If any of the above apply, then the Canadian should obtain an Individual Taxpayer Identification Number (ITIN) from the IRS, and file Form 1040NR*, the US equivalent of the T1 Personal Non-Resident return in Canada. Generally, the 1040NR is due on 15 April of the year following that in which the income was earned. Subsequently, the return can be late-filed for 3 years from that 15 April. Past this date, the IRS does not give refunds. Generally, due to the complexity of the process, most Canadians choose not to file, potentially losing out on hundreds of dollars.

*If the taxpayer has other US source income/property, has lived in the US, or is a US citizen/LPR, they should consult a cross-boarder tax professional to acertain if the 1040NR is the correct return for them.

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