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Intrastate iGaming: Interstate Compacts and Revenue Sharing

January 30th, 2013 No comments

One of the most not only fascinating but also critical issues for state-by-state iGaming legalization is whether states will let their virtual fences down and enter into iGaming compacts with other states. If so, how may states share tax revenue from gaming activity?

Interstate iGaming Compacts

Before evaluating tax revenue sharing possibilities, we must grasp some of the dynamics surrounding interstate compacts.

Look no farther than the State of Nevada, which appears poised to open its doors to intrastate online poker sometime in 2013. But with a population of approximately 2.76 million, Nevada presents profitability concerns for online poker operators offering its product only to customers physically present in the state. This viability issue is compounded many times over as more than a dozen companies have already received preliminary approval to operate in the state.

Sure, some committed poker players may move to Nevada to play online full-time, but it seems unreasonable to expect many recreational players to do so. Certainly not enough to make online poker in Nevada a robust business on its own. And interested parties know this.

In his 2013 State of the State address, Nevada Governor Brian Sandoval urged lawmakers to approve a bill authorizing him to enter into interstate iGaming compacts without first requiring federal legislation authorizing it.

Larger states, however, may not have as strong an incentive to negotiate compacts with smaller states. Consider California, for instance. With a population of over 38 million, the Golden State is larger than every country in Europe but eight.

The Internet Gambling Consumer Protection and Public-Private Partnership Act of 2012 did provide California legislators the alternatives to opt into a federal iGaming system or enter into compacts with other states. The problem with either alternative coming to fruition is that special interest groups in California are mightily struggling to get on the same page for iGaming. That’s why the bill failed to reach committee vote last year. And these groups may hold the belief that if the State reaches compacts for interstate online play, other smaller states would reap the benefits of the pooled liquidity far more than California would.

Another compact concern for California involves losing its residents to partner states. (Note: Expatriation is already a problem for California.) Suppose, however unlikely, that NV presented an attractive proposal to CA for pooling liquidity, such as NV giving CA a significant percentage of gross gaming revenue (“GGR”) generated by the NV players. Once the pooled sites go live, some CA players would move to establish residency in NV and thus avoid paying CA income tax. The analysis of this issue could narrow to whether the additional gaming revenue paid to CA as result of liquidity would exceed the lost income tax revenue from CA expats.

Even if states agree to share revenues based on location of players, as discussed below, there’s likely still an overall benefit to pooling liquidity. By substantially increasing the number of virtual players on a given site, a greater variety and quantity of tables become available for players to choose from. The challenge is figuring out how to distribute the increase in overall benefit so interstate compacting is agreeable to lawmakers and their supporters on all sides of the negotiating table.

With the above in mind, how would states seek to share tax revenues pursuant to interstate iGaming compacts?

Revenue Sharing Pursuant to Interstate Compacts

States that have or are considering legalized online gaming are including their own licensing and taxation regimes in the legislation. We should expect any state’s iGaming legislation to permit an operator to operate in the state only if licensed in the state. In other words, foreign operators in general seem unlikely, at least in the early stages of this emerging industry.

The natural progression to interstate iGaming compacts would seem to involve an operator licensed in more than one state to pool its liquidity among those states. But it’s not necessarily a smooth ride to get there.

New Jersey’s pending iGaming bill, for instance, requires all iGaming servers to be located in Atlantic City in order to comply with the New Jersey State Constitution. If PokerStars is licensed in both NV and NJ and pools its liquidity, for example, then PokerStars would have to ensure all servers running virtual tables with NJ players are located in Atlantic City. If NV players were on these tables as well, would such conduct run afoul of the NV interactive gaming laws? I suspect this type of issue would need to be addressed in the interstate compacts themselves.

As an aside, the notion of requiring operators pursuant to an interstate compact to be licensed in each state it seeks to operate ironically defeats another purpose for compacts: Avoiding paying license fees in multiple states.

With the above considerations in mind, how would states share gaming revenue pursuant to an iGaming compact? Let’s assume, as discussed, that each state will have in place its own gaming taxation model. The result is that operators could be required to apply more than one state’s taxation model to activity taking place on the same online poker table.

Suppose again that PokerStars is licensed in both NV and NJ. NV’s tax is 6.75% of GGR. The pending NJ iGaming bill calls for a 10% tax on GGR. If liquidity is pooled between the states, there could be both NV players and NJ players on the same PokerStars cash game tables. Gaming revenue to PokerStars would be the collected rake for each hand played.

The question then becomes, how do the two state’s gaming taxation models apply to each online poker hand played? A few possible approaches:

  1. The rake is subject to tax in both states;
  2. The rake is subject to tax in the state that the winning player of the hand resides; or
  3. A proportion of rake is subject to tax in state “A” based on the ratio of total wagers made by players in state “A” to total wagers made by players in both states “A” and “B.”

Approach #1 obviously requires modification, otherwise operators would pay GGR tax of the full amount to both states. Operators could be entitled to some tax credit for GGR paid to another jurisdiction. The states would need to negotiate the mechanics of the tax credits as applied to each state.

Approach #2 would seem to be the easiest to implement. Operators would already be required to know the location of all of its players, so the added step of attributing a location to rake collected for each hand does not seem too burdensome. Of course, split pots present more complex situations, but are likely far from insurmountable.

An interesting issue arises with Approach #2, however. States themselves would then be biased with respect to the outcome of each hand in favor of its own residents. The more its own residents win over nonresidents on the pooled tables, the more overall gaming revenue to the state. The bias would be more pronounced with poker tournaments, as the prize distributions are more skewed. Clearly, states themselves should not have preferred winners for quantifiable reasons in games they are regulating.

Approach #3 would be more complicated to implement than #2, but it removes the state bias issue. Let’s try an example for #3 to clarify the mechanics.

Suppose there are three NJ players and three NV players at the same online poker table with a rake of $5 for each hand played. At the conclusion of one hand of Texas Hold’em, player 1 (NJ) wagered $5, player 2 (NJ) wagered $0, player 3 (NJ) wagered $10, player 4 (NV) wagered $25, player 5 (NV) wagered $25, and player 6 (NV) wagered $10. Player 4 won the hand. NJ players wagered a total of $15, and NV players wagered a total of $60. The percentage of rake attributable to NJ would be 15/(15+60), or 20%. Percentage of rake attributable to NV would be 80%. For this hand, $1 of rake would be subject to the 10% GGR tax in NJ, and $4 of rake would be subject to the 6.75% GGR tax in NV.

Any of the three above approaches are viable if each state has a similar GGR model. How would states share revenue if one state taxes gaming revenue based on GGR and another imposes a deposit tax? I will leave that question open for us to think about.

I’m very interested in hearing reactions to this post. Does anyone envision a different path to pooling virtual liquidity in the U.S.? Are there more efficient or agreeable ways that states could seek to share revenue? Consider contributing your thoughts at the LinkedIn group U.S. Internet Gaming: Tax Considerations.

I plan to revisit this topic sooner than later. In about one week, we’ll learn whether iGaming becomes legal in New Jersey. If it does, I’ll cover that next time. If not, I’ll delve into state income tax considerations for both iGaming operators and players.

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