John A. Francisco, Petitioner v. Commissioner of Internal Revenue, Respondent, 119 T.C. 317

Colvin, Judge: Respondent determined deficiencies of $18,324, $52,870, and $31,913 and

section 6662(

a) accuracy-related penalties of $3,665, $10,574, and $6,383 relating to petitioner’s 1995, 1996, and 1997 Federal income taxes, respectively. The issues for decision are:

(1) Whether the

section 931(

a) exclusion applies even though the Secretary has not issued regulations under

section 931(d)(2). We hold that it does; (2) whether income earned by petitioner from performing personal services in international waters is American Samoan source or effectively connected income, as petitioner contends, or U.S. source, as respondent contends. We hold that it is U.S. source income; (3) whether petitioner must include in gross income the amounts of State income tax refunds he received in 1995 and 1996. We hold that he must. FINDINGS OF FACT A. Petitioner Petitioner was a U.S. citizen residing in American Samoa during the years in issue and when he filed his petition. B.

Petitioner’s Fishing Employment Petitioner was employed by the De Silva Sea Encounter Corp. (De Silva), a Nevada corporation, as the chief engineer of a tuna fishing vessel (the MAC Sea Encounter). As chief engineer, petitioner was primarily responsible for the operation, repair, and maintenance of the ship’s engine and other machinery, including the refrigeration, storing, and offloading systems designed to ensure the quality of the catch.

Petitioner performed services for the M/V Sea Encounter in an American Samoan port or territorial waters 7 days in 1995, 10 days in 1996, and 11 days in 1997, and in international waters 208 days in 1995, 193 days in 1996, and 272 days in 1997. Each fishing trip began and ended at a port in American Samoa. Each trip took from 3 weeks to 3 months. After the ship left port, it generally remained at sea until it filled its storage capacity for fish (i.e., 1,150 tons).

The ship returned to port in American Samoa to sell, pursuant to an exclusive contract, the entire catch to the Van Camp Seafood Co. (Van Camp) fish processing plant. De Silva and its workers were paid only for fish accepted by Van Camp. On average, Van Camp rejected about 2 percent of the catch. If Van Camp rejected the entire catch, none of the crew members would be paid. Petitioner was paid the second highest amount of any crew member. Petitioner was paid $30 per ton and had no right to, or any ownership interest in, the fish. Petitioner was paid in American Samoa.

Petitioner was responsible for preparing the ship for each voyage, taking care of the catch, and delivering the fish to the Van Camp cannery in American Samoa. Petitioner’s prevoyage duties included making cold water to refrigerate the fish, making brine to store the fish, and ensuring that the engines and machinery were all in order. At the conclusion of each voyage, petitioner was in charge of the hydraulic equipment used to offload the fish as well as the cargo booms, conveyor belts, and other equipment. On timely filed 1995, 1996, and 1997 returns, petitioner, relying on

section 931, excluded wage income relating to his employment with De Silva. C. Petitioner’s State Tax Payments and Refunds On his 1994 return, petitioner claimed an $8,708 deduction for California State income taxes paid. In 1995, petitioner received a $1,150 California State income tax refund. Petitioner did not report the amount of the 1995 refund on his 1995 Federal income tax return. On his 1995 return, petitioner claimed a $4,000 deduction for California State income taxes paid. In 1996, petitioner received a $3,839 California State income tax refund.

On his 1996 return, petitioner reported as income and also deducted that $3,839 refund. OPINION The issues for decision are whether petitioner’s income earned from services performed in international waters is excludable from income under

section 931, and whether he must include in gross income the amount of his State tax refunds. A. Provisions in the Tax Reform Act of 1986 Relating to Guam, American Samoa, and the CNMI 1. Retention and Revision of the

Section 931(

a) Exclusion Individuals who are U.S. citizens or resident aliens are taxed by the United States on their worldwide income. Sec. 1.1-1(b), Income Tax Regs. However, an exclusion applies to possessions source income of U.S. citizens who reside in Guam, American Samoa, and the Confederated Northern Mariana Islands (CNMl). Sec. 931. Congress amended

section 931 in 1986. Tax Reform Act of 1986 (1986 TRA), Pub. L. 99-514, sec. 1272(a), 100 Stat. 2593. Under

section 931 as amended, an individual who is a bona fide resident of a “specified possession” (e.g., American Samoa) during an entire tax year may exclude from gross income (1) income derived from sources within any specified possession and (2) income effectively connected with the conduct of a trade or business (“American Samoan source or effectively connected income”) by that individual within any specified possession. Sec. 931(a). 2.

Grant to Guam, American Samoa, and the CNMI of Control Over Their Tax Systems Guam, American Samoa, and the CNMI had a mirror or modified mirror system of taxation for many years before 1986. Under that system, American Samoa, in 1963, adopted substantially all of the Internal Revenue Code of 1954, 11 A.S.C.A. sec. 11.0501, but American Samoans paid the tax to American Samoa, not the United States. In 1986, Congress concluded that the Internal Revenue Code, developed for the complex U.S. economy, might be inappropriate for Guam, American Samoa, and the CNMI. S.

Rept. 99-313, at 477-478 (1985), 1986-3 C.B. (Vol. 3) 477-478. Thus, except as explained in the next paragraph of this Opinion, Congress granted to those possessions control over their local tax systems. 1986 TRA sec. 1271(a), 100 Stat. 2591. 3. Concerns About the Potential for Abuse Under the Mirror System of Taxation In 1986, Congress also concluded that the mirror systems of taxation then in effect in Guam, American Samoa, and the CNMI created opportunities for abuse by U.S. taxpayers. S. Rept. 99-313, supra at 478, 1986-3 C.B. (Vol. 3) at 478.

As a result, for each of the specified possessions, Congress delayed (1) implementation of the 1986 amendments to

section 931, and (2) the grant of control over the local tax system until that possession and the Secretary executed a tax implementation agreement providing for elimination of double taxation, prevention of tax abuse, and sharing of tax information. 1986 tea sec. 1271(b), 100 Stat. 2592. The Tax Implementation Agreement Between the United States and American Samoa was executed for the United States by the Assistant Secretary for Tax Policy, effective January 1, 1988. See Tax Implementation Agreement Between the United States of America and American Samoa, 1988-1 C.B. 408. Adoption of that agreement satisfied the sole precondition to availability of the revised

section 931(

a) exclusion for residents of American Samoa. See 1986 TRA sec. 1277(b), 100 Stat. 2600. B. Whether

Section 931(

a) Applies in the Absence of Regulations Under

Section 931(d)(2) 1. Regulation Authority Under

Section 931(d)

(2) Section 931(d)(2) provides:

(2) Determination op source, etc. — The determination as to whether income is described in paragraph (1) or (2) of subsection (

a) shall be made under regulations prescribed by the Secretary. The first issue for decision is whether

section 931(

a) applies even though the Secretary has not issued regulations under

section 931(d)(2). The dissent argues, contrary to the view of both parties, that

section 931(d)(2) delegates to the Secretary the authority to decide (simply by issuing or not issuing regulations) whether the

section 931(

a) exclusion applies to residents of Guam, American Samoa, and the CNMI. Dissenting op. pp. 335-336. Because the Secretary has issued no regulations, according to the dissenting opinion, the

section 931(

a) exclusion has not applied to anyone since 1986, and it will never apply to anyone if the Secretary does not issue regulations under

section 931(d)(2). We believe the view expressed in the dissenting opinion conflicts with the language of the 1986 amendments to

section 931, closely related non-Code provisions enacted in 1986, and clear expressions of congressional intent contained in the legislative history accompanying enactment of those provisions. First,

section 931(

a) itself provides the exclusion, independent of the regulatory authority in

section 931(d)(2). The 1986 Senate Finance Committee report states as follows: An individual who is a bona fide resident of Guam, American Samoa, or the CNMI during the entire taxable year is subject to U.S. taxation in the same manner as a U.S. resident. However, in the case of such an individual, gross income for U.S. tax purposes does not include income derived from sources within any of the three possessions, or income effectively connected with the conduct of a trade or business by that individual within any of the three possessions. * * * [S.

Rept. 99-313, supra at 480, 1986-3 C.B. (Vol. 3) at 480.] This language shows the legislative assumption that the exclusion would take effect independently of the issuance of Treasury regulations. The dissent’s view that the exclusion has no effect absent regulations creates an unnecessary conflict between

section 931(

a) and (d)(2). See FDA v. Brown & Williamson Tobacco Corp., 529 U.S. 120, 133 (2000) (courts must interpret a statute to “ fit, if possible, all parts into an harmonious whole” (quoting FTC v. Mandel Bros., Inc., 359 U.S. 385, 389 (1959))). Second, the legislative history states (and illustrates with examples) that the purpose of the regulatory authority is to prevent abuse under the mirror system of taxation. See S. Rept. 99-313, supra at 481, 1986-3 C.B. (Vol. 3) at 481.

The Senate report states: The bill delegates to the Secretary of the Treasury the authority to prescribe regulations to determine whether income is sourced in, or effectively connected with the conduct of a trade or business in, one of these possessions, and to determine whether an individual is a resident of one of these possessions. The committee anticipates that the Secretary will use this authority to prevent abuse. * * * [Id.] Thus, Congress stated a reasonable purpose for enacting

section 931(d)(2): to prevent abuse. This reading of

section 931(d)(2) avoids any conflict between it and

section 931(a). Third, in closely related provisions in the 1986 TRA (i.e., sections 1271, 1272, and 1277(b), applicable to Guam, American Samoa, and the CNMl), Congress used explicit language to impose a precondition to implementation of the

section 931(

a) exclusion. That is, Congress explicitly provided that the amendments to

section 931(

a) and the grant to the possessions of authority over their local tax systems would take effect only upon adoption of tax implementation agreements between the United States and Guam, American Samoa, and the cnml 1986 TRA secs. 1271(b), 1277(b). In contrast, Congress did not use similar language conditioning implementation of the exclusion on the issuance of regulations. We can reasonably assume Congress intentionally chose different words in closely related statutory provisions to produce a different meaning. Fourth, contrary to the view stated in the dissent,

section 931(d)(2) lacks one “plain meaning”.

Section 931(d)(2) states merely that the determination of whether income is from sources within, or effectively connected with a trade or business within, a possession “shall be made under regulations prescribed by the Secretary.” The statute is silent as to whether those regulations may be issued under

section 931 or another

section of the Code, such as sections governing the determination of sources of income (sections 861-865). In the absence of regulations under

section 931(d)(2), we believe it is appropriate to consider sections 861-865 and related regulations in deciding what is American Samoan source and effectively connected income. 2. The Cases We have frequently held that the Secretary may not prevent implementation of a tax benefit provision simply by failing to issue regulations. Estate of Maddox v. Commissioner, 93 T.C. 228, 233-234 (1989); First Chi. Corp. v. Commissioner, 88 T.C. 663, 676-677 (1987), affd. 842 F.2d 180 (7th Cir. 1988); Occidental Petroleum Corp. v. Commissioner, 82 T.C. 819, 829 (1984). The dissent relies on Alexander v.

Commissioner, 95 T.C. 467, 473 (1990), affd. without published opinion sub nom. Stell v. Commissioner, 999 F.2d 544 (9th Cir. 1993). In Alexander, we considered the effect of the Secretary’s failure to issue regulations under

section 465(c)(3)(D).

Section 465(c)(3)(

D) provides that a limitation imposed on taxpayers by the at-risk rules “shall apply only to the extent provided in regulations prescribed by the Secretary.” In Alexander, we held that, absent regulations, the limitation does not apply. That holding is fully reconcilable with the principle that the Secretary’s failure to issue regulations does not bar application of a beneficial tax statute. Nothing in the cases cited in the dissenting opinion suggests that

section 931(

a) does not apply until regulations are issued under-section 931(d)(2). 3. Conclusion We conclude that the exclusion under

section 931(

a) applies even though the Secretary has not issued regulations under

section 931(d)(2). C. Whether Petitioner’s Income Was American Samoan Source Income or Was Effectively Connected With a Trade or Business in American Samoa 1. Positions of the Parties The parties dispute whether income earned by petitioner for performing services while the M/V Sea Encounter was in international waters is excludable from gross income. Respondent contends primarily that, under

section 863(d)(2), the income petitioner earned for performing services in international waters is U.S. source income. Petitioner relies primarily on

section 931(

a) and on

section 1.863-6, Income Tax Regs., for the proposition that the compensation he earned for services performed in international waters is sourced in American Samoa or is effectively connected with a trade or business in American Samoa. 2. Ocean-Based Personal Services Income We first consider respondent’s contention that petitioner’s income earned in international waters is U.S. source income under

section 863(d). Generally, personal services income of U.S. persons is sourced where the services are performed, without regard to the location of the payor, the residence of the taxpayer, the place of contracting, or the place of payment. Secs. 861(a)(3), 862(a)(3); Dillin v. Commissioner, 56 T.C. 228, 244 (1971); sec. 1.861-4(a), Income Tax Regs. Before 1987, income earned by U.S. citizens and residents from personal services performed in international waters was generally sourced where the services were performed; thus, income from those activities was generally treated as foreign source income.

Sec. 862(a)(3); H. Rept. 99-426, at 381 (1985), 1986-3 C.B. (Vol. 2) 381; S. Rept. 99-313, at 357 (1986), 1986-3 C.B. (Vol. 3) at 357; H. Conf. Rept. 99-841 (Vol. II), at 11-599 (1986), 1986-3 C.B. (Vol. 4) 599. This resulted in a larger foreign tax credit limitation, even though foreign countries generally did not tax that income. H. Rept. 99-426, supra at 382, 1986-3 C.B. (Vol. 2) at 382; S. Rept. 99-313, supra at 358, 1986-3 C.B. (Vol. 3) at

Section 863(

d) was enacted in

Section 863(d)(1) provides generally that income earned by a U.S. person from personal services performed in an ocean-based activity is U.S. source income, and income derived by a non-U.S. person for such services is not U.S. source income. Sec. 863(d)(1); 1986 TRA sec. 1213(a), 100 Stat. 2540. Petitioner contends that Congress intended for

section 863(

d) to apply based on the residence, and not the citizenship, of the taxpayer. If petitioner’s contention were correct,

section 863(

d) would not apply to petitioner (i.e., it would not treat his income earned from personal services performed in international waters as U.S. source) because he is not a U.S. resident. Petitioner bases this contention on the following language in the House Ways and Means Committee report accompanying enactment of the 1986 TRA: all income from space or ocean activities is sourced in the country of residence of the person generating the income: income derived by a U.S. resident is U.S. source income and income derived by a nonresident is sourced outside the United States. * * *[H.

Rept. 99-426, supra at 382, 1986-3 C.B. (Vol. 2) at 382.] We disagree with petitioner; the statutory language, differences between the House and Senate versions of the 1986 TRA, and differences in the House and Senate committee reports for the 1986 TRA compel a different reading. The House bill (section 615(

a) of H.R. 3838) provided that ocean activity income is sourced in the country of residence of the person generating the income. H. Rept. 99-426, supra at 382, 1986-3 C.B. (Vol. 2) at 382. In contrast, the Senate bill (section 915(

a) of H.R. 3838) provided that ocean-activity income derived by U.S. persons is sourced in the United States and income derived by persons other than U.S. persons is sourced outside the United States. S. Rept. 99-313, supra at 358, 1986-3 C.B. (Vol. 3) at 358. The Senate Finance Committee report for the 1986 TRA included a modified version of the House description which reflects the change in bill language.

The Senate report said in pertinent part: all income derived from space or ocean activities is sourced in the country of residence of the person generating the income: income derived by United States persons (as defined in sec. 7701(a)(30)) is U.S. source income and income derived by persons other than U.S. persons is sourced outside the United States. [J<i.] The conference report included the Senate version of the bill on this point with modifications, none of which are relevant here. H. Conf. Rept. 99-841 (Vol. II), supra at 11-600, 1986-3 C.B. (Vol. 4) at 600. Thus,

section 863(

d) as enacted applies to all U.S. persons; i.e., to both U.S. citizens and residents. Petitioner is a U.S. person because he is a U.S. citizen. Thus, subject to our review of authorities cited by petitioner, income earned by petitioner from performing services in international waters is U.S. source income. Sec. 863(d)(2); sec. 1.863-8(d)(2)(ii)(A), Proposed Income Tax Regs., 66 Fed. Reg. 3911 (Jan. 17, 2001). 3. Source of Income Received by Possessions Residents:

Section 1.863-6, Income Tax Regs. We next consider whether authorities cited by petitioner, primarily

section 931(

a) and

section 1.863-6, Income Tax Regs., lead to a result different than respondent contends applies under

section 863(d). As stated above at paragraph A-l,

section 931(

a) provides an exclusion for income sourced or effectively connected with a trade or business in American Samoa. However,

section 931 does not define American Samoan source or effectively connected income, and so we consider the sourcing rules contained in sections 861-865 and related regulations in construing those terms. Sections 1.861-1 through 1.863-5, Income Tax Regs., establish rules for determining whether income is from a U.S. source.

Section 1.863-6, Income Tax Regs., states that the principles of sections 1.861-1 through 1.863-5, Income Tax Regs., are applied in determining whether gross income is from sources within or without a possession of the United States.

Section 1.863-6, Income Tax Regs., also provides that, in applying sections 1.861-1 through 1.863-5, Income Tax Regs., the name of the possession shall be substituted for the term “United States”. Thus, the effect of

section 1.863-6, Income Tax Regs., is to treat income from personal services which would be sourced in the United States under sections 1.861-1 through 1.863-5, Income Tax Regs., if the services were performed in the United States, as sourced in American Samoa if the services were performed in American Samoa. Petitioner contends that, in the absence of regulations under

section 931(d)(2), we should conclude that under

section 1.863-6, Income Tax Regs., petitioner’s fishing income is American Samoa source and thus excludable under

section 931(a). We disagree. Sections 1.861-1 to 1.863-5, Income Tax Regs., adopted before 1986, do not treat income earned from personal services performed in international waters as U.S. source income; instead, they provide that the source of income from personal services is the place where the services are performed. Sec. 1.861-4(b)(l), Income Tax Regs. Income earned from personal services performed in international waters was not treated as U.S. source income until

section 863(d)(2) was enacted in 1986. Thus,

section 1.863-6, Income Tax Regs., does not support petitioner’s position. The Secretary has not proposed that

section 1.863-6, Income Tax Regs., be changed to refer to

section 1.863-8, Proposed Income Tax Regs., 66 Fed. Reg. 3910 (Jan. 17, 2001). Thus,

section 1.863-6, Income Tax Regs., does not incorporate

section 1.863-8, Proposed Income Tax Regs., supra. As a result, income earned from services performed in international waters, which is sourced in the United States by

section 863(

d) and

section 1.863-8, Proposed Income Tax Regs., supra is not treated as American Samoan source if earned by a resident of American Samoa. The Secretary could have proposed that change when

section 1.863-8, Proposed Income Tax Regs., supra was proposed. We consider the absence of proposed changes to

section 1.863-6, Income Tax Regs., to be an indication that the Secretary intended that

section 1.863-6, Income Tax Regs., not incorporate the rules of

section 863(

d) relating to income earned from personal services performed in international waters. 4. Whether

Section 863(

d) Violates the Antidiscrimination Provisions of the 1986 TRA or Results in Discriminatory Treatment Petitioner points out that

section 931 was amended in 1986 because (inter alia): The possessions need tax systems that help them to pursue development policies and to exercise greater control over their own economic welfare. [H. Rept. 99-426, supra at 485, 1986-3 C.B. (Vol. 2) at 485; S. Rept. 99-313, supra at 478,1986-3 C.B. (Vol. 3) at 478.] Petitioner contends that it would be inconsistent for Congress to give the possessions control over their economic welfare while taking away their ability to tax their residents’ income earned from personal services in international waters.

We disagree that Congress intended to end all U.S. taxation of the income of residents of the possessions. Congress made this clear in the Senate report, which states: An individual who is a bona fide resident of Guam, American Samoa, or the CNMI during the entire taxable year is subject to U.S. taxation in the same manner as a U.S. resident. * * * Thus, even a bona fide resident of Guam, the CNMI, or American Samoa is required to file a U.S. return and to pay taxes on a net basis if he receives income from sources outside the three possessions (i.e., U.S. or foreign source income). * * * [S.

Rept. 99-313, supra at 480-481, 1986-3 C.B. (Vol. 3) at 480-481.]

Section 1271(

d) of the 1986 TRA provides that Guam, American Samoa, and the CNMI may not enact any tax law that discriminates against any U.S. person or any resident of any other possession. Petitioner contends that treating income from personal services earned by residents of the possessions as U.S. source income under

section 863(

d) violates

section 1271(

d) of the 1986 TRA because there are different classes of taxpayers within the possessions and there may be unintentional discrimination. We disagree because the provision petitioner cites applies to those specified possessions, and not to the United States.

Petitioner also asserts that a U.S. citizen who resides in American Samoa can avoid sourcing income from the performance of services in international waters in the United States by operating as a personal services corporation formed in American Samoa because Congress exempted bona fide residents of the specified possessions from the treatment of subpart F for controlled foreign corporations. Sec. 957(c)(2). Congress anticipated that problem in the 1986 TRA. S. Rept. 99-313, supra at 358, 1986-3 C.B. (Vol. 3) at 358.

Congress stated that this problem was substantially lessened because space and ocean income is included in the separate foreign tax credit limitation for shipping income, secs. 904(d)(2)(D), 954(f), flush language, and is subject to U.S. tax under the subpart F rules, 1986 TRA sec. 1221(c)(2) (which amended the definition of foreign base company shipping income under

section 954(

f) to include income from a space or ocean activity (as defined in

section 863(d)(2)). H. Conf. Rept. 99-841 (Vol. II), supra at 11-600, 1986-3 C.B. (Vol. 4) at 600; General Explanation of the Tax Reform Act of 1986, at 934 (J. Comm. Print 1987) (the 1986 Bluebook). 5. Whether Petitioner’s Income Was Fully or Partially Sourced in American Samoa Petitioner performed services for the M/V Sea Encounter in an American Samoan port or territorial waters 7 days in 1995, 10 days in 1996, and 11 days in 1997, and in international waters 208 days in 1995, 193 days in 1996, and 272 days in 1997.

Respondent concedes that wages earned by petitioner while the M/V Sea Encounter was in port in American Samoa or within its territorial waters are American Samoan source income, secs. 861(a)(3) and 862(a)(3), and that petitioner may exclude those amounts from income under

section 931(a)(1). Petitioner contends that the services he performed in American Samoa were so substantial that, under the facts and circumstances test of

section 1.861-4(b)(l), Income Tax. Regs. (providing generally that income from labor or services is sourced where the services are performed), all his income should be sourced in American Samoa. He contends that the source of his income should not be determined solely by counting the number of days he performed services in American Samoa. He points out that he received his wages in American Samoa and that his employer’s contract was with an American Samoan cannery. Petitioner contends that, because of those activities, his fishing-related income was sourced exclusively in American Samoa.

Section 1.861-4(b)(l), Income Tax Regs., provides that, where appropriate, income from services performed within and without the United States may be allocated on the basis of time. Under that approach, the amount included in gross income is the amount that bears the same relation to total wages as the number of days the taxpayer performed services in the United States bears to the total number of days for which the taxpayer performed services for which wages were paid. We disagree that all of petitioner’s fishing-related income was sourced in American Samoa.

The location of the payor, the place of contracting, and the place of payment do not control for purposes of sourcing service income. Sec. 861(a)(3); Dillin v. Commissioner, 56 T.C. 228, 244 (1971); sec. 1.861-4(a), Income Tax Regs. Petitioner was chief engineer of the M/V Sea Encounter while it was fishing in international waters, which was the vast majority of the days petitioner performed the services at issue here. We believe that the fact that petitioner was paid based on fish tonnage shows that petitioner’s services performed in American Samoa were not disproportionately important.

Thus, we find no reason to depart from the proportionality rules of

section 1.861-4(b), Income Tax Regs. We conclude that the portion of petitioner’s income that is eligible for the

section 931(

a) exclusion is based on the number of days he worked in American Samoa. 6. Whether Petitioner’s Income Was Effectively Connected With a Trade or Business in American Samoa We next consider whether, as petitioner contends, his income is excludable from U.S. income on the grounds that it was effectively connected with a trade or business in American Samoa. As stated earlier,

section 931(a)(2) provides that the income of an individual who resides in, for example, American Samoa, is excludable from U.S. income if it is “effectively connected with the conduct of a trade or business” in American Samoa. Petitioner contends that all his fishing-related income is effectively connected with the conduct of a trade or business in American Samoa because he performed substantial services in American Samoa (e.g., preparing the vessel before trips and unloading the catch afterwards) and that those services were a material factor in the production of his income. Under

section 864(c), income can be “effectively connected with the conduct of a trade or business within the United States” if it is from “sources within”, or “sources without”, the United States. Sec. 864(c)(1)(A), (c)(4). In the absence of regulations under

section 931(a)(2) defining the phrase “effectively connected with the conduct of a trade or business”, both parties refer to provisions governing whether income is effectively connected with a U.S. trade or business under

section 864(

c) and contend that application of those principles favors their respective positions. We believe respondent has the better argument, and we conclude that application of effectively connected income concepts leads to the same result as occurs by applying the sourcing rules discussed above in paragraph C-5. a. Sources Within

Section 864(c)(1)(

A) determines whether income from sources within the United States is effectively connected with a U.S. trade or business. Under the effectively connected rules applicable to income from sources within the United States, income is effectively connected to the extent it has a U.S. source. See sec. 864(c)(3). Thus, the effect of applying the principles of

section 864(c)(3) to

section 931 would be that a taxpayer’s income would qualify for the

section 931 exclusion to the extent the income is from an American Samoan source. That analysis leads to the same result that we reached above in paragraph C-5. b. Sources Without

Section 864(c)(4) determines whether income from sources without the United States is effectively connected with a U.S. trade or business. The effect of applying the

section 864(c)(4) principles to construe

section 931(a)(2) here is the same as applying the sourcing rules (see par. C-5, above) for two reasons. First, income from sources without the United States is effectively connected with a U.S. trade or business of an individual only if the income is earned through an office or other fixed place of business of that individual. Sec. 864(c)(4)(B); sec. 1.864-7(b)(l), Income Tax Regs. There is no evidence petitioner meets this requirement.

Second, for income received by an individual from sources without the United States to be effectively connected with a U.S. trade or business, it must be income from one of the following categories: Rents, royalties, dividends, interest, or the sale or exchange of personal property. Sec. 864(c)(4)(B). Although the term “trade or business” can refer to income from the performance of personal services, sec. 863(b), that category of income is not listed in

section 864(c)(4)(B). Thus, application of principles governing whether income is effectively connected with a trade or business does not result in sourcing more of petitioner’s income in American Samoa that the amount discussed above in paragraph C-5. 7. Conclusion We conclude that income earned by petitioner in 1995, 1996, and 1997 from the performance of personal services in international waters is not excluded from U.S. tax by

section 931(a). D. Petitioner’s State Tax Payments and Refunds Gross income does not include income attributable to the recovery during the taxable year of any amount deducted in any prior taxable year to the extent such amount did not reduce the amount of tax imposed. Sec. 111; Kadunc v. Commissioner, T.C. Memo. 1997-92. Petitioner claimed an $8,708 income tax deduction relating to payment of State taxes in 1994, and he received a $1,150 State tax refund in 1995. Petitioner contends that he received no tax benefit in 1995 relating to the refund because his 1995 adjusted gross income was negative.

We disagree; 1994 (i.e., the year of the deduction) is the relevant year for determining whether he received a tax benefit. Kadunc v. Commissioner, supra. Petitioner does not contend that he did not receive a tax benefit in 1994. Accordingly, the amount of the 1995 refund is includable in his 1995 gross income. Similarly, in 1995, petitioner claimed a $4,000 income tax deduction relating to payment of State taxes but paid no U.S. income tax because, relying on

section 931, he excluded all of his wage income. In 1996, he received a $3,839 refund. Petitioner contends he received no tax benefit because he had no taxable income in 1995. We disagree. As a result of our holding that he may not exclude his wage income, petitioner enjoyed a tax benefit by his deduction of State income taxes for 1995. Thus, petitioner must include in his 1996 gross income the amount of the refund to the extent respondent allows him a deduction relating to the payment of State taxes in 1995. Accordingly, Decision will be entered under Rule 155. Reviewed by the Court.

Wells, Cohen, Swift, Gerber, Ruwe, Whalen, Halpern, Beghe, Chiechi, Laro, Gale, Thornton, and Marvel, JJ., agree with this majority opinion. VAsquez, J., concurs.

Section references are to the Internal Revenue Code in effect for the years in issue. Rule references are to the Tax Court Rules of Practice and Procedure. Respondent concedes that petitioner is not liable for the accuracy-related penalty for the years in issue. Before 1986, sec. 931 provided an exclusion from U.S. tax for American Samoan source income received by U.S. citizens if certain conditions were met. Specking v. Commissioner, 117 T.C. 95, 102 (2001). For purposes of sec. 931(a), specified possessions are Guam, American Samoa, and the Northern Mariana Islands. Sec. 931(c). SEC. 931. INCOME FROM SOURCES WITHIN GUAM, AMERICAN SAMOA, OR THE NORTHERN MARIANA ISLANDS. (

a) General Rule. — In the case of an individual who is a bona fide resident of a specified possession during the entire taxable year, gross income shall not include— (1) income derived from sources within any specified possession, and (2) income effectively connected with the conduct of a trade or business by such individual within any specified possession. ^ # * (

d) Special Rules. — For purposes of this section— !{í }¡! $ * ¡J: !}: *

(2) Determination of source, etc. — The determination as to whether income is described in paragraph (1) or (2) of subsection (

a) shall be made under regulations prescribed by the Secretary.

(3) Determination of residency. — For purposes of this

section and

section 876, the determination of whether an individual is a bona fide resident of Guam, American Samoa, or the Northern Mariana Islands shall be made under regulations prescribed by the Secretary. See Boral Gas, Inc. v. laulualo, No. CA 87-1 (Am. Samoa Oct. 3, 2002). Sec. 1271(

b) of the Tax Reform Act of 1986 (1986 TRA), Pub. L. 99-514, 100 Stat. 2592, provides: (

b) Agreements to Alleviate Certain Problems Relating to Tax Administration. — Subsection (

a) shall apply to Guam, American Samoa, or the Northern Mariana Islands only if (and so long as) an implementing agreement is in effect between the United States and such possession with respect to- il) the elimination of double taxation involving taxation by such possession and taxation by the United States, (2) the establishment of rules under which the evasion or avoidance of United States income tax shall not be permitted or facilitated by such possession, (3) the exchange of information between such possession and the United States for purposes of tax administration, and (4) the resolution of other problems arising in connection with the administration of the tax laws of such possession or the United States.

Any such implementing agreement shall be executed on behalf of the United States by the Secretary of the Treasury after consultation with the Secretary of the Interior. 1986 TRA sec. 1277(b), 100 Stat. 2600, provides as follows: (

b) Special rule for Guam, American Samoa, and the Northern Mariana Islands. — The amendments made by this subtitle shall apply with respect to Guam, American Samoa, or the Northern Mariana Islands (and to residents thereof and corporations created or organized therein) only if (and so long as) an implementing agreement under

section 1271 is in effect between the United States and such possession. A U.S. person is a citizen or resident of the United States. Sec. 7701(a)(30)(A). See supra note 9. Sec. 1.863-6, Income Tax Regs., provides: § 1.863-6. Income from sources within a foreign country or possession of the United States.— The principles applied in §§ 1.861-1 to 1.863-5, inclusive, for determining the gross and the taxable income from sources within and without the United States shall generally be applied, for purposes of the income tax, in determining the gross and the taxable income from sources within and without a foreign country, or * * * possession of the United States. * * * In the application of this

section the name of the particular foreign country or possession of the United States shall be substituted for the term “United States, * * * ” The last sentence quoted above was added to sec. 1.863-6, Income Tax Regs., in 1975. T.D. 7378, 1975-2 C.B. 272, 283. Sec. 863(

d) is effective for tax years beginning after Dec. 31, 1986. 1986 TRA sec. 1213(b); see also sec. 1.863-8(b), Proposed Income Tax Regs., 66 Fed. Reg. 3910 (Jan. 17, 2001). Sec. 1.861-4(b)(l)(i), Income Tax Regs., provides as follows: If a specific amount is paid for labor or personal services performed in the United States, that amount * * * shall be included in the gross income.

If no accurate allocation or segregation of compensation for labor or personal services performed in the United States can be made, or when such labor or service is performed partly within and partly without the United States, the amount to be included in the gross income shall be determined on the basis that most correctly reflects the proper source of income under the facts and circumstances of the particular case.

In many cases the facts and circumstances will be such that an apportionment on the time basis will be acceptable, that is, the amount to be included in gross income will be that amount which bears the same relation to the total compensation as the number of days of performance of the labor or services within the United States bears to the total number of days of performance of labor or services for which the payment is made. In other cases, the facts and circumstances will be such that another method of apportionment will be acceptable.