14 T.C. 757">*757 The Commissioner determined deficiencies in excess profits tax against the petitioner as follows: For the period July 29, 1942, to June 30, 1943, $ 68,150.58; and for the fiscal year ended June 30, 1944, $ 50,497.40.

The petitioner contends that the Commissioner erred in using as the petitioner's basis for depreciation of assets1950 U.S. Tax Ct. LEXIS 210">*211 acquired from American Ecla Corporation their cost to the petitioner rather than their basis in the hands of the transferor, and in determining that the petitioner's equity invested capital based upon those assets should be their cost instead of the transferor's basis under sections 718 (a) (2) and 760. Both issues are said to depend upon whether the transaction whereby the petitioner acquired those assets constituted a tax free reorganization within the meaning of section 112 (g) (1) (D).

FINDINGS OF FACT.

The petitioner's returns for the periods here involved were filed with the collector of internal revenue for the first district of New York.

Ericsson Screw Machine Products Co. (herein called Old Ericsson) was incorporated in 1913 for the purpose of carrying on the business of manufacturing screw machine products and precision parts. It was successful in that business, was in a sound financial condition in 1942, and had made good profits for a number of prior years. It believed from experience that war stimulated competition and would seriously interfere with its business for a period after the war, and in 1942 it was investigating the possibility of using some of its funds 1950 U.S. Tax Ct. LEXIS 210">*212 in a business unrelated to that which it was carrying on to help it during the anticipated postwar period.

14 T.C. 757">*758 American Ecla Corporation (hereinafter called Ecla) had been incorporated in 1938 for the purpose of engaging in the manufacture and development of two-way stretch and waterproof fabrics for use principally in girdles, bathing suits, and similar garments.

Ecla had acquired certain patents and patent applications in January, 1939, for $ 630,000 in cash and had begun experimental operations in a leased plant in 1939 to develop those patents.

Marc A. Chavannes supervised the technical manufacturing operations and experimental work of the company. He originated improvements on the basic patents and applications and took out additional applications covering those improvements in his own name while an employee of Ecla. Ecla was indebted to him in 1942 for salary and other items and as a result there was a serious legal question as to whether he or Ecla had a valid legal claim to his patent applications.

The financial sponsors of Ecla, principally Europeans, found themselves unable to provide further financial support as a result of the war and Ecla became pressed for funds. 1950 U.S. Tax Ct. LEXIS 210">*213 Also, plans for the introduction of its new products were abandoned because of the silk and rubber shortage. Those events rendered Ecla's commercial prospects highly uncertain. It was handicapped in obtaining war orders because of its lack of a favorable commercial history. Its financial condition on May 31, 1942, was critical. Its current liabilities to trade creditors, for pay rolls, interest, etc., aggregated approximately $ 18,700 and its current assets were approximately $ 650, including $ 34 in cash. The creditors were pressing the company and bankruptcy appeared imminent at that time.

Old Ericsson learned of Ecla about the beginning of 1942 and investigated it. Old Ericsson realized that it might gain tax advantages from the acquisition of the patents, machinery, and equipment of Ecla if it could have the high basis which those assets had in the hands of Ecla. However, its president was not interested in any deal until he became convinced, after conferences with Chavannes, that the latter could safely and profitably manufacture a plastic film product for which there would be a great demand. The proposed manufacturing process was expensive, new, and dissimilar to anything1950 U.S. Tax Ct. LEXIS 210">*214 theretofore attempted by Ecla, but was to be under patent improvements on which Chavannes was working. Old Ericsson was then willing to go on with the plan, regardless of whether or not it would get the tax benefits above mentioned. The estimated cost of the necessary plant and equipment was about $ 200,000, of which Old Ericsson would furnish one-half.

An agreement was entered into in July, 1942, by Ecla, Old Ericsson, Chavannes, William B. Nichols & Co., William B. Nichols, Alfred P. Pestalozzi, and Sidney Mattison. The latter three were officers of 14 T.C. 757">*759 Ecla. The syndicate referred to in the agreement consisted of certain officers and creditors of Ecla. The agreement provided that a corporation, later named Ecla Patents Corporation and herein called Patents, would be organized and Ecla would transfer to it its machinery and equipment and its so-called old patents. The machinery and equipment was subject to an existing chattel mortgage and the agreement provided that "The mortgage will however be reduced to approximately $ 11,500 immediately and will be further reduced to approximately $ 6,500 when American Ecla Corporation shall receive the purchase price of the stock1950 U.S. Tax Ct. LEXIS 210">*215 of a consolidated company hereafter mentioned." Ecla was to receive in exchange for those assets all of the stock of Patents. Ecla was not to be liable under the mortgage. Rent, which might be paid for the use of the machinery, was to apply first in the payment of interest and then in the reduction of the principal of the mortgage. Old Ericsson and Patents were to be consolidated to form the petitioner, the Old Ericsson interests to receive 89 per cent of its stock and Ecla to receive 11 per cent.

Paragraph 5 of the agreement was as follows:

Ecla to give present stockholders of Ericsson an option to purchase the stock of the consolidated company issued to Ecla within two years after the consolidation, for not less than $ 5,000. (Since proceeds of the exercise of this option will be necessary to pay off Mr. Lubovitch, $ 2,000, and to subscribe to capital of the operating company, $ 3,000, within sixty days after the consummation of these arrangements Ecla to be free to pledge stock as collateral for a loan in a sum not to exceed $ 5,000 with provisions satisfactory to Ericsson; in the event that Ecla is unable to meet said loan at its maturity, Ericsson to have the right to1950 U.S. Tax Ct. LEXIS 210">*216 pay same in lieu of exercising its option and to acquire the stock so pledged; Ericsson in that event to pay to Ecla any difference between the agreed option price and the amount of said loan.) Ecla will agree to pay proceeds of exercise of this option or of loan anticipating same to the mortgagee in reduction of the mortgage on machinery and equipment.

Chavannes was stated to be the owner of the new inventions and improvements, for some of which applications for patents had been filed, and he granted to the petitioner an exclusive license on the so-called new patents. Seventy-five per cent of all royalties received by the petitioner "from the operating company" were to be paid to Chavannes, the petitioner to pay him for the year beginning July 1, 1942, a minimum advance royalty of $ 10,000, and for each year thereafter a minimum royalty of $ 5,000 per annum. The royalties mentioned were payable with respect to the old and the new patents, but not with respect to any applications for patents not related thereto. The $ 10,000 advance royalty mentioned was to be used by Ecla to take care of its most pressing liabilities, which had to be disposed of to render the deal possible. Arrangements1950 U.S. Tax Ct. LEXIS 210">*217 were to be made with creditors of Ecla where necessary. The deal was to be approved by the debenture holders and stockholders of Ecla. The expenses of 14 T.C. 757">*760 organization, consolidation, and so on, were to be shared equally by the petitioner and Ecla, with a limitation of $ 1,000 on Ecla's share.

The agreement also provided for the incorporation of an "operating company," called Plastic Film Corporation. The Ericsson interests and the syndicate each agreed to invest $ 3,000 in that corporation, to be used as working capital, in addition to which Ericsson interests were to loan the company $ 6,000 in cash "and the syndicate will reduce its mortgage on the machinery by $ 6,000 to about $ 11,500 in consideration of which both Ericsson interests and the syndicate will receive the company's notes," later to be exchanged for preferred stock. The Ericsson interests, the syndicate, and Chavannes were each to receive one-third of 54 per cent of the stock. The remainder of the stock was to be held for further financing. The petitioner was to grant this operating company an exclusive license under all of the patents, old and new, mentioned above and was to receive royalties consisting1950 U.S. Tax Ct. LEXIS 210">*218 of a portion of the sales price of all merchandise manufactured under the license and a percentage of the gross processing charge on merchandise processed under the license. The royalties were subject to revision. The petitioner was to rent the machinery and equipment to the operating company at a rental based on sales of the operating company. The operating company was to enter into a contract with Chavannes giving to the petitioner "or its licensor" title to any improvements upon any products or processes covered by the license, but giving to Chavannes title to any new unrelated inventions, and requiring Chavannes to give the operating company an exclusive license under any new inventions for a specified royalty.

Ecla transferred the patents and machinery to Patents on August 25, 1942, and received in exchange all of the capital stock of Patents. Patents assumed a chattel mortgage on the machinery and equipment in the amount of $ 6,528, plus accrued interest of $ 458.72. Ecla's adjusted basis on the net assets transferred was $ 599,892.82.

Patents and Old Ericsson consolidated on September 1, 1942, at which time Ecla surrendered all of the stock previously issued by Patents1950 U.S. Tax Ct. LEXIS 210">*219 and received in exchange 77 shares of the common stock of the petitioner, and the stockholders of Old Ericsson surrendered their stock in that corporation and received in exchange all of the preferred stock then issued (550.73 shares) and 550.73 shares of the common stock of the petitioner. The petitioner issued no other shares. Patents never held any meetings and never transacted any business except as stated herein.

Ecla, on or about August 25, 1942, granted an option to the stockholders of Old Ericsson, reciting that whereas Ecla owned 11 per cent of the stock of the petitioner, and the stockholders of Old Ericsson were desirous of acquiring that stock, it was agreed that they could 14 T.C. 757">*761 acquire it by the payment of $ 5,000 at any time within two years. It was the understanding of the parties at the time of entering into the agreement in July, 1942, and thereafter that the stockholders of Old Ericsson would acquire from Ecla for $ 5,000 all of the stock of the petitioner which was transferred to Ecla at the time Patents and Old Ericsson were consolidated to form the petitioner. Ecla borrowed $ 5,000 from a bank on October 10, 1942, giving its note, guaranteed by the petitioner. 1950 U.S. Tax Ct. LEXIS 210">*220 Ecla pledged 77 shares of the petitioner's stock as collateral for the loan. The petitioner paid off the loan on January 8, 1943, and received the 77 shares of its stock as its own.

A corporation named Plastic Film Corporation (hereinafter called Plastic) was organized in July, 1942. Chavannes, the petitioner, and other interests, each paid $ 3,000 and each received 1,800 shares of its capital stock. The petitioner and other interests each loaned it $ 6,000.

Chavannes executed a license agreement with Patents on August 25, 1942, and on the same day assigned his interest in the agreement to Ecla. The petitioner paid royalties under the agreement as follows: $ 10,000 during the ten months ended June 30, 1943; $ 10,044.09 during the fiscal year ended June 30, 1944; and $ 5,000 during the fiscal year ended June 30, 1945.

The petitioner executed a license agreement with Plastic on February 5, 1943. Plastic paid royalties to the petitioner thereunder as follows: $ 226.54 during the ten months ended June 30, 1943; $ 13,392.12 during the year ended June 30, 1944; and $ 3,595.33 during the year ended June 30, 1945.

The petitioner leased to Plastic the machinery and equipment which it1950 U.S. Tax Ct. LEXIS 210">*221 had acquired from Ecla. It received rent for the machinery and equipment as follows: $ 550 during the ten months ended June 30, 1943, and $ 600 during each of the succeeding two fiscal years.

Plastic entered into an employment agreement with Chavannes on October 10, 1942, under which it employed him as general manager for five years from July 1, 1942, he to receive as compensation for his services, in addition to the license fees, a percentage of gross receipts of Plastic. The agreement also provided that Chavannes should own any new inventions which he might make, but Plastic should have an exclusive license on those inventions.

The following table shows the amount paid to Plastic for its stock up to June 30, 1945:

14 T.C. 757">*762 The petitioner and its stockholders owned 21 per cent of the preferred stock and 17 per cent of the common stock of Plastic as of June 30, 1945. Plastic had net losses up to the close of 1944 of about $ 370,000, but its1950 U.S. Tax Ct. LEXIS 210">*222 net sales for 1945 exceeded $ 3,000,000 and it had a net profit in that year of about $ 183,000. Its success was due to new methods devised by Chavannes and not to the patents transferred from Ecla. The latter were found to be "played out."

Ecla, on its return for its fiscal year ended November 30, 1942, reported a net loss of $ 588,972.25 from the sale or exchange of property other than capital assets consisting of its patents and machinery and equipment. The gross selling price for the patents, machinery, and equipment was shown as $ 17,807.29.

The stipulation of facts is incorporated herein by this reference.

OPINION.

The petitioner claims that it is entitled to use the Ecla basis for the assets acquired from Ecla in computing depreciation deductions and equity invested capital because the transaction whereby it acquired the assets was a reorganization within the meaning of section 112 (g) (1) (D). Secs. 113 (a) (6) and (b); 114 (a); 718 (a) (2); and 760. The reorganization definition relied upon is "a transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor or its shareholders or both are in control of1950 U.S. Tax Ct. LEXIS 210">*223 the corporation to which the assets are transferred." The petitioner begins with Old Ericsson and Ecla and reasons that both transferred assets to it and immediately after the transfer owned all of its stock. Although the statute mentions only a transfer by one corporation to another whereas here two corporations transferred assets to the petitioner, nevertheless, the petitioner argues that the terms of the statute are met and there is a reorganization where each of the transferring corporations receives stock of the transferee for its assets and the stock thus received by the two transferors gives them control. If this reasoning is sound, at least each transferor must transfer assets for stock and not merely sell, to comply with section 112 (g) (1) (D). The Commissioner contends that the participating parties intended the transfer of assets by Ecla to be a sale, the real consideration for which was to be money rather than stock; in other words, that Ecla was to retain no interest in the transferred assets through ownership of stock of the petitioner and, for that reason, if for no other, the provisions of the statute defining a reorganization were not met.

The president of Old1950 U.S. Tax Ct. LEXIS 210">*224 Ericsson, who is also president of the petitioner, was the only witness. He testified that Old Ericsson was at all times fully aware of the possible tax benefits which are the subject 14 T.C. 757">*763 of the present controversy. The Old Ericsson interests were endeavoring to obtain those benefits. Such a purpose is not objectionable, but the steps employed must come within the words and purpose of the statute relied upon. The petitioner might have acquired the desired tax benefits had the plan permitted Ecla to retain an interest in the tranferred assets through ownership of stock in the transferee corporation. Otherwise, the transaction was a sale and the reorganization provisions do not apply and were not intended to apply. Electrical Securities Corporation v. Commissioner, 92 Fed. (2d) 593; Cortland Specialty Co. v. Commissioner, 60 Fed. (2d) 937; Pinellas Ice & Cold Storage Co. v. Commissioner, 287 U.S. 462">287 U.S. 462. Thus, it is important to determine whether the temporary holding of the petitioner's stock by Ecla was merely a "ritualistic incantation" in an effort to meet the words 1950 U.S. Tax Ct. LEXIS 210">*225 of section 112 (g) (1) (D), whereas the real intention of the parties was that Ecla should ultimately receive its consideration in cash and should not, when the integral plan was complete, be the owner of any of the stock of the petitioner. Cf. Sam Pickard, 40 B. T. A. 258; affd., 113 Fed. (2d) 488; Wilbur F. Burns, 30 B. T. A. 163; affd. sub nom. Bassick v. Commissioner, 85 Fed. (2d) 8; certiorari denied, 299 U.S. 592">299 U.S. 592.

The actual steps are set out in the stipulation. Ecla transferred part of its assets to Patents in exchange for all of the stock of Patents, a corporation organized and used solely for the convenience of the parties in these particular transactions. Cf. Gregory v. Helvering, 293 U.S. 465">293 U.S. 465. Patents then consolidated with Old Ericsson to form the petitioner, Ecla surrendering all of the stock of Patents and receiving 77 shares of the stock of the petitioner. But the agreements and the transactions do not stop there and were not intended to stop there. Ecla gave an option to the Old1950 U.S. Tax Ct. LEXIS 210">*226 Ericsson interests to purchase the 77 shares of the petitioner's stock for $ 5,000 in cash. The written agreements and the pledge of the stock for the loan indicate the necessity which Ecla had for this cash. The actual option recites that "the party of the second part is desirous of acquiring the said stock." Ericsson, who was the party of the second part to that agreement representing the Old Ericsson interests, testified, both on cross-examination and on redirect examination, that the understanding at the time was that the Old Ericsson interests would actually purchase the 77 shares of stock from Ecla for $ 5,000. Counsel for the petitioner had him later acknowledge that he had a right to exercise the option at any time within two years after August 25, 1942, but his testimony as a whole and the instruments themselves indicate that the Ericsson interests intended and agreed to acquire all of the stock of the petitioner and Ecla was not to own any of it when the transactions were complete. Some corroboration for this conclusion may be found in 14 T.C. 757">*764 the fact that Ecla reported the transaction on its return as a sale and claimed the resulting loss. The exercise of the option1950 U.S. Tax Ct. LEXIS 210">*227 and the surrender of the 77 shares by Ecla was one of the steps essential and inseparable from the rest in accomplishing the result which the parties sought when they began their transactions. Thus, Ecla had no stock interest in the transferred assets at the completion of the plan and the continuity of interest through stockholding by each transferor, essential to the petitioner's theory of the alleged reorganization, was lacking.

Although the result reached above is based upon the conclusion that Ecla was to receive $ 5,000 for the 77 shares of the petitioner's stock temporarily placed in its name and therefore sold its assets instead of transferring them for stock, the justice of it appears also from a broader, less technical view of what happened. The Old Ericsson interests had a right to find some means of investing surplus funds and they apparently accomplished that result. Furthermore, it may be assumed that the acquisition of the Ecla assets contributed in some important way to the accomplishment of that result, although that is not too clear from the evidence. Those assets, which had such a substantial basis in the hands of Ecla, had lost most, if not all, of their value1950 U.S. Tax Ct. LEXIS 210">*228 before the petitioner acquired them and Ecla was willing to receive, and actually did receive, for those assets a relatively small amount. Thus the petitioner sought a basis of about $ 600,000 with correspondingly large tax benefits by the payment of a relatively small amount. Such a result might appear reasonable enough if the persons who had held the equity in the assets while they declined in value were to retain some indirect interest in those assets, thus keeping their chances of ultimate gain or loss still alive. But the reason for such a result is difficult to find where those who indirectly owned the assets while they declined in value have terminated all chances of recoupment of their loss and the corporation claiming the high basis is one in which those persons have no stock interest. Congress has indicated no intention to defer recognition of loss under such circumstances or to give strangers to the loss in value of the assets a basis which would enable them to reap whatever benefits the future might reveal from the use or disposition of the assets. It would be less difficult to understand the Congressional purpose if Ecla had had no agreement to sell the 77 shares, 1950 U.S. Tax Ct. LEXIS 210">*229 but had, nevertheless, sold them in a later wholly separate transaction, since in that transaction it would have realized its loss and had it recognized for tax purposes.

Decision will be entered for the respondent.