36 T.C. 377">*378 Respondent determined deficiencies in the petitioner's income taxes as follows:

By amendment to his answer to the amended petition respondent has asked that the deficiencies set forth above be increased by certain amounts in the event we decide the major question presented herein adversely to the petitioner.

The primary issue in this proceeding is whether the petitioner's basis as to certain depreciable properties should be their cost (and, if so, the amount thereof and its proper allocation) or should be the cost of such properties to corporations merged into petitioner. Related questions have to do with the amount of gain or loss realized upon the sale of a part of such properties and with the amounts by which petitioner's depreciation base should be reduced by reason of certain dispositions of parts of such properties.

FINDINGS OF FACT.

Some of the facts have been stipulated. The stipulated facts are so found and the stipulation of facts, together with the exhibits attached thereto, is incorporated herein by this reference.

The petitioner is the Long Island Water Corporation, a New York corporation 1961 U.S. Tax Ct. LEXIS 141">*144 with its principal office located at Lynbrook, New York. Since its incorporation in 1925 petitioner has been engaged in the distribution and sale of water to communities located on Long Island, New York. The petitioner has kept its books and filed its income tax returns according to a calendar year accrual method of accounting. The returns for the years in issue were filed with the then collector of internal revenue at Brooklyn, New York.

In February or March of 1925 a large public utility holding company, the Associated Gas and Electric Company (hereinafter referred to as Associated), asked a public utility engineer to make an investigation and submit a preliminary appraisal of the property of 36 T.C. 377">*379 the Queens County Water Company of Long Island (hereinafter referred to as Queens), a firm which had engaged in the distribution and sale of water to communities located in or adjacent to Queens and Nassau counties, Long Island, New York, since its incorporation on March 27, 1884.

On April 1, 1925, pursuant to an understanding with Associated, the investment banking firm of Marshall Field, Glore, Ward & Company (hereinafter referred to as Marshall Field) contracted with Queens' president for 1961 U.S. Tax Ct. LEXIS 141">*145 the cash purchase of the outstanding capital stock of Queens.

On April 6, 1925, Marshall Field and Associated entered into a written agreement evidenced by the following proposal by Marshall Field and acceptance by Associated:

Associated Gas and Electric Company,

61 Broadway, New York City.

Gentlemen: We enclose herewith a copy of our contract for the purchase, at $ 280.50 per share, of not less than 90% of the outstanding capital stock of The Queens County Water Company, evidenced by our letter of April 1, 1925, to Mr. Henry de Forest Baldwin and his acceptance noted thereon under the same date. Mr. Baldwin is very confident that 100% of the stock will be delivered although some shares may not come in until the first of May. We are writing this letter to confirm the understanding which has been reached between your Company and ourselves in the matter.

1. We have made the purchase on behalf of your Company and ourselves, you to have 51% interest therein and the undersigned the remaining 49%. The total purchase price (assuming the acquisition of 100% of the outstanding Stock) will be $ 2,945,250 for the 10,500 shares outstanding. To this must be added 1961 U.S. Tax Ct. LEXIS 141">*146 the cost (exclusive of accrued interest) of calling the outstanding $ 702,000 of bonds at 105, or $ 737,100, making the total purchase price, on the basis mentioned $ 3,682,350. We shall provide the entire funds requisite to make the purchase and to carry the transaction, pledging, in order to raise the requisite funds, the entire stock to be purchased; it being the intent of our understanding that the entire transaction is to be worked out without your raising or providing any cash funds whatever.

2. The debt and stock of the Company will be re-adjusted so that the Company, or a new company to be formed for the purpose in succession to the present company, will create an issue of First Mortgage Bonds, unlimited in aggregate principal amount and issuable in series, and issues of First Preferred, Second Preferred and Common Stock, all without nominal or par value. The total number of authorized shares of each class of stock shall be worked out between us except that the Common Stock shall be divided into such number of shares as shall be fixed solely by your Company.

3. The First Preferred Stock shall be entitled to dividends at the rate of either $ 6.50 or $ 7 (as you shall determine) 1961 U.S. Tax Ct. LEXIS 141">*147 per/share per annum. The Second Preferred Stock shall be entitled to dividends at the rate of $ 8 per share per annum. Both classes of Preferred Stock shall be non voting and shall be redeemable at $ 105 per share and accrued dividends, and in the event of dissolution shall be entitled to $ 100 per share and accrued dividends, the First Preferred in preference to the Second Preferred and Common, and the Second Preferred 36 T.C. 377">*380 in preference to the Common. If your Company so decides, the First Preferred shall be convertible, at the option of the holders after such date as your Company shall fix and/or (except while held by us) at any time at the option of the Queens Company, share for share, into the proposed new $ 7 Preferred Stock of your Company. If you so elect, it may be so convertible at the option of the Queens Company, but not at the option of the holders. This new Preferred Stock, we understand, is to be entitled to cumulative preferred dividends at $ 7 per share per annum, and is to be on a parity with your present outstanding Preferred Stock (Original Series, entitled to cumulative preferred dividends at $ 3.50 per share per annum) and your present outstanding Preferred Stock 1961 U.S. Tax Ct. LEXIS 141">*148 ($ 6 Series, entitled to cumulative preferred dividends at $ 6 per share per annum).

4. The following securities, in addition to the entire amount of no par value common stock, shall be issued in the manner provided in Paragraph 5 hereof, unless a different manner is agreed upon between us, and the same shall be taken by us at the following prices (plus accrued interest or dividends, as the case may be), producing the following proceeds (exclusive of accrued interest and dividends) to be applied as follows:

If said bonds are sold to the public at a price in excess of 98 1/2 the excess shall be paid to the Queens Company.

5. If a new company is formed, all of the securities above mentioned, plus the entire no par Common Stock to be issued, shall be issued by the new company in exchange for the par value stock 1961 U.S. Tax Ct. LEXIS 141">*149 to be purchased, plus an amount of cash (exclusive of accrued interest) sufficient to redeem the $ 702,000 bonds now outstanding, subject to adjustment for accrued interest and dividends. The present Company and the new company shall thereafter be consolidated by consolidation, merger or otherwise, as you and ourselves shall determine. If a new company is not formed, the proceeds of the bonds, in excess of the amount (exclusive of accrued interest) to redeem the present outstanding bonds, shall be declared as a dividend on the stock now outstanding, and the dividends so received by us shall be applied, as above provided, in part payment of the purchase price of the stock, and in such case, also, the First and Second Preferred Stock and Common Stock to be issued, shall be issued in exchange for and/or as a dividend upon the par value stock now outstanding, the latter to be retired.

6. Immediately upon receipt by us of the securities mentioned in Paragraph 4 and the no par Common Stock which is to be issued to represent the equity, we shall deliver to you

(a) 51% of such Common Stock in exchange for $ 100,000 (preference value) of the new $ 7 Preferred Stock of your Company (we to pay 1961 U.S. Tax Ct. LEXIS 141">*150 you the accrued dividends thereon, if any), retaining the remaining 49% which shall include 36 T.C. 377">*381 the shares, if any, to be issued in exchange for the present outstanding par value shares not acquired, if any; and

(b) 75% or $ 327,750 (preference value) of the Second Preferred Stock to be acquired by us at the same price paid by us, namely, 92 and accrued dividends, or a total price of $ 301,530, exclusive of preferred dividends, and we shall accept in payment therefor, new $ 7 Preferred Stock of your Company at 91 and accrued dividends (said price being computed on a 7.14 current return basis less a discount of 7 points), making a total of approximately $ 331,352 (preference value) of such new $ 7 Preferred Stock, subject to adjustment for accrued dividends.

7. The application of the proceeds of the $ 3,000,000 new bonds, remaining after the redemption of the bonds now outstanding, to the repayment of purchase price to be paid by us, will leave $ 907,440 remaining unpaid (exclusive of accrued interest and dividends), and for such outlay on our part, after the foregoing shall be consummated, we shall own the following securities, at the respective cost to us as follows, exclusive of accrued 1961 U.S. Tax Ct. LEXIS 141">*151 dividends:

You will have 51% of the total Common Stock outstanding and $ 327,750 (preference value) Second Preferred, at a cost to you of approximately $ 431,352 (preference value) of your new $ 7 Preferred Stock, subject to adjustment for accrued dividends.

8. A customer and employee ownership campaign shall be instituted and all or as much as possible of the $ 532,000 (preference value) First Preferred Stock so to be acquired by us shall be sold to customers and employees of the Queens Company. As and when so sold, the same shall be taken up from us at 95 and accrued dividends. In case any or all thereof shall not be sold within one year from the date hereof, we shall have the right to put the unsold portion thereof, or all in case none is sold, to your Company at 1961 U.S. Tax Ct. LEXIS 141">*152 95 and accrued dividends, and in case the same is so put, we will accept in payment thereof your new $ 7 Preferred Stock at 91 and accrued dividends (said price being computed on a 7.14 current return basis less a discount of 7 points). If none of the First Preferred Stock is sold you will deliver to us approximately $ 555,385 (preference value) of your new $ 7 Preferred Stock in exchange for said $ 532,000 (preference value) of First Preferred Stock, subject to an adjustment for accrued dividends.

9. The fees and expenses of the engineers, accountants and counsel whom we have retained to investigate the property, and interest on the loans to be made by us to carry the transaction from the date of purchase to the effective date of the readjustments of debt and stock and from which interest and dividends on the new securities to be issued shall accrue, shall be paid by the Queens Company. To the extent not reimbursed by dividends declaration, the same shall be evidenced by the One Year 7% Note of the Queens Company which we shall take at par and accrued interest.

10. We will not sell the 49% of the new Common Stock (subject to adjustment for the unacquired minority, if any) to be retained 1961 U.S. Tax Ct. LEXIS 141">*153 by us without first 36 T.C. 377">*382 taking up the sale thereof with your Company, nor thereafter unless within a period of twenty days we shall not be able to agree upon the price to be paid therefor.

11. In case any additional First Mortgage Bonds of the Queens Company are issued or any other funded debt, the sale thereof shall first be taken up with us, and the sale thereof shall not be taken up with others unless after a period of twenty days we shall be unable to agree upon terms satisfactory to each. If upon any issue we fail to so agree, all liability under this paragraph shall terminate and end. An appropriate agreement shall be entered into between us and the Queens Company to reflect the understanding in this paragraph.

12. Your Company shall have the management of the Queens Company and to that end contracts in the usual form used by the J. G. White Management Corporation shall be used. The fee to be paid you for management shall be 2% of the gross operating revenue; the fee for construction shall be 6%. It is understood that so long as the J. G. White Management Corporation manages the properties of your Company, you shall have the right to delegate such management to it in whole or 1961 U.S. Tax Ct. LEXIS 141">*154 in part.

13. In addition to the fees and expenses mentioned in Paragraph 9 hereof, all additional fees and expenses incurred by either of us in consummating and carrying out this Agreement shall be paid by the Queens Company. In case the funds of the Queens Company shall be insufficient to pay the same, as well as the expenses to be incurred by it in consummating this transaction (e.g., mortgage recording tax, etc.), additional First Preferred Stock may be offered to the customers and employees of the Queens Company and the proceeds of the first shares so sold may be applied to defray such fees and expenses.

14. It is our purpose to distribute the Preferred Stock of your Company to be received by us among investors to the extent that we are able so to do. To the extent that we are not so able we will keep in touch with you and cooperate with you so that the disposition thereof will not prejudice or interfere with the market condition of the Preferred Stock of your Company.

15. We understand that an issue of Preferred Stock ($ 6 Series) is now being offered by bankers to the public. We agree that you shall not be under obligation either to create the new $ 7 Preferred Stock or to 1961 U.S. Tax Ct. LEXIS 141">*155 deliver to us the amount thereof called for by this Agreement until the term of the syndicate or selling group formed to distribute such Preferred Stock ($ 6 Series) shall terminate. Said delivery shall in no event be delivered later than September 1, 1925.

16. All details and phases of the transaction, including the terms of the new securities to be issued, and those of the new mortgage, for which express provision is not made herein, shall be worked out between us. Wherever reference is made herein to the present Queens Company, it includes a successor if such is formed.

If the foregoing is in accordance with your understanding, we will be obliged if you will so indicate at the place noted below for your acceptance.

Yours very truly,

Marshall Field, Globe, Ward & Company,

By J. T. Foster, V.P.

Accepted this 6th day of April, 1925

Associated Gas and Electric Company,

By H. C. Hopson,

Vice President.

36 T.C. 377">*383 As contemplated as a possibility in the contract between Associated and Marshall Field petitioner was incorporated on May 4, 1925, under the name of Bellport Water Supply, Inc. The consent of a municipality was necessary to the formation of a new water utility company. Such a consent was obtained 1961 U.S. Tax Ct. LEXIS 141">*156 from the Village of Bellport, Long Island, on April 24, 1925. Petitioner's corporate name was changed to the Long Island Water Corporation on May 6, 1925. At the time of incorporation Marshall Field paid $ 1,000 cash for the issuance of 10 shares of petitioner's common stock to certain individuals. By amendment of its charter on May 6, 1925, petitioner's capital stock was increased to 35,000 shares.

At a meeting of its board of directors on May 6, 1925, called "for the purpose of authorizing the acquisition of the entire outstanding capital stock of The Queens County Water Company and the issue of securities * * * in exchange therefor, and the merger of The Queens County Water Company into Long Island Water Corporation," the petitioner accepted an offer made by Marshall Field to exchange the Queens stock for petitioner's demand promissory note in the amount of $ 3,344,000 and 19,990 shares of its no-par-value common stock. On the same day the board adopted a resolution merging Queens with petitioner, the merger being completed on May 8, 1925, with the filing of a certificate to that effect with the secretary of state of New York. On May 22, 1925, petitioner classified its 35,000 1961 U.S. Tax Ct. LEXIS 141">*157 shares of capital stock into 20,000 shares of common stock, 10,000 shares of first preferred stock, and 5,000 shares of second preferred stock. The $ 3,344,000 note was subsequently paid by petitioner on or about May 26, 1925, through issuances of bonds and nonvoting preferred stock and its own note to Marshall Field as follows:

Petitioner duly paid the $ 112,100 promissory note. In addition Marshall Field paid, on behalf of petitioner, the $ 737,100 due on the mortgage bonds, releasing the physical properties of Queens from a trust indenture. In consideration thereof petitioner issued an equivalent amount of its own bonds to Marshall 1961 U.S. Tax Ct. LEXIS 141">*158 Field, which in May 1925 marketed all of these bonds at 98 1/2.

36 T.C. 377">*384 By September 15, 1925, pursuant to the agreement made on April 6, 1925, Marshall Field had transferred to Associated all of its stock-holdings in petitioner in exchange for 15,183.37 shares of Associated's preferred stock which were marketed through a syndicate for $ 100 per share in July 1925.

Petitioner assumed Queens' liabilities in addition to its acquisition of all the physical properties and other assets, the net result of which was $ 10,460.37 in current assets passing to petitioner. Queens' depreciable property had a book value of $ 2,443,884.27, and accumulated depreciation as of December 31, 1924, was $ 552,348.86. Net additions through April 30, 1925, amounted to $ 42,787.23.

A complete inventory and appraisal of the assets formerly owned by Queens was made by the public utility engineer employed by Associated and completed by August 1, 1925. It valued Queens' depreciable property at $ 4,535,793.68, with accumulated depreciation of $ 660,450. The physical depreciable assets of Queens were entered on petitioner's books in accord with the engineer's appraisal. The land was appraised at $ 661,400, which amount 1961 U.S. Tax Ct. LEXIS 141">*159 was also entered on petitioner's books. The engineer's appraisal reflected the reproduction cost new of the property. The depreciation figure was the difference in value between the property as it existed and the value of the same property if it were new. All of the engineer's figures related to the date of May 1, 1925.

Sometime in April 1925 Queens wrote up on its books the fixed capital account in order to reflect the preliminary valuation made by Associated's engineer. This was done through the creation of a "Fixed Capital" account in the amount of $ 3,454,963.13 and concurrent credits of $ 221,291.78 to retirement reserve and $ 3,233,671.35 to capital surplus. Exclusive of this writeup, the fixed capital of Queens on April 30, 1925, as shown by its books of account, was $ 2,945,576.88. This figure was further divided as follows:

This total differs only slightly from the amount Marshall Field paid Queens' stockholders for their stock -- $ 2,945,250. The engineer's appraisal compares as follows:

The overhead accounts were computed by 1961 U.S. Tax Ct. LEXIS 141">*160 applying arbitrary percentages to the total value of the depreciable property.

36 T.C. 377">*385 Roosevelt Water, Power and Light Company (hereinafter referred to as Roosevelt), and Baldwin Water Company (hereinafter referred to as Baldwin) were water companies which also operated on Long Island. The territory served by Baldwin was adjacent to the territory served by petitioner, and the territory served by Roosevelt was adjacent to the territory served by Baldwin. On June 11, 1925, petitioner's vice president obtained an option to purchase 3,848 shares of Roosevelt's 4,000 shares of common stock at $ 32.50 per share, and on the same date obtained an option to purchase 445 shares of Baldwin's 456 shares of common stock at $ 550 per share. These options cost $ 10,000 and $ 17,500, respectively. On or before July 23, 1925, and pursuant to these options petitioner had obtained 4,000 shares of Roosevelt's common stock and 451 shares of Baldwin's common stock. On August 6, 1926, petitioner purchased the remaining 5 outstanding shares of Baldwin's common stock. Including the price of the options and incidental fees and expenses the total cost to petitioner of Roosevelt's common stock was $ 141,319.90 and 1961 U.S. Tax Ct. LEXIS 141">*161 the total cost of all of Baldwin's common stock was $ 271,366.23. These acquisitions were originally entered on petitioner's books as "Investments."

Roosevelt was merged with the petitioner on August 25, 1925, the latter assuming Roosevelt's liabilities in the amount of $ 81,307.79. Although petitioner had taken the assets acquired from Baldwin onto its books by December 31, 1925, Baldwin was not formally merged with petitioner until February 4, 1927, with petitioner assuming Baldwin's liabilities in the amount of $ 74,249.35. Associated advanced cash in the amount of $ 409,936.13 to enable petitioner to purchase the stock of Roosevelt and Baldwin. In return Associated received 4,456 shares of petitioner's preferred stock which were accepted at $ 92 a share.

In the early part of 1926 the same engineer who had appraised the properties of Queens appraised the properties of Roosevelt and Baldwin as of October 31, 1925. These appraisals reflected the reproduction cost new of such properties as of that date with depreciation from such value to reflect the fact that such properties had been used. Sometime in 1925 these properties were carried on petitioner's books at their appraised 1961 U.S. Tax Ct. LEXIS 141">*162 value.

Pursuant to a contract entered into on March 2, 1926, the petitioner on June 26, 1926, acquired for $ 30,000 cash the operating water distribution properties of Island Park-Long Beach, Inc., including all materials and supplies. Of the total purchase price the amount of $ 17,000 represented the cost of the depreciable properties and the amount of $ 13,000 represented the cost of materials and supplies. The Island Park properties were located in and had been used to provide water utility services for an area adjacent to the other areas served by petitioner.

36 T.C. 377">*386 The Island Park properties were placed on petitioner's books in 1927 on the basis of an appraisal by a public utility engineer in the amount of $ 71,390.76 with depreciation from present cost of $ 20,490.

In 1929 petitioner acquired the depreciable operating water distribution properties of the Rockville Centre Manor Company at a cost of $ 3,000. Such properties were located in and had been used to provide water utility services for an area adjacent to other areas served by petitioner. Such properties were placed on the books in 1929 on the basis of an appraisal by a public utility engineer in the amount of $ 10,231.05.

A 1961 U.S. Tax Ct. LEXIS 141">*163 summary of the book values of the properties herein involved, as appearing on the books of the transferor corporations, the appraised values of such properties on the books of petitioner, and additions thereto is as follows:

The 1961 U.S. Tax Ct. LEXIS 141">*164 appraisal made by the engineer included certain overhead costs, such as organization costs, legal fees, taxes, and interest during construction. In 1927 all of these entries were reversed with the exception of a single item labeled "Injuries and damages during construction" amounting to $ 51,715. These overheads were replaced by figures computed under the so-called Brooklyn-Borough formula which amounted in final form to 45.2 percent of the 1925 appraised value of depreciable assets submitted by the engineer.

Prior to petitioner's acquisition of the Queens, Roosevelt, and Baldwin properties the three companies had operated as individual companies and were not interconnected. After the acquisition of the Roosevelt and Baldwin water distribution properties in 1925 work was commenced to lay the necessary water mains to connect those water distribution properties with that acquired from Queens to form an integrated water distribution system. The work was completed and the mains connected on January 10, 1926. After the underground 36 T.C. 377">*387 distribution system of these three companies was connected they functioned as a single integrated system and the wells of each of the old companies became 1961 U.S. Tax Ct. LEXIS 141">*165 part of the regular water supply for the entire interconnected system.

Part of the depreciable property petitioner acquired from Roosevelt in 1925 was sold to the Village of Freeport in 1929, and a reduction in plant account in the amount of $ 93,616 was made on petitioner's books. This reduction in plant account represented the then book value of the property sold, which was based upon the engineer's appraised 1925 reproduction cost of the property increased by the overheads computed under the Brooklyn-Borough formula and the net additions to the depreciable property from 1925 to the date of sale. The net additions amounted to $ 5,274.95 and the undepreciated 1925 book value on petitioner's books was $ 62,113.74. Although the basis to Roosevelt of all its depreciable property was $ 93,531.07, the books of the old Roosevelt company have not been in existence for a good many years and there is no known source available for determining the cost or other basis of the specific property sold in the hands of the transferor. As a result of this sale in 1929 the respondent reduced petitioner's depreciable base for tax purposes in the amount of $ 93,616.

In 1931 petitioner sold almost all 1961 U.S. Tax Ct. LEXIS 141">*166 of the depreciable property in Queens County which it had acquired from Queens to the City of New York. The 1925 book value on the books of petitioner (not including overheads) was $ 1,665,277.86, with net additions until the sale increasing this amount to $ 1,940,401.57. The respondent required a reduction in basis as a result of this sale in the amount of $ 2,572,221.28.

In 1951 petitioner received $ 74,500 for a 72.3825-acre tract of land which it had acquired from Queens in 1925. The costs connected with the sale amounted to $ 5,234.50. Originally the petitioner reported a capital gain of $ 59,466.10 resulting from the use of 1893-1910 cost figures of Queens. The land was a part of a 281.428-acre tract entered on petitioner's books in 1925 with a value of $ 509,000, based upon the engineer's appraisal. The engineer obtained this figure from a "qualified real estate dealer or an appraiser familiar with the real estate values," and incorporated the figure into his report. The entire tract was not of uniform value. In a more recent appraisal of 1925 values the value of the entire tract was $ 602,000, and the parcel in issue had a value of $ 85,000, if it were used for developing 1961 U.S. Tax Ct. LEXIS 141">*167 one-family homes, its highest and best use.

Petitioner's outstanding capital stock was owned by Associated until July 14, 1944, during which time consolidated Federal income tax returns were filed. At that time the present owners, who are unrelated in any way to Associated or its stockholders, acquired all of petitioner's outstanding capital stock. Separate Federal income tax 36 T.C. 377">*388 returns have been filed for the period July 15 to December 31, 1944, and for each calendar year thereafter. On its returns for all years since May 1, 1925, including those in issue, petitioner computed its allowable depreciation in the amount of 1.8 percent of the average balance of its depreciable assets. The respondent used the same figure and the parties have stipulated that this rate is correct.

The negotiations and agreements which resulted in the property formerly owned by Queens being thereafter held by petitioner were interdependent steps of one integrated transaction, which began with the oral agreement between Associated and Marshall Field sometime prior to April 1925 and ended with the merger of Queens into petitioner on May 8, 1925. Before the steps were taken Queens' stockholders were in control 1961 U.S. Tax Ct. LEXIS 141">*168 of its assets. When the steps were completed Associated owned all of petitioner's outstanding stock and was in control of the assets. There was no continuity of interest or ownership as to those in control prior to these transactions and those in control after the transactions were completed.

Marshall Field derived financial advantage from this series of transactions which, from the surrounding circumstances, we find to have been conducted at arm's length. The fair market value of petitioner's securities and those of Associated, which were transferred as consideration for the assets obtained from Queens, was $ 4,583,556.03 which was computed as follows:

1961 U.S. Tax Ct. LEXIS 141">*169 The adjustment for accrued dividends on Associated's stock was provided for in the letter contract of April 6, 1925, which is set forth in our findings.

OPINION.

The primary issue in this case concerns the proper depreciation bases to petitioner of the properties formerly owned by the Queens, Roosevelt, and Baldwin Companies. Respondent contends that these properties were acquired in connection with reorganizations 36 T.C. 377">*389 as defined in either section 112(g)(1) (A) and (F) of the Internal Revenue Code of 1939 or section 203(h)(1) (A) and (D) of the Revenue Act of 1924, and therefore the bases should be the same as in the hands of the transferor corporations. The petitioner contends that there were no statutory reorganizations and that when the transactions are considered in their entireties they are in reality purchases of assets by petitioner and therefore petitioner's basis must be cost. Petitioner cites in its argument on brief Southwell Combing Co., 30 T.C. 487">30 T.C. 487; Orr Mills, 30 T.C. 150">30 T.C. 150; Estate of James F. Suter, 29 T.C. 244">29 T.C. 244; Montana-Dakota Utilities Co., 25 T.C. 408">25 T.C. 408; American Wire Fabrics Corporation, 16 T.C. 607">16 T.C. 607; and Illinois Water Service Co., 2 T.C. 1200">2 T.C. 1200.

A number of those cases rely 1961 U.S. Tax Ct. LEXIS 141">*170 upon the principle laid down in Commissioner v. Ashland Oil & Refining Co., 99 F.2d 588; Koppers Coal Co., 6 T.C. 1209">6 T.C. 1209; and Kimbell-Diamond Milling Co., 14 T.C. 74">14 T.C. 74, affd. 187 F.2d 718, commonly referred to as the Kimbell-Diamond rule. In discussing those cases in John Simmons Co., 25 T.C. 635">25 T.C. 635, we said at pages 641-642:

Our examination of the cases cited * * * convinces us that the principle enunciated therein was intended to be and should be limited to the peculiar situations disclosed by the facts in each of those cases * * *. In each of those cases it appeared that an existing corporation had as its primary purpose or indeed its sole purpose, the purchase of a particular asset or a group of assets of another corporation, but was forced by circumstances beyond its control to effect the acquisition through the channels of first acquiring stock and then liquidating the subsidiary. * * * [Emphasis supplied.]

In North American Service Co., 33 T.C. 677">33 T.C. 677, 33 T.C. 677">690-691, we stated the rule to be "that where a going business desires to acquire the asset of another corporation and the only means available by which it can acquire that asset is to purchase all of the outstanding stock and liquidate 1961 U.S. Tax Ct. LEXIS 141">*171 the acquired corporation, the complete liquidation of the acquired corporation will be treated as one of the steps of a single transaction, namely, the purchase of an asset." (Emphasis supplied.)

In 30 T.C. 150">Orr Mills, supra at 154, we stated the rule to be "that where a taxpayer, interested primarily in a corporation's assets, is compelled to first purchase stock and then liquidate the corporation in order to acquire the desired assets, the separate steps taken to accomplish the primary objective will be treated as a single transaction." (Emphasis supplied.)

These cases clearly indicate that a prerequisite to the application of the so-called Kimbell-Diamond rule is the impossibility of accomplishing the direct acquisition of assets and the consequent necessity of purchasing the stock of the corporation owning the assets sought to be acquired.

The record herein does not disclose any unsuccessful negotiations for the direct purchase of the assets of any corporation at any time 36 T.C. 377">*390 or any other circumstance which would make the direct purchase of the assets impossible.

The position of the petitioner on this point may be summarized as follows: The underlying purpose of petitioner and those acting for 1961 U.S. Tax Ct. LEXIS 141">*172 it was to acquire the physical assets of Queens, Roosevelt, and Baldwin, as indicated by (1) the fact that appraisals of such assets were made prior to the purchases, (2) the conclusion drawn in petitioner's brief that the Transportation Corporation Law of New York dealing with Water-Works Corporations (under which petitioner was organized), to quote petitioner's brief, "confines its corporate powers to the ownership and operation of the necessary physical properties to carry on a water distribution business," ^{11961 U.S. Tax Ct. LEXIS 141">*173} and (3) the fact that immediately after the acquisition by petitioner of all of the stock of each company the petitioner by merger acquired the ownership of the properties owned by each and then integrated such properties into a single system, thus supplying "the pragmatic test of the ultimate result." Petitioner then argues that the Kimbell-Diamond rule applies.

This position is equivalent to advancing the proposition that where a corporation desires to acquire the totality of the business assets ² of another corporation and chooses on its own volition to effect such acquisition by purchasing the stock of the other corporation and then merging such other corporation with itself, the provisions of the Code dealing with acquisitions of properties incident to tax-free reorganizations should be ignored and the basis of the business assets thus acquired in the hands of the acquiring corporation shall be its cost of the stock purchased.

As we have already indicated, the prior opinions of this Court do not support this proposition and the statements made by us of the Kimbell-Diamond rule directly contradict it. We are not disposed to alter our position on this matter or to overrule our prior statements with regard thereto.

Respondent contends that the integration-of-assets factor is also a prerequisite to the application of the Kimbell-Diamond rule. 1961 U.S. Tax Ct. LEXIS 141">*174 This contention has been rejected in 33 T.C. 677">North American Service Co., supra. See also United States v. Mattison, 273 F.2d 13. ³ This remains an important factor for consideration in cases of this type, but it is not a prerequisite to the application of the rule.

36 T.C. 377">*391 Even if prior unsuccessful negotiations for the direct acquisition of assets or other circumstances demonstrating the impossibility of such direct acquisition do not constitute a prerequisite to the application of the Kimbell-Diamond rule but merely constitute an important factor to be considered in determining whether the sole purpose for the purchase of the stock of a corporation was to acquire its assets, similar to other factors such as integration of assets or "stripping down" of assets, we would nevertheless find it impossible to conclude that petitioner has proved that the acquisition by it of the stock of the Queens Company through the transactions described in our findings was 1961 U.S. Tax Ct. LEXIS 141">*175 for the sole purpose of acquiring assets. Those matters pointed to by petitioner as proving such purpose have been set forth above. We do not consider it important that a preliminary appraisal of the assets of Queens was made before the Queens stock was bought. We do not know what other investigations were made. The fact that such an appraisal of assets was made is in no way inconsistent with a purpose to buy the stock of Queens since an approximation of the value of the assets of Queens would be a pertinent factor in an estimate of a fair price to be offered for its stock regardless of the purpose for its acquisition. The detailed inventory and appraisal made after the acquisition of the stock would be irrelevant to the question of the purpose for such acquisition. Nor are we impressed by petitioner's assertion that under the New York laws governing its organization (which we have outlined above) it was required to own physical assets directly rather than through a wholly owned operating subsidiary. Our construction of these laws does not accord with petitioner's assertion and petitioner has not cited any decided cases which would support it. We do consider it to be an important 1961 U.S. Tax Ct. LEXIS 141">*176 factor for our consideration that immediately after the acquisition by petitioner of all of the Queens stock it acquired by merger the direct ownership of all of Queens' properties. However, as against this factor in petitioner's favor, there are other important factors militating against it: The absence of a showing that it was impossible for petitioner to acquire the assets of Queens by a direct purchase (if this be a factor rather than a prerequisite), the fact that petitioner, at the time it purchased the Queens stock, had no business and owned no assets into which the assets of Queens could be integrated, and the fact that all of the assets owned by Queens and used by it in a going business were acquired without any "stripping down." Considering this balance (or, rather, imbalance) of pertinent factors we would be unable to conclude that petitioner has borne its burden of proving that the sole or primary purpose of acquiring the Queens stock was to acquire its assets.

We understand petitioner to further argue that, regardless of the applicability of the so-called Kimbell-Diamond rule, the properties 36 T.C. 377">*392 here involved were not acquired pursuant to a statutory reorganization since 1961 U.S. Tax Ct. LEXIS 141">*177 there was not the requisite continuity of interest or control. Petitioner contends that the transaction consisted of a series of interdependent steps and must be considered as a whole. Thus considered, according to its argument, the transaction began with the oral agreement made between Marshall Field and Associated sometime prior to April 1925, and ended with the formal merger of Baldwin with petitioner in the early part of 1927, resulting in the properties here involved being owned by a new corporation owned by stockholders having no relationship to the stockholders of the corporations owning the properties at the beginning of the transaction.

Two cases are particularly relied on by petitioner in this connection: 30 T.C. 487">Southwell Combing Co., supra, ⁴ and 16 T.C. 607">American Wire Fabrics Corporation, supra. In the latter case we said at page 613:

The test to be applied in order to determine whether a particular transaction is complete in itself or whether it is merely a step in a series of integrated transactions or, put another way, whether a series of steps should be treated as a single, indivisible transaction or should retain their separate entity is whether the various steps were "so interdependent 1961 U.S. Tax Ct. LEXIS 141">*178 that the legal relations created by one transaction would have been fruitless without the completion of the series." American Bantam Car Co., 11 T.C. 397">11 T.C. 397, affd., 177 Fed. (2d) 513. See also, ACF-Brill Motors Co., 14 T.C. 263">14 T.C. 263, Independent Oil Co., 6 T.C. 194">6 T.C. 194; Spang, Chalfant & Co., 31 B.T.A. 721">31 B.T.A. 721; Paul, Selected Studies in Federal Taxation, 2d Series, pp. 200-254. * * *

Looking to the facts of the instant case and again bearing in mind that the burden of proof is on petitioner, it is clear to us that the acquisition by petitioner of the stock of Roosevelt and Baldwin and the subsequent mergers of those two companies with petitioner were not so integrated with or interdependent upon the prior transactions that we can say that the legal relations created by the prior transactions would have been fruitless if they had not been accomplished. The acquisition by Associated (in cooperation with and assisted by Marshall Field) of an operating water company on Long Island in all probability led to the later acquisition of the Roosevelt and Baldwin Companies, but nothing 1961 U.S. Tax Ct. LEXIS 141">*179 in the record convinces us that the plan for the acquisition of the first operating company (Queens) or its merger into petitioner contemplated or would have been fruitless without the subsequent acquisitions of Roosevelt and Baldwin.

Leaving out of consideration the acquisition of Roosevelt and Baldwin, petitioner's argument is more convincing when confined to the acquisition by merger of the properties formerly owned by Queens. The crux of the question thus presented is whether the acquisition by Associated and Marshall Field of all of the stock of Queens and the organization of petitioner with its acquisition of all of Queens' 36 T.C. 377">*393 properties by merger may be considered as two separate transactions or must be considered as interdependent steps in one transaction.

The facts herein clearly show that the formation of petitioner and its acquisition of the property of Queens constituted "a contemplated possibility under the plan that actually eventuated" and must therefore be considered as an interdependent step therein. Avco Manufacturing Corporation, 25 T.C. 975">25 T.C. 975, 25 T.C. 975">983-986.

We therefore consider that all of the steps taken pursuant to the plan beginning with the oral agreement between Associated1961 U.S. Tax Ct. LEXIS 141">*180 and Marshall Field sometime prior to April 1925 and ending with the merger of Queens into petitioner on May 8, 1925, must be considered as interdependent steps of one integrated transaction which, when completed, resulted in the property formerly owned by Queens being thereafter held by petitioner. Since the former stockholders of Queens had no relationship to the stockholders of petitioner and retained no vestige of ownership or control with regard to the property acquired by petitioner there could not be the continuity of control or ownership required in a statutory reorganization. 16 T.C. 607">American Wire Fabrics Corporation, supra.

We therefore conclude that the petitioner's basis as to the property formerly owned by Queens was its cost, and that its basis as to the properties formerly owned by Roosevelt and Baldwin was the bases of those corporations.

The cost of assets received in exchange for securities is the fair market value of the securities exchanged. Hazeltine Corporation, 32 B.T.A. 110">32 B.T.A. 110. The petitioner's basis for the land sold in 1951 must be determined by allocating the cost to the various assets acquired. C. D. Johnson Lumber Corporation, 12 T.C. 348">12 T.C. 348, 12 T.C. 348">363; Wren Bowyer, 33 T.C. 660">33 T.C. 660.

The 1961 U.S. Tax Ct. LEXIS 141">*181 petitioner paid $ 4,583,556.03 for land appraised at $ 661,400 and depreciable property appraised at $ 3,875,343.68. (This figure was obtained by subtracting from the appraised reproduction cost new the reserve for depreciation estimated by the public utility engineer.) By applying appropriate comparisons expressed as percentage amounts of the appraised net depreciated value, the cost of the depreciables to petitioner is found to be $ 3,915,331.31 and the cost of the land is found to be $ 668,224.72.

The 281.428-acre tract was appraised in 1925 at $ 509,000, and the application of a percentage comparison (509,000/661,400) discloses that the portion of the total cost figure applicable to this tract was $ 514,252.11. The land was found to be of varying worth, and the parcel sold was not the most valuable piece of the tract. Applying percentages comparing the appraised value of the parcel sold to the entire appraised value of the tract, based upon recent appraisals of 1925 values, the basis to petitioner of the parcel sold in 1951 is found 36 T.C. 377">*394 to be $ 72,610.34. Adding to this figure the costs of the sale, amounting to $ 5,234.50, petitioner sustained an ordinary loss of $ 3,344.84 in 1961 U.S. Tax Ct. LEXIS 141">*182 1951. See sec. 117(j), I.R.C. 1939.

The parties were unable to agree upon the composition of peitioner's gross depreciable base. The rate of depreciation allowed by the respondent is not an issue before this Court. The parties have stipulated that the rate used over the years was 1.8 percent of the gross depreciable base. That base is the cost of the property increased by any additions and decreased by any reductions necessitated by the sale or other disposition of property included therein. We see no merit in the petitioner's contention that Internal Revenue Service Bulletin F authorizes the addition to the gross depreciable base of a beginning depreciation reserve in the event the property purchased is used property. While that is a factor that may be considered in choosing the applicable rate, it is not a factor to be considered when the rate is agreed upon and only the gross depreciable base itself is in issue.

The parties were unable to agree upon the correctness of the reductions in basis required of petitioner by the respondent in 1929 and 1931 as a result of the sale of land and other property acquired from Queens and Roosevelt.

As an alternative issue, in the event we decided 1961 U.S. Tax Ct. LEXIS 141">*183 (as we have) that the petitioner's basis for the property formerly owned by Roosevelt and Baldwin was the bases of those corporations, the petitioner affirmatively alleged that the respondent had excessively reduced its tax base for purposes of depreciation as a result of the sale of depreciable property acquired from Roosevelt to the Village of Freeport in 1929. The respondent asserts that his reduction was proper in view of the lack of evidence of the original cost or other basis of the property in the hands of the transferor.

The respondent's reduction in petitioner's tax basis for purposes of depreciation, occasioned by this sale in 1929, was $ 93,616, which amount exceeds the basis to which we have determined the petitioner is entitled for all of the depreciable property it acquired from Roosevelt. The parties stipulated that Roosevelt's book value of this property was $ 93,531.07. They further stipulated that the appraised value of this same property on petitioner's books was $ 221,641.29. The undepreciated 1925 book value of the property sold in 1929 was $ 62,113.74. Adding the net additions to the date of sale ($ 5,274.95) to the product obtained by utilizing a ratio comparing 1961 U.S. Tax Ct. LEXIS 141">*184 the appraised value of the property sold to the appraised value on petitioner's books of all the depreciable property acquired from Roosevelt as one factor, and the book value of all of the depreciables in the hands of the transferor as another factor, we have determined that the transferor's basis of the property sold by petitioner in 1929 was $ 31,486.47. The reduction 36 T.C. 377">*395 in petitioner's tax basis for purposes of depreciation resulting from the sale in 1929 should be in that amount, and any reduction beyond that amount was, in view of our findings, excessive.

Having determined that petitioner's basis as to the property formerly owned by Queens is its cost and having determined the amount of such cost, we assume that the parties will be able to agree in computation under Rule 50 on the proper amount by which petitioner's tax basis for purposes of depreciation should be reduced on account of the sale in 1931 to the City of New York of a part of the property acquired by petitioner from Queens. ⁵ This may be done by making a proper allocation of a part of petitioner's total cost of Queens' depreciable property to the depreciable property sold such as, for example, by allocating that 1961 U.S. Tax Ct. LEXIS 141">*185 proportion of such total cost which the appraised value of the property sold bears to the appraised value of all of the depreciable property acquired from Queens.

Decision will be entered under Rule 50.