Strassburger Insulation Limited v. Minister of National Revenue, [1988] 1 CTC 2507, 88 DTC 1356

Christie, A.C.J.T.C.: — In computing its income for its 1983 taxation year the appellant sought to deduct $20,000 paid in settlement of a claim for damages plus $12,589 in legal fees related to that claim. The respondent reassessed on September 6, 1984 and disallowed these deductions. The appellant objected on September 26, 1984 and on February 6, 1985 the respondent confirmed the reassessment. Hence this appeal. This position was taken by counsel for the Minister at the hearing: “Firstly, the Minister does not contest the amounts, that the amounts were paid. Secondly, in my submission, the issue is the same with respect to both. If you allow one, you have to allow the other. If you disallow one you must disallow the other. They stand in toto together." The appellant has not differentiated between the two. I agree that this is the correct approach and I have adopted it.

The president of the appellant is Mr. Morgan R. Strassburger. Prior to October 15, 1959 has father carried on business as a sole proprietor under the name Strassburger Supplies. The business involved insulation, roofing and remodelling of windows, doors and awnings. On this last mentioned date a charter was issued under the Corporations Act 1953 of Ontario creating Strassburger Supplies Limited. It carried on the business of the proprietorship, but in 1969 emphasis was shifted to the insulation aspect and this became the primary focus of the corporation’s business. Three kinds of insulation were involved: sprayed urethane, urea formaldehyde foam insulation or UFI and Canadian Gypsum sealing insulation, also known as rock wool insulation.

Strassburger Supplies Limited did a considerable volume of business insulating residential, commericial and agricultural buildings. The sprayed insulation was acquired from Witco Chemical Canada Limited ("Witco"). Strassburger Supplies Limited believed that sprayed urethane insulation was not flammable. It discovered that it was under these circumstances. Barlin Construction Limited ("Barlin") was under contract to transport slag from steel plants in the Hamilton area to the plant of National Slag Limited ("Slag") at 139 Windermere Road, Hamilton. Under the contract Barlin, in consideration of a payment of $10,000, was authorized to use a portion of the premises at 139 Windermere that included a Quonset hut and an adjacent wooden frame building. During the early hours of the morning of March 29, 1975 employees of Barlin were working in the Quonset hut using an oxyacetylene torch when sparks from it ignited varsol that was being used nearby to clean the floor. This in turn, set fire to the insulation material lining the hut causing a fire that destroyed the hut and severely damaged the adjoining building.

The fire led to a writ being issued out of the Supreme Court of Ontario on December 30, 1976 by Slag as plaintiff against Barlin as defendant claiming $26,002 in damages for alleged negligence on the part of Barlin’s employees. The statement of claim followed on June 14,1977 and one of the particulars given of the alleged negligence was that the torch was "being used in close proximity to the inflammable insulating material without adequate precautions being taken." On December 1, 1978 a notice was issued by Barlin to Strassburger Supplies Limited and Witco naming them as third parties. Barlin’s claim for contribution and indemnity from the third parties was based on provisions of the Sale of Goods Act and alleged negligence both related to the combustibility of the insulation. A further proceeding was instituted regarding the fire by a writ issued on July 23,1979 with Barlin as plaintiff and Strassburger Supplies Limited and Witco as defendants. The statement of claim duplicates the claim for $26,002 in the third party proceedings already referred to and, in addition, claims $50,069 for the loss of a truck, truck parts and equipment and $23,929 for interruption and dislocation of business operations. The total claim is $100,000.

Strassburger Supplies Limited was not insured for claims of the kind being made by Barlin. In the face of the litigation and apprehended similar litigation and acting on legal and accounting advice Strassburger Holdings Limited was incorporated on October 4,1979 under the Business Corporations Act of Ontario. Morgan Strassburger was appointed president of the company. On that date Strassburger Supplies Limited conveyed real estate in the City of Waterloo valued at $413,101 to Strassburger Holdings Limited and it also sold and transferred chattels such as vehicles, office, shop and radio equipment to Strassburger Holdings Limited for $167,185. These two steps effected the transfer of the fixed assets of Strassburger Supplies Limited to Strassburger Holdings Limited although the former continued in business. It retained its current assets and Strassburger Holdings Limited leased the fixed assets back to Strassburger Supplies Limited.

I mentioned at the outset that Strassburger Supplies Limited applied or installed three types of insulation, one of which was UFI. Between 1968 and December 19, 1980 it installed this product in residential and commercial buildings some 1,500 times. The company did not regard the installation of this material to be hazardous. Morgan Strassburger said its use had been approved by Central Mortgage and Housing Corporation and in relation to the federal Chip Insulation Program. Nevertheless in the course of time UFI became identified with serious health problems and in December 1980 its further use was prohibited by federal authority. Because of the controversy surrounding this insulation and the attendant publicity Strassburger Supplies Limited became concerned about the potential for numerous lawsuits. Again acting on legal and accounting advice the appellant was incorporated on May 11, 1981 under the Business Corporations Act of Ontario.

On May 12, 1981 a meeting of the board of directors of Strassburger Supplies Limited approved a transfer of all of the common shares (3,000) in the capital stock of this company from its shareholders to the appellant. At a subsequent meeting of the Board of Strassburger Supplies Limited held on May 14, 1981 “IT WAS RESOLVED that pursuant to section 39 of The Business Corporations Act and after having received tenders, the corporation do purchase two thousand, nine hundred and ninety-nine (2,999) of its issued shares for cancellation effective July 1, 1981. The consideration to be paid by the corporation shall be the excess of the value of the tangible assets of the corporation less the liabilities of the corporation in accordance with the balance sheet to be prepared as of June 30, 1981.” At a further meeting of the board of directors of Strassburger Supplies Limited held on August 10,1981 : "IT WAS RESOLVED that two thousand, nine hundred and ninety-nine (2,999) common shares be purchased for cancellation for the sum of $408,787.28 and which $358,915.64 is deemed to be a dividend pursuant to The Income Tax Act being excess over the paid-up capital of the shares being purchased. The secretary was instructed to cancel the said shares."

As of August 1981 Strassburger Supplies Limited was without tangible assets (it was believed there was some goodwill left) and the appellant became the operating business entity. The lease of the fixed assets between Strassburger Holdings Limited and Strassburger Supplies Limited was assigned to the appellant. The evidence is that while the appellant and the other corporations did not believe that the steps taken by them and their shareholders would be effective in protecting the fixed assets against claims being made in pending litigation, it was hoped that they would afford protection against future claims. They were fully aware of the Fraudulent Conveyances Act of Ontario. [1]

This litigation followed the incorporation of the appellant. Melville Minogue Limited v. Strassburger Supplies Limited et al. The writ was issued on January 7, 1983 and the claim for damages was based on the inflammability of sprayed insulation applied by Strassburger Supplies Limited. The fire that precipitated the litigation occurred on November 26, 1980. Kaas et al. v. Strassburger Supplies Limited. This action also arose out of the fire just referred to. The next mentioned lawsuit and the one following relate to the installation of UFI. Gysbers & Gysbers v. Strassburger Supplies Limited et al. The writ was issued on October 26, 1982. The insulation had been installed in 1977. Kitchen & Kitchen v. Douglas Towers, Canada Permanent Trust Company and Jane Mederak. These proceedings were instituted in a District Court on January 21, 1985. A proceeding against Strassburger Supplies Limited as third party was commenced on March 22, 1985. The insulation had been installed under an agreement dated December 19, 1979. Horizon Chicks Limited v. Strassburger Insulation Limited et al. The writ was issued on June 15, 1985. The cause of action related to sprayed insulation. The fire occurred on May 17, 1983. The insulation is said to have been negligently applied in 1978. As already mentioned Strassburger Insulation Limited did not come into existence until May 11, 1981 so these proceedings appear to have been obviously flawed, but nothing turns on this with reference to the disposition of the appeal at hand.

All of this litigation was settled except Horizon Chicks Limited v. Strassburger Insulation Limited et al. This action was dismissed for failure on the part of the plaintiff to comply with an order directing that the case be placed on a list for trial by a specified date.

The claim by Barlin against Strassburger Supplies Limited and Witco was settled by the payment of $85,000 inclusive of Barlin's costs. The appellant paid $20,000 and Witco paid $65,000. This settlement was arrived at on March 1, 1983. In addition the appellant paid the legal fees of counsel acting for Strassburger Supplies Limited pertaining to that claim in the sum of $12,589.

While the appellant was under no actual or potential liability for the damages sustained by Barlin, I am satisfied that in the context in which the payments were made this constituted a bona fide and reasonable exercise of business judgment on the part of the appellant. Morgan Strassburger said that the payments were made because of concern over potential problems under the Fraudulent Conveyances Act. This is understandable. At the time of payment the fixed assets which the appellant required to carry on business were the assets that it had obtained under the lease with Strassburger Holdings Limited. Those assets were the property of Strassburger Supplies Limited at the time of the fire on March 29, 1975 and on December 30, 1976 when Slag sued Barlin and on December 1, 1978 when Strassburger Supplies Limited was named a third party in those proceedings and on July 23,1979 when Barlin sued Strassburger Supplies Limited and Witco. Morgan Strassburger also mentioned protection of the name Strassburger and maintaining good relations with its suppliers as reasons for the payments having been made. I regard these as peripheral at best. This evidence was given almost en passant. No particulars were forthcoming to explain why the Strassburger name might have been in jeopardy or why the appellant may have had concerns about relationships with suppliers or how making the expenditures in issue would alleviate these concerns. On the other hand a great deal of evidence focused on the Barlin claim and related matters.

I am satisfied that the entire $32,589 paid in damages and for legal fees was an outlay or expense made or incurred by the appellant for the purpose of gaining or producing income from its business within the meaning of paragraph 18(1)(a) of the Income Tax Act. That leaves this question: In computing its income for the year under appeal, is the appellant prohibited from deducting the expenses in issue because they were payments on account of capital within the meaning of paragraph 18(1)(b)? [2] My answer is yes.

The Queen v. Jager Homes Ltd. and Jager Holdings (Calgary) Ltd., [1988] 1 C.T.C. 215; 88 D.T.C. 6119, is a recent decision of the Federal Court of Appeal that reaffirms the general proposition that an expenditure by a taxpayer for the preservation or protection of capital assets is a capital outlay and not deductible in computing income by reason of paragraph 18(1)(b) of the Income Tax Act. In Jager Homes the respondent companies sought to deduct legal fees incurred by them in defending a petition to the Supreme Court of Alberta that they be wound up. Mr. Justice Urie delivered the judgment of the Court. After reviewing numerous authorities he concluded that the defence to the petition and consequent expenditures for legal fees was to preserve the respondents as corporate entities and sequentially their continued capacity to earn income. Expenditures of this kind are on account of capital.

The evidence leads me to the conclusion that the essential purpose of paying the damages and the legal fees was to preserve or protect the fixed assets that the appellant had under lease from Strassburger Holdings Limited. The appellant's leasehold interest in these assets was capital in nature. They were necessary to the appellant in its business and because of their history their continued availability to the appellant was threatened by the Barlin claim. It follows that the $32,589 was payment on account of capital and cannot be deducted in computing the appellant's income for its 1983 taxation year.

The appeal is dismissed.

Appeal dismissed.