The Queen v. Farquhar Bethune Insurance Ltd., 82 DTC 6239, [1982] CTC 282 (FCA)

Heald, J:—This is an appeal from a judgment of the Trial Division allowing the respondent’s appeal from a reassessment of income tax made by the Minister of National Revenue in respect of respondent’s 1973 taxation year.

The issue for determination was, in my view, correctly stated by the learned trial judge (AB pp 61 and 62) and I summarize that issue as follows: Whether or not the expenditure made by the respondent in the sum of $75,000 was an outlay or expense made or incurred by the respondent for the purpose of gaining or producing income from its business within the meaning of the exception contained in paragraph 18(1 )(a) of the Income Tax Act or whether it was a capital expenditure within the meaning of para graph 18(1 )(b) of the Income Tax Act* [1] In the reassessment appealed from, the Minister categorized the expenditure as being on capital account within the meaning of paragraph 18(1 )(b) (below).

The respondent has, since 1962, carried on the business of a general insurance agency in and about the City of Ottawa. By agreement dated June 14, 1973, the respondent entered into an agreement with Orville Kerr Limited (Orville Kerr), the operator of a general insurance business. That agreement reads as follows (AB pp 29-32 inclusive):

WHEREAS the Operator now carried on a general insurance business dealing in group and personal life, accident, health, fire, casualty insurance and pension plans, including annuities or growth funds.

AND WHEREAS the Operator is desirous of making arrangements with the Company pursuant to which the Operator will continue to carry on a group and personal life, accident, health insurance, and pension plans, including annuities or growth funds business from premises owned and occupied by the Company.

AND WHEREAS the Company wishes to have access to the list of accounts and relevant files now maintained by the Operator for its fire and casualty customers, all on terms and conditions as herein set forth.

NOW THEREFORE THIS AGREEMENT WITNESSETH that in consideration of the sum of ONE DOLLAR ($1.00) now paid by the Company to the Operator and for other good and valuable consideration, the receipt and sufficiency whereof being hereby acknowledged, the parties respectively covenant and agree as follows:

1. The parties acknowledge that the foregoing recitals are true and accurate in all regards.

2. (a) The Company hereby undertakes to permit the Operator to locate its place of business in the premises occupied by the Company from time to time in consideration of annual payment by the Operator to the Company equal to the Company’s cost as agreed from time to time (but in any event not more than ONE THOUSAND DOLLARS ($1,000) per annum) and in order to ensure minimum disruption of the Company’s operations, the Operator agrees to occupy Company premises as aforesaid for a period of not less than one year. The Company will for the above consideration provide the Operator with a desk, chair, telephone service and stenographic services with respect to business performed by the Operator on the Company’s behalf.

(b) The Company covenants and agrees that the Operator shall continue to Carry on its business of the sale of group and personal life, accident, health insurance and pension plans, including annuities or growth funds, without interference by the Company so as to permit the Operator to capitalize on its existing and future goodwill through solicitation of all of its existing accounts including those appearing in the list and files to be delivered to the Company as hereinafter provided.

3. The Operator hereby undertakes to deliver to the Company on the execution of these presents, a complete list of its existing clientele in the areas of fire and casualty insurance, together with any and all files relating to such customers, so that the Company may thereafter service such customers to the extent that they may be willing to use the facilities of the Company, and for and in consideration of the sum of SEVENTY-FIVE THOUSAND DOLLARS ($75,000) payable to the extent of THIRTY THOUSAND DOLLARS ($30,000) on the execution hereof, and the balance of FORTY-FIVE THOUSAND DOLLARS ($45,000) together with interest on the said sum of the balance thereof as the same may be from time to time, as a rate /4% per annum above the chartered bank prime rate as the same may be from time to time, which is available to most favoured commercial customers, in two equal instalments of TWENTY- TWO THOUSAND, FIVE HUNDRED DOLLARS ($22,500) plus interest at the aforesaid rate the first payment, including interest, which shall be due and payable on June 30, 1974, and the balance, together with interest shall be due and payable on June 30, 1975, provided always that the Company shall have the right to prepay the balance or any part thereof at any time without notice or bonus, provided that in default of payment of the moneys herein when payable, the balance of the moneys owing hereunder shall immediately become due and payable at the option of the Operator, and provided that in the event any judgment is obtained in compliance with the aforesaid which is not paid within thirty (30) days of the obtaining of same, this Agreement shall terminate at the option of the Operator. Provided further that in the event of bankruptcy of the Company, this Agreement shall terminate forthwith at the option of the Operator and all money paid hereunder shall be retained by the Operator.

4. Commencing August 1, 1973, and for so long thereafter as the Operator shall occupy premises of the Company as aforesaid, but in any event for a period of not less than three years from August 1, 1973, the Operator agrees to absolutely refrain either directly or indirectly from competing in the business of fire and casualty insurance. The Company for its part, likewise covenants for the same period of time, to refrain from competing with the Operator in the fields of Group or Personal Life, Accident, Health insurance and Pension plans, including annuities or growth funds but notwithstanding anything hereinbefore contained, in the event the Operator should, during the aforesaid time period, sell any insurance in the fire and casualty fields to any persons or firms who are not now clientele of the Company, or of the Operator, the same shall be so sold for the account of the Company in which event a commission equal to 50% of first year net commissions and 30% of net commissions in subsequent years shall be paid by the Company to the Operator without any deduction for administrative costs, so long as the servicing of said accounts is performed by the Operator to the satisfaction of the Company.

5. Any return commissions due clients in relation to the endorsement or termination of any Fire or Casualty policy issued through the Operator and where such endorsement or cancellation is effective after July 31, 1973, will be paid for by the Company and the Company agrees to hold harmless the Operator from any liability in respect thereto.

6. Notwithstanding that the Operator shall be licensed through the Company for “other than life” business, at least until August 1, 1976, the relationship between the parties shall at all times be that of independent contractors and in no sense shall the Operator be deemed to be the Agent of the Company nor in any sense shall the Company be deemed to have assumed, or in future to assume the liabilities of the Operator nor to have any right, whether present or future, to any of the assets or to the goodwill of the Operator and it is further agreed between the parties that the sum of $75,000 payable by the Company to the Operator as hereinbefore provided, is a consideration payable by the Company to the Operator for access to the Operator’s fire and casualty customers’ lists and related policy files to permit the Company to commence servicing such customers, and not as consideration for any proprietary interest which the Operator may have therein.

7. This Agreement shall enure to the benefit of and be binding upon the parties hereto, their executors, successors, administrators and assigns.

Subsequent to the execution of the agreement, the respondent, although not receiving a formal listing of its clients, had full access to Orville Kerr’s clientele in the area of fire and casualty insurance. Initially this amounted to access to approximately 1,000 files involving premium volume of approximately $300,000. In 1974, the year following the transaction, the respondent achieved premium volume of approximately $236,000 from the Orville Kerr accounts. The premium volume figure was $205,000 for 1975, $195,000 for 1976, $203,000 for 1977 and $171,000 for 1978. Shortly after the agreement was entered into, Orville Kerr as President of Orville Kerr Limited wrote to his customers as follows: (AB p 34):

ORVILLE KERR LIMITED

Effective the first of July, 1973, I have made arrangements with Farquhar Bethune Insurance Limited of Ottawa to take over the servicing of all of my Fire and Casualty Insurance accounts.

I have made this decision bearing in mind your best interests with respect to providing the highest quality possible service and markets, along with the stability of insurance, in the light of the many changes that are taking place in the industry.

While I will not longer be directly involved in the personal control of your Fire and Casualty Insurance account, as it will be serviced by Mr PA Boyd and his staff at Farquhar Bethune, it is my plan to work with this large and progressive company.

I should also stress that the above arrangement does not apply to your Life, Accident, Health, Pension or Group Policies or Plans. I, personally, will continue to look after the selling and servicing of these lines of insurance for you.

At this time, I would like to express my gratitude for your strong support and loyalty in the past, and hope that you will appreciate my course of action in making this change and will enjoy your association with this fine company. To facilitate this transfer Mrs Brodersen will be taking up employment with Farquhar Bethune.

Yours very sincerely,

Orville Kerr — President ORVILLE KERR LIMITED

At approximately the same time an announcement was inserted in the Ottawa newspapers which stated, inter alia:

Arrangements have been made for the continuation of service on Orville Kerr’s many Fire and Casualty General Insurance accounts by the staff of Farquhar Bethune Insurance Limited. Orville Kerr will henceforth concentrate his endeavours in the field of commercial industrial insurance sales as well as Life, Accident and Health and Group sales.

Mr Farquhar testified that it was the hope and expectation of the respondent that it would keep a substantial number of Orville Kerr’s customers for years to come. He said that the respondent did retain many of those customers and the revenue therefrom had diminished significantly by 1978. He also agreed that, but for the June 14, 1973 agreement, the respondent would not likely have acquired very many of the Kerr clients.

In preparing its financial statements for presentation at its annual shareholders’ meeting, the respondent, in computing its profit for the period ending December 31, 1973, did not deduct the said amount of $75,000 but, rather, amortized it over a period of five years. The company auditor explained this treatment by observing that many expenditures are treated differently from an accounting point of view as compared to an income tax perspective since, in preparing financial statements, chartered accountants are required to adhere to generally accepted accounting principles whereas the same requirement is not present in the preparation of corporate income tax returns. Thus, in preparing its 1973 income tax return, the respondent sought to deduct the $75,000 payment to Orville Kerr in full.

The learned trial judge found on the evidence before him, both oral and documentary, that the $75,000 expenditure by the respondent was on income account because there had been no acquisition of the fire and casualty insurance business of Orville Kerr as a going concern and no acquisition of a tangible or intangible capital asset but, on the contrary, what the respondent had acquired was the customers’ lists and access to the information in the policy files of Orville Kerr’s fire and casualty insurance business.

In deciding the issues raised in this appeal, I have found useful the decision of this Court in the case of Cumberland Investments Limited v The Queen, [1975] CTC 439; 75 DTC 5309. In that case the appellant taxpayer company carried on the business of a Supervising general insurance agency. All of the company’s business was handled through local agents or sub-agents who dealt directly with the public. The appellant entered into an agreement with one of its smaller competitors, Company M, whereby the appellant purchased for $150,000 a list of M’s sub-agents, a card-index system showing the names of all its policyholders and M’s covenant not to compete against the appellant in the future. In dismissing the taxpayer’s appeal, the court held that subject acquisition was a capital asset capable of increasing the taxpayer company’s income and that the expenditure was incurred to work an immediate and substantial expansion in the company’s business. Thurlow, J (as he then was) stated:

It was a lump sum payable to a competitor to persuade him to yield up his business and goodwill and thus not an ordinary expense incident to the insuring process as were, for example, the commissions allowed to agents for their services.

and again on the same page:

. . . it seems to me that it was not anticipated that it would be a short lived advantage but must have been expected to be one that would be of enduring benefit to the business.

Urie, J also wrote reasons in the Cumberland case (Supra) and after reviewing the relevant authorities,* [2]

The advantage sought in this instance, it seems to me, was twofold; (1) to enlarge the income earnings structure of the Appellant by gaining access to a number of new sub-agents capable of diverting applications for insurance to it and

(2) to eliminate a competitor.

On the same page, Mr Justice Urie summarized his conclusion in the following passage:

In my view, the key to ascertaining the nature of the expenditure in this instance lies in the knowledge that the Appellant through its acquisition enlarged its potential income earning structure by about 10%. To turn this potential into actuality required the further expenditures necessary to ensure that the sub-agents whose names were acquired would do business with the Applicant. The latter undoubtedly would be outlays made for the purpose of earning income from the enlarged income earning structure and thus deductible in calculating the Appellant’s taxable income. Viewed in this way it is quite apparent the acquisition was a capital asset capable of increasing the Appellant’s income and the Respondent was, therefore, correct in disallowing the deduction pursuant to section 12(1 )(b) of the Act.

This view of the matter is in no way affected by the fact that, in addition to the once and for all expenditure made to Mr Hayes, expenses would be incurred thereafter to keep the sub-agents in the Appellant’s fold. Such recurrent expenditures can, in my view, be analogized to those made by the owner of capital assets, such as production machinery for repair and maintenance. It is difficult to envisage a case where the purchase price of such income earning machinery, would not be a capital expenditure while cost of repairs and maintenance would undoubtedly be, in the normal course, deductible expenses. The same may be said for the once and for all payment made to Mr Hayes for the capital assets he sold and for the continued expenditures made by the Appellant thereafter to maintain the capital asset acquired intact.

In my view, the factual situation in Cumberland (supra), while not identical to that in the case at bar, is sufficiently similar so as to render relevant the reasoning of Justices Thurlow and Urie in that case. Here, paragraph 3 of the agreement required Orville Kerr to deliver to the respondent . a complete list of its existing clientele in the areas of fire and casualty insurance, together with any and all files relating to such customers, so that the Company may thereafter service such customers to the extent that they may be willing to use the facilities of the Company.” Paragraph 4 of the agreement contains a covenant by Orville Kerr for a period of not less than three years from August 1, 1973 .. to absolutely refrain either directly or indi- rectly from competing in the business of fire and casualty insurance.” In respect of the non-competition covenant as set forth in paragraph 4 of the agreement supra, it should be pointed out that the viva voce testimony of Mr Farquhar, the President of the respondent, was to the effect that he did not direct his mind to the necessity of a non-competition clause because of the precarious state of Mr Kerr’s health at that time; that the inclusion of the clause in the agreement resulted from . . the caution of my attorney” (Transcript p 47); and that because of a substantial improvement in the health of Mr Kerr, he had gone back into the fire and casualty business in the last two or three years and has taken back “. .. a lot of the business we were entrusted to service (Transcript p 34).

Notwithstanding this oral testimony which was accepted by the learned Trial Judge, it is my opinion that on the totality of the evidence, documentary and oral, the payment in issue was a lump sum payment to a competitor in return for which the respondent was to receive the fire and casualty insurance business of Orville Kerr including such goodwill as that business possessed on June 14, 1973. In furtherance of the agreement and to ensure that the goodwill of the fire and casualty business passed to the respondent, Orville Kerr wrote to all of his clients advising them of the transaction and recommending that they continue their fire and casualty policies with the respondent. The letter was followed by an announcement to like effect in the Ottawa daily press. As in Cumberland (supra), it is my opinion that the advantages accomplished by subject agreement were the enlargement of the respondent’s income-earning structure by the addition of a significant amount of annual premium volume and the elimination of a competitor in the fire and casualty insurance business. The fact that the annual premium volume increase was reduced in subsequent years does not change the nature of the transaction. There could be many explanations for this attrition and I do not propose to speculate on the cause thereof. Likewise, the fact that Orville Kerr, at a later date, re-entered the fire and casualty business, does not alter the nature of the transaction in 1973. The fact that the transaction was characterized in the oral evidence of Mr Farquhar and in the written agreement as a payment “.. . for access to the Operator’s fire and casualty customers’ lists and related policy files to permit the Company to commence servicing such customers, and not as consideration for any proprietary interest which the Operator may have therein.” does not alter the true nature of the transaction. It is my opinion that when the “reality of what transpired” and the “follow-up procedure” carried out to ensure the continuity of the Orville Kerr customer relationships are scrutinized, the proper conclusion is that the respondent acquired a capital asset capable of increasing its income. I therefore have the view that the Minister was correct in disallowing the deduction claimed pursuant to paragraph 18(1 )(b) of the Income Tax Act.

Accordingly, I would allow the appeal with costs both here and in the Trial Division and restore the notice of reassessment dated April 6, 1978 which was issued for the taxation year 1973.