Under the current tax rules, a distribution of a capital gain by a company to its shareholders is taxable unless the distribution is made in the course of the liquidation of the company. However this exemption does not apply to capital gains arising in transactions with associated persons, except in limited circumstances where the associated person capital gain arises in the course of the liquidation of a close company (and the associated person is not a company). These gains are commonly referred to as “tainted capital gains”.
Take the following example. Mum and dad operate a successful business through a company owned by them. Mum and dad decide to retire and the company sells the business to a company owned by their daughter and son in law, resulting in a $500,000 capital gain. This gain is not taxable to the company. However when the gain is distributed by the company, even on liquidation, mum and dad will be taxable on the $500,000.
Further, even if the capital gain arose in the course of the liquidation of the company the amount would remain taxable because the transaction resulting in the capital gain is with an associated company.
As a result commercially driven transactions and even normal family succession planning were seriously compromised, with transactions having to be carefully structured to ensure a tainted gain did not arise.
From a policy perspective it is difficult to justify the legislation as it stands. The original policy intent was to prevent companies creating artificial capital gains with related parties which could be distributed tax free without liquidating the company under the tax legislation as it stood prior to 1985 (instead of distributing revenue reserves).
Since then the legislation has been changed to tax the distribution of capital gains unless this was done on liquidation and, in our view, effectively making the tainted capital gains tax rules unnecessary.
Further the situation was aggravated when the somewhat narrow definition of “related person” was replaced with the extensive definition of “associated person” meaning far more transactions were caught by the rules.
Finally, the over reach of the tax rules relating to capital gains has been recognised, with the “tainting” being removed from almost all transactions. A Bill proposes a wide range of changes to the tainted capital gain rules. Inland Revenue is to be commended for driving this change.
The capital gains that remain affected are those between associated companies where:
- At the time of disposal, a group of persons holds in both the vendor and purchaser company a common voting or market value interest of 85%; and
- At the time of liquidating the vendor company there is effectively an 85% common voting or market value interest in both the vendor company and the company now owning the property.
Unlike the associated persons rules there is no proposed aggregation of shareholdings held by associated persons etc. So looking at the example above, as there is not an 85% common voting interest in each of the companies the first part of the requirement above has not been met. This means that the distribution of the $500,000 capital gain will not be taxable to mum and dad.
The proposed changes are to take effect from the date of enactment and apply to distributions made on or after that date. As a result the rules effectively apply retrospectively, i.e. if a company is currently sitting on a tainted capital gain, it may be distributed tax free on liquidation after that date (unless the transaction was with an 85% or more commonly owned company and the two companies are still 85% or more commonly owned).