Tainted Capital Gains

When a company (not being a Look Through Company) derives a capital gain from a transaction with an associated party the gain becomes tainted.  This means that the gain when distributed to a shareholder is taxable as a dividend.  This tainting of an “associated person capital gain” has been a source of irritation for tax advisers and companies alike.  

A transaction between a company and its shareholder which involves a transfer of value is presumed to be a dividend and taxable. Capital gains could however be distributed tax free to a shareholder if the amount is distributed on or during liquidation of the company.  The distribution of capital gains tax free (on or during liquidation) only applies to third party capital gains and not a capital gain arising from a transaction with an associated party.  Such gains are tainted and are taxable to the recipient even when distributed on liquidation.

The Closely Held Companies Bill contains a welcome tax reform amending the definition of the type of gain which is tainted.  The existing rule will be replaced with a rule that only applies to the sale of property between one company (Company A) and another company (Company B) and:

  • there is a group of persons with 85% common ownership of each company (measured by voting interest and market value interest); and
  • on liquidation of Company A the aggregate total given to all companies that own the property or part of the property is 85% or more.

This means that if Company B were to sell the property to a genuine third party prior to the liquidation of Company A the original gain in Company A is no longer be tainted as the property will have left the group by the time of liquidation. 

The provision is intended to apply to capital gains made either prior to or after the date of enactment provided the relevant distribution as a result of the liquidation occurs after the date of enactment.  It is not retrospective for those liquidations already undertaken.

Mitigating a tainted capital gain has been a significant headache particularly for succession planning in a family business and for business combinations where the existing shareholders retain a sufficient shareholding in the new combined business.  These changes will make it easier to undertake such commercially driven transactions and allow the family businesses and business combinations to succeed without creating a tainted capital gain.

Whisky Match – Laphroaig Quarter Cask

Our whisky match for this welcome reform is the Laphroaig Quarter Cask. The Laphroaig distillery is located in the south east shoreline of the island of Islay (pronounced “eye-lah”) along a stretch of coast featuring the Ardbeg and Lagavullin Distilleries.  It is sweet, spicy and very smoky.  Its nose is pungent with coal-smoke, coal-tar and iodine.  It is known for its strong medicinal taste and was sold to the USA during the prohibition as a tonic. 

The Quarter Cask is one of the best expressions of Laphroaig and is well matched with the amendments to “tainted capital gain” as the reforms provide a medicinal cure and a welcome tonic to a historical piece of tax legislation which caused so many headaches for taxpayers and tax advisers alike.