Greg Neil: Relief provided for 'tainted' capital gains

Greg Neil

If a company is seeking to sell a particular asset, or all of the assets comprising its business, a common concern for income tax purposes is whether any capital gain derived on sale may be "tainted".

This is because, if the gain is tainted, it cannot subsequently be distributed to the company shareholders tax-free.

However, a recent law change means that tainted capital gains are now far less of a concern for companies in the process of selling business assets.

In New Zealand a standard company can only distribute capital gains to shareholders on a tax-free basis upon a liquidation of the company.

A restriction applies, however, where the gain was derived from a transaction with an associated party, such as a business sale to the next generation of the family or to an entity with common ownership as part of a restructure.

In those circumstances the capital gain could be tainted which means it could not be distributed tax-free to shareholders as part of the liquidation.

More recently there have been certain concessions in this area for close companies, but the general position regarding tainted capital gains dates back to the 1980s.

The rule was designed to prevent taxpayers from artificially creating capital reserves for a company using transactions between related parties.

A distribution on the liquidation of the company could then be made tax-free on account of the reserves rather than as a taxable dividend. It has long been recognised that the scope of the rule was somewhat broader than necessary but it has been an accepted part of the New Zealand tax landscape for a long time.

However, that has all changed due to a recent law change. With effect from the end of March this year, the scope of the tainted capital gains rule has been significantly narrowed.

First, it now only applies to a disposal of assets by a company to another company. As a result, disposals to individuals and trustees (including corporate trustees) are no longer subject to this rule.

Second, even if the disposal is to another company, there is a requirement for the vendor and purchaser companies to essentially have common ownership to the extent of 85 per cent or more at the point of liquidation before tainting applies.

Importantly, the new law applies to all distributions made after the date of enactment. This means that it applies to capital gains derived both before and after the date of enactment which will be good news for those with companies sitting idle with historic capital gains.

Greg Neill is a tax partner at Crowe Horwath - Hawke's Bay and can be contacted at greg.neill@crowehorwath.co.nz

This information is general in nature and readers should seek specialist advice before making financial decisions.