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Distributing a capital gain

Tax free distribution of capital gains from a company.

A relic of New Zealand’s revenue past are provisions in the current Income Tax Act 2007 that imposes income tax on distributions of ‘available capital’ from ordinary companies to shareholders unless such a distribution is made during the course of a winding up of that company.  Available capital in simple terms includes any tax free capital gains derived by the said company[1]

Take this example; Jack and Jill hold shares in a company that owns only a commercial building purchased many years ago for investment purposes to derive taxable rental income. The company sells the commercial building and derives a significant capital gain.

Under current legislation the company can only distribute that capital gain to Jack and Jill tax free on its liquidation. Where a tax free capital gain is distributed to a shareholder in the course of a winding up of a company, such distributions are tax free in the hands of the shareholder(s) of that company, as the Income Tax Act 2007 provides that in such a case the distributions falls outside of the dividend rules and is accordingly not taxable.

Any distribution of this capital gain other than during the course of its liquidation would however be fully taxable in the hands of Jack and Jill at their individual personal marginal income tax rates, this despite the fact that the gain itself was originally tax free in the hands of the company.

If the company only owned the commercial building and had no other assets or business operations, winding up the company would not present any problems. Where however the company does have other assets or business operations, the impracticality of winding up becomes manifest.

Taxpayers winding up a company to extract capital gains tax free need to be extremely careful when making such distributions, as they require a precise sequence of events to occur in order for the shareholder(s) to qualify for this tax free distribution and getting the sequence wrong can be extremely costly. Having to wind up a company to access its ‘available capital’ results in compliance costs for taxpayers, as professionals usually have to be employed to manage the process, given the expensive consequences of getting it wrong

[1] Capital gains (as computed by a formula in the Income Tax Act 2007) and share capital constitute ‘available capital’ and can be distributed tax free only during the course of a liquidation

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