The capital gains that an entity realizes but cannot distribute tax-free to its shareholders/ owners. This inability to distribute the full amount of capital gains reflects “tainting”- i.e., negative impact on the distributable amount of such gains. In general, distribution of capital gains triggers a tax liability, and it is typically treated as a taxable dividend.

The restriction to distribution of capital gains is usually eased out if distribution is made at the time of liquidation of the entity. Even in the specific case where an entity realizing capital gains may select to distribute the gains on liquidation, capital gains can still be tainted if such gains were realized on transacting with an associated party.

Tainting of capital gains ensures that a group cannot shift capital assets from one entity to another, in the group, in an attempt to create a capital reserve so to avoid distributing taxable gains or embarking on a taxable distribution of retained earnings.