News articles often discuss the effects of taxes on capital gains when a company sells a long-term investment. Investors must understand the concept of capital gains to properly value their effects on firm profitability.
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Capital Gains and Losses
Corporations often invest in long-term securities for the purpose of creating value. However, long-term assets create a type of option that allows a corporation to decide when the value of the asset should be realized for tax purposes. This so called tax-timing option gives corporations the flexibility to decide when the gains or losses from an investment are realized.
When corporations invest in long-term assets, the gain or loss from the asset is taxed only when the asset is sold or the value of the asset is realized by the firm. Long-term is typically defined as any asset that is held for one year or longer. Otherwise, the investment in the asset is considered short-term.
Suppose a corporation buys stock in another company and holds it for five year. Since the stock is held for a year or longer, it is considered a long-term asset. Throughout the holding of the stock, its value fluctuates as the underlying company to which it belongs operates and realizes varying levels of profitability.
This postponement of taxes is called a tax-timing option which allows a corporation the option to dispose of the asset claiming either a gain or loss based on the asset’s value at the time of its sale. Otherwise, the corporation may hold on to the asset and postpone taxes indefinitely.
This has an important effect for investors in firms that hold long-term assets. Suppose that a company has $100,000 invested in a long-term asset that was originally purchased for $80,000. Essentially, investment in this asset has brought $20,000 of value into the firm as a direct result of the investment. However, if the firm announces that the asset will be sold, the value the asset brings to the company is less than $20,000 because of taxes owed on the capital gain of holding the asset. Although the corporation has gained, it loses some of its value to taxes when the asset is sold, reducing the value of the company had it otherwise decided to hold on to the asset and continue to defer taxes.
In the past, corporate capital gains were taxed at a lower rate than income. Lower taxes on capital gains are an incentive for companies to invest in long-term assets. However, in 1987, capital gains began being taxed at a higher rate to encourage income from operations rather than from investments.