The return of capital refers to the return of invested funds from an investee to an investor. This transfer of funds matches both of the following criteria:
- The amount is designated as a return of the original investment; and
- The amount is less than or up to the amount of the original investment.
A return of capital can occur when the activity in which an investment was originally made is being liquidated.
The taxability aspects of the return of capital are as follows:
- The return of capital is not taxable
- Any amount returned that exceeds the original amount of an investment is taxable income
- If an amount paid to an investor is not designated as a return of capital, it is considered to be taxable income
- A dividend is taxable income, since it is not a return of capital
When there is a legitimate return of capital, this may mean that the ownership percentage of the investor in the investee may be reduced to the point where the investor no longer has any semblance of control over the investee. If so, the investor may have to alter the method being used to account for the investment. This usually means switching from the equity method of accounting to the cost method of accounting.