- Off-market share buy-backs can provide significant benefits in the context of companies with:
- surplus franking credits,
- good profit reserves relative to their share capital, and
- a healthy contingent of super funds and life insurance companies amongst their shareholders.
- As Telstra has just illustrated, companies can eliminate shareholdings at a discount to market price of up to 14%.
- These buy-backs do require a relatively low cost of debt and investors, super funds in particular, with an ability to use tax losses ie, making capital gains – probably the reason we are seeing off-market buy-backs again now.
- The 1.5% company tax rate reduction next financial year may reduce the attractiveness of off-market buy-backs.
- The tax losses they typically generate are a significant contributor to their attractiveness, and remain available in spite of previous Government plans to abolish them.
Overview of tax benefits
A number of companies have returned cash to shareholders this year, including Aviva, Clough, eBet, MYOB and Telstra. Wesfarmers is in the process of doing so, Woodside attempted to do so, and CSL will do so over the course of the next year.
Tax can be key to the form that cash returns take. Both Aviva and MYOB used an equal return of capital; Clough used a special dividend; Wesfarmers is using a combined special dividend and capital return; and CSL will use an on-market share buy-back.
Telstra has also just completed an off-market share buy-back. So what exactly is their attractiveness now, given the 7 year hiatus?
In fact there are good tax reasons for a buy-back this financial year if otherwise it might be on the agenda. To recognise the reasons why, you need to understand the tax benefits of an off-market share buy-back. Consider the following example.
A super fund buys a $2.00 share and sells it for $1.80 into an off-market share buy-back offer ie, at a 10% discount to market price. The buy-back proceeds include a 50% franked dividend component. The balance is a return of share capital.
In this example the super fund receives $1.80 cash + 19¢ excess franking credit + tax loss valued at 9¢ = $2.08. For the fund’s $2.00 investment therefore, the transaction delivers $2.08 ie, a 4% return.
The biggest beneficiary though is the company. It removes a $2.00 share for a $1.80 spend, and so makes an immediate return of 11% ie, 20¢ on every $1.80 cash spent.
The benefit is normally expressed in increased forecast earnings per share (EPS). The simple mathematics of this example demonstrate though, that ongoing shareholders can often receive a greater benefit, through the company, than shareholders selling into the buy-back.
The key tax ingredients of a successful buy-back, and the size of the purchase price discount it can deliver to the company, are the excess franking credit (19¢ in the example) and the tax loss (9¢ in the example).
The tax mechanics
Excess franking credits are generated by super funds and life insurance companies that pay tax at 15% but receive dividends franked with 30% credits. With each franked dividend received, these investors receive double the tax credit they need, and the excess is fully refundable. Significant dividend components of buy-backs therefore produce significant excess credits.
There are nuances in the calculation of tax losses. In broad terms the dividend component of the buy-back is excluded from the proceeds received for sale of the share – in classical ideology it is regarded as income paid on the share rather than proceeds of its disposal. Invariably therefore, significant dividend components of buy-backs also produce significant capital losses.
Tax exempt shareholders, for example super funds in pension phase (nearly one third of all super funds), receive an even greater benefit. These funds cannot utilise tax losses because they do not make taxable gains. However, they are refunded the whole of the franking credits because they are not taxed on dividends. In the example above a super fund in the pension phase would receive an excess franking credit of 38¢ in place of the 19¢.
It isn't possible to load up the dividend component for two reasons.
- The ATO caps the purchase price discount at 14%, so sweetening a buy-back with franking credits beyond what is sufficient to achieve a 14% discount will not deliver any further benefit to the company – it will just waste franking credits. (The ATO always insists on some wastage if the company has non-resident shareholders.)
- The ATO normally invokes a capital first rule, such that the buy-back proceeds are treated as a return of capital to the extent of the average capital backing per share. Only the balance of the buy-back proceeds can constitute a dividend component.
Why this year – what’s new?
The tax mechanics have not changed since the GFC. This year, however, super funds and life insurance companies seem to once again have capital gains, giving them capacity once again to utilise capital losses. The cost of debt is also relatively low compared to equity and, it seems, companies again have borrowing capacity they are not otherwise using.
In other words, the climate seems once again to suit off-market share buy-backs.
Buy-back, capital return or special dividend?
As mentioned above, off-market share buy-backs suit companies with excess franking credits and good profit reserves relative to share capital. Too few franking credits means the company could soon be unable to frank ordinary dividends; too much share capital, relatively, means a small dividend component of the buy-back. It’s not a case of one size fits all.
Three recent transactions illustrate the alternatives open to companies.
- On 15 October 2014, CSL announced an on-market share buy-back, which involves the company purchasing shares in the market as if it was any other purchaser. Selling shareholders do not identify the purchaser and for tax purposes treat these sales as any other. CSL has been paying unfranked dividends and therefore, perhaps, was similarly only in a position to offer an unfranked dividend component of an off-market share buy-back. That would significantly diminish the value of a share buy-back such that an on-market sale would be more attractive – so no buy-back purchase price discount for the company and therefore no reason to undertake a buy-back. On the other hand, improving EPS by funding discounted capital gains on the sale of shares compares favourably to paying fully taxable unfranked dividends.
- On 20 November 2014, Wesfarmers shareholders will vote on a combined special dividend and equal capital return following the sale of the group’s insurance businesses. An initial special dividend has already been paid and the ATO will allow an aggregate 32% franked dividend component of these distributions. A buy-back may have allowed a larger dividend component and accordingly delivered more franking credits to those best able to use them. However, the company distributes virtually all of its profits each year and therefore does not have abundant profit reserves relative to its market capital. It may have wanted to preserve the remaining balance. Also note that, unlike a buy-back, the capital return here does not involve a sale of the shares and is itself tax effective for that reason.
- On 6 October 2014, Telstra completed an off-market share buy-back. Approximately half of the buy-back proceeds comprised a franked dividend – the recipe for a successful off-market buy-back. The excess franking credits and capital losses generated provided both a premium for participating super funds, etc. and the maximum allowable 14% purchase price discount for the company.
Proposed changes affecting buy-backs next year
Legislation to reduce the company tax rate from 30% to 28.5% on 1 July 2015 is currently before the Senate. For large companies the 1.5% tax rate reduction will be replaced by a 1.5% paid parental levy (PPL). The PPL will not generate franking credits, and the rate at which companies can pass out franking credits will also fall from $30 credits with every $70 cash dividend, to $28.50 credits with every $71.50 cash. This is not only a marginal change. For a super fund or life insurance company it represents a 12% reduction of excess franking credits, and on a transaction benefit analysis that’s significant.
Finally, as illustrated above, capital losses are a key part of off-market share buy-back benefits. The previous Government had proposed, on a Board of Tax recommendation, that these losses be denied. The current Government abandoned the proposal in December 2013. If revived however, the measure would make off-market buy-backs significantly less attractive.