Should you participate in a share buy-back?
The Federal Labor Party has stated it would change the dividend imputation system if returned to power in 2019. This is expected to see a spike in the number of off-market share buy-backs. The big question for investors is: should you participate?
Labor’s policy would see a scrapping of cash refunds of franking credits for most investors with low or zero taxable income. The deadline for excess franking credits to be paid as cash refunds to low-taxed investors is expected to be June 30.
Ahead of this potential change of government, there is an expectation from the investing community that there will be a spike in off-market share buy-backs and special dividends as companies seek to take advantage of existing arrangements to distribute excess franking credits sitting on their balance sheets. These companies should have historically generated large domestic profits and have surplus capital so as to not compromise the balance sheet when the capital is returned. The larger miners (BHP and RIO) have already returned capital following their asset divestments, and Woolworths and Caltex are mooted as potential candidates.
For domestic investors, the decision to participate in an off-market buy-back will depend on a number of factors. The most significant will be the investor’s marginal tax rate and the buy-back price. Put simply, the benefit of an off-market buy-back to investors is the value of the franking credits associated with the buy-back; this is because the tender price is split into a franked dividend component and a capital component of which the dividend is a significant percentage of the final price.
For example, in Rio Tinto’s recent A$2,871 million buy-back, the fully-franked dividend component of the final buy-back price of $69.69 per share was $60.25 per share, while the capital component was $9.44 per share. In this example, the value of the franking credits associated with the dividend is $25.82 per share – a potential cash refund for those with low marginal tax rates. In addition, depending on the cost base of your Rio Tinto shares, the $9.44 per share capital component may lead to capital losses which may be utilised to offset capital gains.
Rio Tinto’s tender booklet explains the mechanics of an off-market buy-back to an investor on page 15.
It is important to remember most off-market buy-backs are conducted at a significant discount to the prevailing share price, while also being subjected to scale-backs depending on the level of demand. This is because of the beneficial economics for domestic superannuation investors (taxed at 15 per cent) which leads to high levels of participation from many large institutional investors.
Each investor should assess their own particular tax situation to determine the relative economics of the buy-back although the general rule is those with a lower marginal tax rate (15 per cent or lower) are the biggest beneficiaries.