COVID-19 has effectively put an end to off-market share buyback schemes, as companies look to conserve their cash holdings. It couldn’t come at a better time.
The COVID-19 pandemic has provided the Federal Government with a win it may not have anticipated.
The lack of tax-driven off-market buybacks will positively impact the Federal Government’s tax revenue, according to Monash Business School’s Professor Christine Brown.
In a recent article (co-authored with Professor Kevin Davis from the University of Melbourne – and former Monash professor) Professor Brown argues that these tax-driven schemes should be abolished by the government.
She believes that not only do these schemes affect the Federal Budget’s bottom line, but they are also structured to favour certain shareholders over others, are overly complex and their removal will work to simplify the Australian tax system.
“When they were first introduced, the implications were not fully understood,” she says.
“Now they have become a clever and complicated rort where instead of companies paying a special dividend to all shareholders, they attract only low or zero-tax paying (mostly institutional) shareholders at a cost to the government.”
Off-market buybacks tax-driven
Tax-driven off-market buybacks are used by large Australian companies to distribute cash and ultimately stream franking or tax credits to low-tax rate shareholders.
Since they were first used in 1997 by the Commonwealth Bank, around 60 of these schemes have been used by large ASX-listed companies, returning almost $50 billion of cash to specific shareholders, along with around $17 billion of imputation tax credits.
Rio Tinto and Commonwealth Bank have done four of these schemes each and BHP has done five. The mining giant has also done the biggest, distributing almost $7.4 billion to some of its shareholders in 2018.
Plugging the tax revenue hole
However, the cost to government tax revenue is significant.
In 2018 alone, the loss to government tax revenue from these schemes is estimated to be around $2 billion.
The other major problem with the scheme is that only certain types of shareholders are able to r reap the tax benefits of them. These shareholders will usually be in the zero or 15 per cent tax brackets and generally include superannuation funds, retirees and charities.
“All shareholders can bid into the tender process used to participate, but participating is beneficial only to those on low tax rates,” says Professor Brown.
“Because of those franking credit benefits, the buy-back price determined in the tender is below the price at which the shares are trading on the ASX. For example, if a company’s current share market price is $10, the buyback price determined in the tender generally would be below market, at $8.60 (because of a 14 per cent maximum discount allowed by the ATO) split between franked dividends of, say, $7 and $1.60 of return of capital.”
When these schemes are offered, there is a lot of uncertainty around how successful tenders will be for shareholders.
There is a significant excess supply of shares offered at the discounted price, leading to large scale-backs of amounts bought back, relative to those offered by participants.
Participating shareholders will have some of their shares accepted and some not.
They can also skim more government revenue by scoring a potential capital gains tax benefit – as the capital return component is low, generally leading to a capital loss for tax purposes.
Tax-driven off-market share buybacks are too complex
These schemes require special regulatory and tax treatment.
The Australian Securities and Investment Commission has to give special dispensation relief to allow these buybacks to occur while the Australian Tax Office has already made a host of special tax determinations to deal with them.
The ATO has imposed a maximum 14 per cent limit on the discount of the shares to market price. While low tax rate investors would be willing to accept a much lower price for their shares – even around a 20 per cent discount –this maximum discount limit disadvantages non-participants.
“There is a lack of transparency around these decisions concerning these schemes,” says Professor Brown.
“For example, the ATO has never explained why the 14 per cent limit has been decided upon as the maximum allowable discount.”
Not consistent with other tax rules
Though there are rules designed to prevent the trading of franking credits – these schemes are still somehow permitted.
“The government has strong views on dividend streaming and this is a de facto streaming, which otherwise would be illegal,” she says.
“Basically, the companies build up tax credits in a notional account and then distribute these unused credits back to certain shareholders while buying back shares at a price below market price.”
Professor Brown argues that companies, instead of offering these schemes, should offer special dividends with a separate return of capital to all investors.
“These could be structured to pay out the same amount of cash and franked dividends with less complexity and cost to government tax revenue and could be accessed by all shareholders,” she says.