Why time’s up for the mischief in off-market share buybacks
The refunding of excess franking credits supersizes the benefits of share buybacks and listed entities have exploited this for years.
Franking credits belong to all shareholders and streaming credits to a particular shareholder class is normally prohibited because it’s unequitable. So why do we allow it if it’s inconsistent with the fundamental principles of our imputation system?
If a company pays tax, it will credit its franking account. If it decides to pay a dividend, it will attach franking credits to the dividend so shareholders can take advantage of the tax that has been paid on the income that the dividend was sourced from.
The principle aim of our imputation system is to avoid double taxation and Australia is one of the few countries in the world with such a system. It goes one step further by allowing the refunding of franking credits. This has been in place since 2000.
Franking credits can be used to offset shareholder tax liability and if there is no tax to pay the government will provide a cash refund. The Australian Labor Party proposed removing payments for excess franking credits during the 2019 federal election, causing a heated national debate.
This led to more Australians learning about the inner workings of our imputation system. It also exposed the real value of franking credits for people like self-funded retirees, super funds, and entities that pay no tax.
The streaming advantages of off-market share buybacks is an anomaly in our tax system as compared to on-market share buybacks, which are treated differently because the proceeds are on capital account, resulting in either a capital gain or a capital loss.
Off-market buyback proceeds for the share that’s bought back consist of a capital amount and a fully franked dividend. This can cause differing tax outcomes depending on the shareholders’ cost base for the shares sold, and their overall marginal tax rate. This is where the benefit of the franking credits become visible.
Shareholders who can monetise franking credits can run over most off-market offers, which often forces a tender process to meet the insatiable appetite from tax-advantaged shareholders — there’s always more bees than honey. CBA’s buyback in 2021 was oversubscribed by $18 billion.
There are several complex anti-avoidance provisions in the rules which prohibit the streaming of franked distributions to certain groups of shareholders. However, buybacks are one of the few exceptions where the streaming of credits is permitted, and listed entities have been exploiting this at the taxpayers’ expense.
To be fair, you can’t hold it against listed entities that use this kind of capital management because the only real downside for the company is more administration costs. It’s also completely legal, and it benefits all the shareholders.
Shareholders who don’t participate in off-market share buybacks usually have to opt in, and generally they’re not disadvantaged either way because the company can usually buy back the shares at a market discount so earnings can be accretive going forward.
In 2018, the off-market buyback price for BHP was $27.64 when shares were trading at $32.14. The excess franking credits benefited tax-advantaged shareholders by making up for the market shortfall, which would have been very different if the shares were sold on the ASX.
For non-resident shareholders, franking credits have no value so missing out isn’t an issue. In the past, there were schemes (now not allowed) where non-residents could loan shares for a fee to Australian entities during the dividend holding period so that the franking credits could be accessed by Australian domicile beneficiaries.
Simply put, refunding excess franking credits supersizes off-market share buyback opportunities. There’s nothing wrong with refunding excess franking credits, but when they’re combined with off-market buyback opportunities it can create a lot of mischief at the public’s expense.
A company that undertakes a buyback is required to debit its franking account for franking credits that would have been lost to dividends paid to non-residents, but this debit doesn’t fully compensate for the streaming effect that occurs between the high and low tax rates of domestic investors.
Refunding excess franking credits comes at a substantial cost to government revenue. Anyone that doubts this should look at the academic research by Emeritus Professor Christine Brown from Monash University and Professor Kevin Davis from the University of Melbourne entitled ‘Tax-driven Off-Market Buybacks (TOMBs): Time to Lay Them to Rest’, published in Australian Tax Forum 2020.
The cost to taxpayers is a function of the size and number of buybacks that have happened during a particular period., When the government is running a structural deficit, all tax concessions should be evaluated. There are a lot of other options for companies to undertake capital management initiatives like pro-rata capital distributions, special dividends, and on-market buybacks so it is not as if there are few other alternatives
The Treasury has off-market buybacks as a form of tax concession in expenditure statements, but it’s difficult to calculate the real cost of this concession because of the assumptions one must make such as cost base and tax rate of every shareholder participating in the offer.
In the future, the real battle will be to keep the refunding of franking credits policy in place, so let’s not lose sight of the big picture. If we want to ensure that refunding excess imputation credits policy is protected, then there are some sacrifices that will have to be made along the way.
Tony Greco is general manager of technical policy at IPA.
