The government has introduced a Bill to change the tax treatment of off-market share buy-backs (where a company directly repurchases shares from its shareholders and cancels them) by listed public companies. Schedule 4 of Treasury Laws Amendment (2023 Measures No. 1) Bill 2023, introduced on 16 February 2023, deals with these buy-back measures.
The proposed measures may impact the price at which off-market share buy-backs occur.
However, more significantly, the changes may also reduce how frequently listed public companies conduct off-market buy-backs in the future as the proposed changes remove the tax benefits that underpinned their attractiveness.
Traditionally, off-market buy-backs of shares of listed public companies have occurred at a discount to their trading values. The discount has the effect of compensating shareholders that do not participate in the buy-back by effectively redistributing some of the tax benefits obtained by those participating shareholders to the non-participating shareholders in the form of a potentially higher share price. Typically, the tax benefits of off-market share buy-backs favour low tax rate taxpayers who can obtain a cash refund of excess franking credits, including superannuation funds, tax-exempt taxpayers (including charities), retirees and low-tax rate individuals - the key here is that these taxpayers ordinarily pay tax at a lower rate than the company tax rate of 30%.
Guidance from the Australian Taxation Office (ATO) has restricted the discount to 14%, although the actual discount is often less. Under the proposed changes, the rationale for the discounted buy-back price will be removed, raising the question as to why listed companies would choose to undertake an off-market buy-back at all.
What are the proposed changes for company share buy-backs?
We reported in our October 2022 Budget summary that the Federal Government had announced changes to the way off-market share buy-backs conducted by listed public companies will be treated for franking credit purposes, with a consequential impact on the way capital gains tax (CGT) implications are calculated. The proposed measures apply to buy-backs first announced to the market after 7:30pm AEDT on 25 October 2022.
A share buy-back occurs when a company agrees with its shareholders that the company will buy back shares on issue. An off-market buy-back occurs outside the ordinary course of trading on a stock exchange. An on-market share buy-back involves the company purchasing shares in the ordinary course of trading on a stock exchange. In the former case, shareholders will know they are selling to the company and, in most cases, will have a choice as to whether to sell some or all their shares or continue to hold them.
Recent off-market share buy-backs include those conducted by Qube , JB Hi-fi and Westpac , all pre-dating the effective date of these proposed measures. To our knowledge, at the date of this article, only two off-market share buy-backs have been announced since 25 October 2022.
Why are these changes being proposed?
The Labor Party has been under sustained criticism for any proposal affecting franking credits, and this proposed change is no different (and like its sister measure relating to franked special dividends funded by capital raisings contained in Schedule 5 of the Bill).
Nonetheless, the tax treatment of share buy-backs has been reviewed independently by the Board of Tax , which recommended (quoting from its final report):
“ the off-market share buyback provisions should generally apply in the same way to listed and unlisted companies ”; and
“ there are a number of other circumstances where companies’ shares are cancelled in the same way as buy-backs, including capital reductions involving share cancellations in those cases shareholders are not entitled to [capital] losses. It would seem appropriate to align the taxation treatment ”
The Board made the following observations:
There is an unequal distribution of franking credits that arises in off-market share buy-backs conducted by listed public companies. Off-market share buy-backs can enable companies to distribute franking credits to those shareholders who are best able to use them and avoid them being wasted on shareholders for whom franking credits are not as valued, and as a result minimise the wastage of franking credits.
Capital losses arising from off-market share buy-backs conducted by listed public companies exacerbate the unequal flow of benefits between shareholders who participate in a buy-back and those who do not.
The greater the discount from market value, the more incentive there is for low rate and tax-exempt shareholders to participate in off-market share buy-backs conducted by listed public companies. However, while participating shareholders receive the franking credits and the capital loss, non-participating shareholders may benefit through an increase in earnings per share and a higher market price per share.
The ATO considers that streaming of franking credits routinely occurs in an off-market share buy-back. According to the Board’s report, there is clear evidence of over-participation by superannuation funds and zero-rate taxpayers in off-market share buy-backs generally. The ATO generally expects that the buy-back should remain attractive to a broader range of taxpayers at a 14% discount. However, where a discount of greater than 14% is proposed, the attractiveness of an off-market share buy-back diminishes for all but zero-rate and 15% taxpayers, mainly superannuation funds.
In addition, although the Board noted that buy-backs, as a capital management tool, often return cash that is surplus to the company’s needs, it is possible to borrow money to fund the buy-back. In such cases, not only are franking credits being distributed to shareholders who are more likely to be able to benefit from them, but the company incurs deductible borrowing costs that are then used to reduce future tax payments, resulting in two hits to the revenue.
Effects of the proposed measures
The proposed measures make relatively small drafting changes to the income tax law that make significant changes to align the treatment of on-market and off-market share buy-backs by listed public companies for tax purposes. The proposed changes do not impact (off-market) share buybacks by unlisted companies.
The changes have the following effects:
| Off-market Share Buy-backs | Off-market Share Buy-backs | On-market Share Buy-backs | |
|---|---|---|---|
| Existing law | Proposed law for listed public companies | ||
| Dividend component of the buy-back price for shareholders | The buy-back price has a dividend component and a capital component, with the capital component treated as the capital proceeds for the disposal of the shares | The buy-back price will not have a dividend component; instead, the whole price will be treated as the capital proceeds for the disposal of the shares | Same as the proposed treatment of off-market buy-backs conducted by listed companies, that is, the whole buy-back price is treated as capital proceeds for the disposal of the shares |
| Franking account of the company | The company can generally frank the dividend component of the buy-back price. The franking account balance is reduced by the franking credits distributed to shareholders with the dividend component | The company will suffer a reduction in the franking account balance by the franking credits that would have been distributed to shareholders had the company not been a listed public company and the notional dividend component had been franked to 100% (or the company’s benchmark franking percentage, if applicable) | Same as the proposed change to off-market buy-backs conducted by listed companies, being the company suffers a reduction in the franking account balance by the franking credits that would have been distributed to shareholders had the buy-back been an off-market buy-back and the notional dividend component been franked to 100% (or the company’s benchmark franking percentage, if applicable) |
Off-market Share Buy-backs
On-market Share Buy-backs
Dividend component of the buy-back price for shareholders
The buy-back price has a dividend component and a capital component, with the capital component treated as the capital proceeds for the disposal of the shares
The buy-back price will not have a dividend component; instead, the whole price will be treated as the capital proceeds for the disposal of the shares
Same as the proposed treatment of off-market buy-backs conducted by listed companies, that is, the whole buy-back price is treated as capital proceeds for the disposal of the shares
Franking account of the company
The company can generally frank the dividend component of the buy-back price. The franking account balance is reduced by the franking credits distributed to shareholders with the dividend component
The company will suffer a reduction in the franking account balance by the franking credits that would have been distributed to shareholders had the company not been a listed public company and the notional dividend component had been franked to 100% (or the company’s benchmark franking percentage, if applicable)
Same as the proposed change to off-market buy-backs conducted by listed companies, being the company suffers a reduction in the franking account balance by the franking credits that would have been distributed to shareholders had the buy-back been an off-market buy-back and the notional dividend component been franked to 100% (or the company’s benchmark franking percentage, if applicable)
In a related change, a dividend arising from a selective capital reduction by a listed public company will not be frankable, but the franking credit balance will be reduced in a similar way.
Value impact of proposed measures
Why does selling at a discount makes sense?
As noted above, off-market share buy-backs by listed public companies have traditionally been conducted at a discount to the trading value of the shares because of the benefit of franking credits attached to the dividend component of the buy-back price and the capital losses that typically arise for participating shareholders, with participation greatest amongst shareholders who are taxed at less than the company tax rate of 30%. But for the tax benefits, shareholders would sell on-market.
The Board of Tax, in Table 4.1 of its discussion paper on off-market share buy-backs, compared the economic after-tax outcomes of an off-market share buy-back for different shareholders. Despite the passage of time, that comparison remains accurate (ignoring the proposed measures). The comparison can be summarised as follows:
| After-tax Return on Original Investment | Off-market Share Buy-back | Disposal On-market |
|---|---|---|
| Individuals who pay tax (including the Medicare levy) at less than the rate of 30%, superannuation funds and tax-exempt entities | 110% to 140% | 90% to 100% |
| Individuals who pay tax (including the Medicare levy) at more than the rate of 30%, non-residents and companies | 56% to 80% | 70% to 100% |
After-tax Return on Original Investment
Off-market Share Buy-back
Disposal On-market
Individuals who pay tax (including the Medicare levy) at less than the rate of 30%, superannuation funds and tax-exempt entities
110% to 140%
90% to 100%
Individuals who pay tax (including the Medicare levy) at more than the rate of 30%, non-residents and companies
56% to 80%
70% to 100%
As this shows, the first category of shareholders (individuals who pay tax at less than the company tax rate of 30%, superannuation funds and tax-exempt entities) are better off participating in an off-market share buy-back despite the buy-back price being at a discount to market value, whereas the second category of shareholders are worse off. This comes down to the tax benefits that arise for the first category of shareholders from franking credits and capital losses.
What could happen under the proposed measures for company share buy-backs?
It seems the one certain outcome is that companies will no longer have a clear preference to implement an off-market share buy-back as a means of capital management.
Once the franking credit benefits are removed under the proposed measures, there is no fundamental tax difference between an on-market and an off-market buy-back for a listed public company. An on-market buy-back has the commercial attraction that shares may be acquired opportunistically at less than what they might otherwise have been bought back at in an off-market buy-back. The exception is for large shareholdings, where an off-market buy-back may remain a practical way for the company to facilitate large shareholders exiting their investment without immediately impacting the prevailing share price.
An important issue arises from a rule that exists in the current law to adjust for distortions in the market value of the shares caused by the announcement of the off-market share buy-back and subsequent on-market trading. The tax law currently requires capital gains and losses under the buy-back to be calculated based on the market value of the shares prior to the announcement of the buy-back. The Bill makes no change to these provisions for listed public companies, which we understand to be a deliberate decision.
It may be that there will not be much of a distortion given the proposed measures remove the incentives for a listed public company that is proposing to undertake an off-market share buy-back to purchase its shares at a discount. However, the above distortion adjustment does make it difficult, if not impossible, for a company and its shareholders to predict the outcomes of an off-market share buy-back, and it will further encourage a move to other means of capital management.
Although some commentators have speculated that companies will simply increase the frequency and amount of special dividends in response to the proposed measures, in our experience, this will be an exception rather than the rule. Buy-backs have traditionally allowed the distribution of franking credits that were otherwise trapped. The payment of special dividends has its own tax and commercial considerations including, importantly, the availability of profits in the company (not just the group) paying the dividend and the application of integrity rules aimed at preventing capital/dividend streaming. Further, dividends must be paid proportionately to all shareholders and will result in wastage (although whether this is any more than is the case with share buy-backs will vary from company to company).