Income in the context of shares, refers to periodic dividends, while franking credits are tax credits accompanying those dividends reflecting the tax already paid by the issuing company on its profits.
As investors in the Australian share market, understanding the mechanics and implications of share buybacks is crucial. Companies may decide to repurchase their own shares, a decision driven by several factors ranging from capital management to stock undervaluation. Historically, there were two primary methods adopted in Australia: off-market and on-market buybacks we’ll discuss this in detail, however, following legislation in 2023 to prevent tax leakage, off-market buybacks are no longer an option for companies.
On-Market Buybacks:
Companies purchase their shares from the open market, typically over an extended period and within guidelines set by the Australian Securities Exchange (ASX).
Benefits:
Company’s Perspective: It’s a straightforward process with flexibility in terms of timing and quantity of shares to be bought. There’s minimal administrative burden as compared to off-market buybacks.
Shareholder’s Perspective: The buyback can signal the company’s confidence in its stock, potentially driving the share price up. Moreover, all shareholders benefit equally from potential price appreciation, without the need to part with their holdings.
Negatives:
Company’s Perspective: These buybacks can be more expensive as they don’t often come with the tax benefits associated with off market repurchases. Also, acquiring large volumes can inadvertently push the share price up, leading to higher costs.
Shareholder’s Perspective: As there is no separation in terms of capital and dividend components, they do not receive the direct tax benefits that might come with off-market buybacks.
Off-Market Buybacks:
Companies make a direct offer to shareholders, who then have the choice to sell their shares back at a predetermined price, often at a discount to the current market value.
Benefits:
Company’s Perspective: The selective nature allows companies to target specific shareholders, often those with reduced capital gains or those looking for tax benefits. This can lead to an effective reallocation of capital.
Shareholder’s Perspective: Eligible participants might benefit from tax concessions, especially if they hold shares at a low-cost base. Plus, the choice to participate rests entirely with the shareholder.
Negatives:
Company’s Perspective: The process can be lengthy and expensive, with necessary documentation and potential regulatory hurdles.
Shareholder’s Perspective: Not all shareholders are invited, potentially leading to feelings of exclusion. Those selling might also miss future potential value appreciation of the stock.
Why Might a Company Choose One Over the Other?
Financial Position & Strategy: If a company is cash-rich and believes its shares are undervalued, it might opt for an on-market buyback. Alternatively, if it aims to provide targeted tax benefits to certain shareholders, an off-market buyback becomes more attractive.
Market Signals: A company might opt for an on-market buyback to signal to the market its confidence in the intrinsic value of the stock, while an off-market buyback can serve as a more strategic tool for capital restructuring.
Regulatory and Operational Ease: The on-market process, being more straightforward, might appeal to companies looking for fewer administrative burdens, while firms with specific shareholder restructuring objectives might be willing to navigate the complexities of an off-market buyback.
Tax Benefits in Off-Market Buybacks
When Australian companies execute off-market buybacks, they typically structure the buyback price in two parts.
Capital Component (usually a fixed amount)
This is the portion of the buyback price that’s considered a return of capital. If the capital component is less than the shareholder’s cost base (what they originally paid for the shares), then the shareholder will realize a capital gain. If the capital component is more than the cost base, they’ll realize a capital loss.
Dividend Component (makes up the remainder of the buyback price)
The dividend component is considered a fully franked dividend for tax purposes. In Australia, a franked dividend comes with franking credits. These credits are a tax paid by the company, which the shareholder can offset against their income tax liability. In essence, franking credits prevent the double taxation of dividends.
The primary benefit for shareholders participating in off-market buybacks is the receipt of franking credits from the dividend component. Especially for shareholders in lower tax brackets or tax-exempt entities like self-managed superannuation funds, these credits can result in significant tax refunds. The capital return can help shareholders manage their capital gains or losses for tax purposes.
On-Market Buybacks don’t provide these tax advantages. When companies buy back shares on-market, they simply purchase their shares at the prevailing market price. There’s no separation of the purchase price into capital and dividend components, so there are no franking credits to be passed onto the shareholders. Shareholders, while benefiting from potential stock price appreciation due to the buyback, don’t receive the direct tax advantages that an off-market buyback might provide.
While both types of buybacks can return value to shareholders, the off-market buyback in the Australian context provides a unique advantage in terms of tax benefits, particularly due to the provision of franking credits.
