Off-market share buy-backs: the impact of tax changes on investor behaviour

Overview of the measures

The Federal Government in September released draft legislation inserting a targeted integrity measure for franked dividends funded by capital raisings. This was a previously announced, unlegislated measure from the 2016-17 MYEFO. The measure would deny shareholders utilising a franking credit received on distributions that had been sourced via a capital raising, targeting out of cycle distributions. The potential broad and retrospective application of this measure has caused concerns in the market.

Share buybacks

As part of the Government’s first Budget, it was announced that from budget night, off-market share buybacks would be treated in the same way as on-market share buy-backs, as such eliminating off-market share buybacks as a tax efficient capital management option. Following the announcement the government released exposure draft legislation on 17 November 2022.

To further explain the impact of these change, under the current law, there are separate tax regimes for on and off-market share buybacks:

• Off-market buy-backs are considered to be a mix of dividend and proceeds for disposal of the share. As such, where the company has sufficient franking credits they can attach franking credits to the dividend component. From the shareholder’s perspective they will receive a franked dividend and typically make a capital gain or loss with respect to the proceeds component.
• For on-market share buy-backs, there is no dividend component. Rather, the entire buyback amount is considered proceeds for the disposal of the share. The company is also required to debit their franking account as if the buyback was conducted off-market. In the hands of the investor, typically there is a capital gain or loss with respect to the proceeds component.

For investors with tax rates lower than the company tax rate, for example superannuation funds, accessing off-market share buybacks has generally been more preferential on an after-tax basis. While the buyback price in an off-market buy-back is generally less than for an on-market buyback, the refundable nature of the franking credit could be valued as additional proceeds. This has been especially beneficial for superannuation members who are in the pension phase and are generally exempt from income tax on income and capital gains. As such, participation in off-market share buy-backs has been a common investment decision for superannuation funds and a well-used capital management mechanism for the ASX 200.

Given that on-market buy-backs do not attract concessional franking benefits, yet result in penalty franking debits to the company buying back its shares, this method of capital management results in lost franking credits in the system. By seeking to align the off-market buy-back treatment with the on-market treatment, the Government has messaged this change as “improving the integrity of the tax system”. However, the prevalence of off-market share buybacks was not, in our view, a consequence of a tax abuse, but rather a consequence of a legislated mechanism in the off-market buy-back tax rules operating in conjunction with the policy intention for superannuation income to be taxed at a concessionary rate. The proposed changes will not only alter the capital management plans of listed companies, but could also alter how investors view those companies.

The role of franking in shaping investment decisions

Market conditions have resulted in Australian listed companies having a high dividend payout ratio, especially compared to their United States peers. While there are a number of factors, the imputation system has been a key contributing factor. For those investors who search for yield, the receipt of a fully franked dividend is more tax efficient than a bond yield. The dichotomy is especially true for superannuation investors who can value the franking credit more than individual investors with higher marginal tax rates. This search for yield has seen the market reward those companies which have a high payout ratio and which fully or majority frank their distributions.

While there are obviously multiple factors which drive investment decisions, it is worthwhile considering the potential implications which the franking regime has on investment decisions. For example, a diversion of funds away from capital investment and innovation within in the business may be a consequence of the franking regime. Franked cash distributions deliver a more immediate benefit to investors, than the longer term capital growth that capital investment may yield. The impact of this is quite stark when compared to US listed entities which often have significantly lower payout ratios than Australian companies. This could also be a factor shaping the economies of the two countries. The top of the US market is dominated by technology and health companies where research and development are key to their growth, compared to the Australian market that is dominated by financials and materials businesses.

While the authors of this article certainly do not advocate a movement away from the franking regime, it is worth observing that the US employs a classical tax system which results in effective double taxation of dividend income (given no tax credits are available to investors for taxes paid in the company), effectively creating a disincentive to paying dividends. Another interesting comparison is the nature of the pension regimes. In both countries the pension funds are material investors in the market, however unlike their tax exempt American peers, Australian superannuation funds need to look to the best post-tax outcome for their members and the imputation system is a structural feature to help that end.