Fully franked dividends a bonus of buybacks

Share buybacks have been conducted by companies such as BHP, Woolworths, Telstra and the banks, particularly after they have had profitable years.

CBA announced a $6bn off-market share buyback. Picture: NCA NewsWire/Bianca De Marchi

August represents one of the four corporate reporting periods in Australia each year and along with allowing investors to learn how their investments have performed, there is occasionally a bonus in the form of a special dividend or an off-market share buyback.

Share buybacks confuse many investors. Why would a company, they ask, invest in its own shares?

Companies undertake buybacks for a variety of reasons: to clean up their share registers, to return excess capital to shareholders, and to clear franking credits from their balance sheets which have resulted from tax being paid on profits.

Companies must incentivise shareholders to take up an offer. For many investors, buybacks are a way of reducing capital gains tax as well as refreshing the capital cost of shares in a portfolio. Note that franking credits do not appear for the investor until the next tax return.

Share buybacks have been conducted by companies such as BHP, Woolworths, Telstra and the banks, particularly after they have had profitable years.

Most large companies aim to pay out a certain percentage of their profits to shareholders. For the big banks this can be between 60-65 per cent each year. Paying higher dividends to shareholders is one way of achieving this payout ratio. Share buybacks are another.

Buybacks require the blessing of the Australian Taxation Office, and can either be on-market – with the company acting like any other buyer of shares – or off-market. Once the buyback is completed the shares purchased are cancelled, thus increasing the value of the shares remaining in the market.

Off-market buybacks are often made with a large, fully franked dividend component, which especially benefits shareholders who pay little or no tax, such as people who draw pensions from their super funds.

For these shareholders the large fully franked dividend can be valuable, with the value of the franking credit returned via the tax system.

In fact, for anyone who pays less than 30 per cent tax (the corporate rate), share buybacks can represent good value.

For shareholders who pay higher rates of tax, they are less valuable. Even if a share buyback is priced at a discount to the prevailing market price, franking credits flowing through to many shareholders can more than make up for the discount.

Share buybacks undertaken by big companies can involve many millions of shares. In May 2019 retailer Woolworths undertook an off-market buyback, offering to buy shares from shareholders at $28.94 per share, a 14 per cent discount to the prevailing market price of $33.64. The offer was made up of a capital component ($4.79 per share) and a dividend component ($24.15).

So many shareholders were keen to accept the offer that investors were scaled back nearly 85 per cent. The company ended up buying 58.7 million of its own shares for a total of $1.7bn.

So, when do share buybacks represent good value for shareholders? Not surprisingly, it’s all about tax rates and the imputation credits that flow to investors on different tax levels.

On Wednesday this week – as part of its annual results in which it announced a full-year cash profit of $8.65bn – CBA announced a $6bn off-market share buyback, with a pay date of October 8. The price offered will be a 10-14 discount to the market price of CBA shares at the close of the offer. The price includes a capital component of $21.66 per share, with the balance made up of a fully franked dividend.

Let’s look at a simple example of what this means for three different investors, each of whom owns, say 100 CBA shares for which they paid $24.50 per share more than 20 years ago. The calculations are based on a 14 per cent discount to an assumed CBA share price of $108.27. Investor A is a pension fund (paying no tax), investor B is a super fund (paying 15 per cent tax on income) and investor C pays the top marginal tax rate of 47 per cent (including the 2 per cent Medicare levy).

Investor A will receive an equivalent sale price of $123.69 per share, or $12,368.54 for the 100 shares, which includes franking credits of $3060.76.

Investor B will receive an equivalent sale price of $108.38 per share, or $10,838.16 for the 100 shares, which includes franking credits of $1530.38 (income for super funds is taxed at 15 per cent, half the corporate tax rate). Due to the original purchase price being higher than the capital returned on each share, a capital loss is generated.

Investor C will receive an equivalent sale price of $75.73 per share, or $7573.35 for the 100 shares, which includes a tax of $1734.43 (because the investor’s tax rate is higher than the corporate tax rate).

Again, a capital loss is generated.

Alex Moffatt is a director of wealth manager and aged care adviser Joseph Palmer & Sons.