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Tax Issues: Understanding “off-market” share buy-backs

Every Issue

Cite as: (2004) 78(1-2) LIJ, p. 80

Taxation rules are complex for share buy-backs which occur outside the ordinary course of stock exchange trading.

Share buy-backs are becoming increasingly popular in Australia, as evidenced by some high profile buy-backs undertaken last year by large companies such as Woolworths and Telstra. One reason behind the popularity of share buy-backs is that they can provide shareholders with a tax-efficient mechanism for realising their shares. This is particularly so in the case of “off-market purchases” which are buy-backs that occur outside the ordinary course of trading on the stock exchange.

The taxation rules in this area are complex and the consequences of a buy-back will depend on the particular shareholder’s individual circumstances. For example, different consequences flow depending on factors such as whether the shareholder is:

  • an individual, company or superannuation fund;
  • a resident or non-resident; and
  • a sharetrader or an ordinary investor (i.e. who holds their shares on capital account and falls within the capital gains tax (CGT) rules).

The shareholder’s tax rate will also be a crucial factor. The cost base of the shareholder’s shares and, for ordinary investors, whether they acquired their shares before or after 19 September 1985 (when CGT commenced), whether they have or can use capital losses and whether they are entitled to a CGT “discount” will also be relevant factors.

Bearing these issues in mind, the following general discussion focuses on how an off-market buy-back affects resident individual, corporate and complying superannuation fund shareholders who hold their shares on capital account and acquired them after 19 September 1985. The example illustrates the impact of a hypothetical off-market buy-back on different types of shareholders with different marginal tax rates and compares the buy-back with an ordinary sale in the market.

Corporate law perspective

Under the Corporations Act, a company may buy back its shares provided the buy-back does not materially prejudice its ability to pay its creditors and provided certain prescribed procedures (which depend on the nature of the buy-back) are followed.

Companies undertake share buy-backs for a variety of reasons. For instance, they may use share buy-backs as a takeover defence mechanism, to raise the market value of their shares, as a mechanism for removing shareholders with small parcels of shares (resulting in administrative efficiencies) or to support employee share schemes. A share buy-back may also be an appropriate “investment” for a company when it considers that its shares are undervalued and can result in enhanced earnings per share for the remaining shareholders. Share buy-backs can be used to increase the shareholdings of particular shareholders whose shares are not bought back, enabling them to gain or retain control of the company without being required to fund the acquisition of further shares themselves. They can also simply be an efficient means for companies with surplus cash to return equity to shareholders, who can then redirect their capital into other investments.

Companies are able to use either or both their share capital and their profits to fund a buy-back.

Taxation consequences

From the perspective of resident shareholders who hold shares on capital accounts which they acquired after 19 September 1985, the income tax and CGT consequences of an off-market purchase depends on the cost base of their shares and the amount and composition of the purchase price paid by the company for them.

In simple terms, the purchase price that a company pays for its shares under a buy-back may consist of either or both a “dividend” and a “capital” component. For example:

Dividend component: The dividend component is the difference between the purchase price and that part of the purchase price which is debited against the company’s share capital account. This dividend is frankable and the company can choose to allocate franking credits to it under the general imputation rules. Subject to minimum holding period rules and various anti-avoidance provisions, resident shareholders are required to “gross up” franked dividends and are entitled to tax offsets for the franking credits.

Capital component: The capital component (i.e. the amount the shareholder is deemed to have received as consideration for the sale of the shares under the buy-back) is the purchase price paid for the shares (or their market value, if this is greater) less the amount of the purchase price which is a dividend (as discussed above).

Broadly, the shareholder’s capital gain or loss will be equal to the difference between this capital component and the cost base of the shares. A shareholder who is an individual or a complying superannuation fund and has held the shares for at least 12 months is generally entitled to a CGT “discount” of 50 per cent or 331/3 per cent respectively on any capital gain on those shares, meaning that only 50 per cent or 662/3 per cent respectively of the capital gain (after first offsetting any capital losses available to the shareholder) is included in the shareholder’s assessable income.

This CGT discount does not apply where the shareholder has elected to index the cost base of the shares in calculating the capital gain (which is only available for shares acquired before 21 September 1999) or to shareholders which are companies.

Example
The following example highlights the basic operation of the above rules.

X Co, an ASX listed company, buys back some of its shares for $9 each in an off-market purchase. The purchase price of $9 is funded out of profits ($7) (the dividend component) and share capital ($2) (the capital component). The $7 dividend component is fully franked.

X Co’s shareholders include:

  • A (a resident individual shareholder subject to tax at the rate of 18.5 per cent, including Medicare levy);
  • B (a resident individual shareholder subject to tax at the rate of 48.5 per cent, including Medicare levy);
  • C (a resident company subject to tax at the rate of 30 per cent); and
  • D (a complying superannuation fund subject to tax at the rate of 15 per cent).

Assume that each of the above shareholders sells one share under the buy-back and the cost base of their shares is $5 each. In these circumstances, the relevant positions of the shareholders are outlined below:


A
18.5 per cent
shareholder

B
48.5 per cent
shareholder

C
30 per cent
shareholder

D
15 per cent
shareholder

Income tax consequences





Dividend

$7.00

$7.00

$7.00

$7.00

Plus franking credit gross up

$3.00

$3.00

$3.00

$3.00

Taxable income

$10.00

$10.00

$10.00

$10.00

Tax

$1.85

$4.85

$3.00

$1.50

Less franking credit

($3.00)

($3.00)

($3.00)

($3.00)

Net tax/(refund)

($1.15)

$1.85

Nil

($1.50)






CGT consequences





Cost base

$5.00

$5.00

$5.00

$5.00

Less capital proceeds

$2.00

$2.00

$2.00

$2.00

Capital loss

($3.00)

($3.00)

($3.00)

($3.00)






Net after-tax position




Consideration received

$9.00

$9.00

$9.00

$9.00

Less tax or plus refund

$1.15

($1.85)

Nil

$1.50

After-tax benefit

$10.15

$7.15

$9.00

$10.50

Capital loss benefit

($3.00)

($3.00)

($3.00)

($3.00)

If the above shareholders had sold their shares in the marketplace, rather than under the buy-back, for $9, they would each have made a capital gain of $4 ($9–$5). Furthermore, assuming they were eligible for the discount, A and B would have their gains reduced to $2 ($4 x 50 per cent) and D’s capital gain would be reduced to $2.67 ($4 x 662/3 per cent). On this basis, the position of the relevant shareholders would be as follows:


A
18.5 per cent
shareholder

B
48.5 per cent
shareholder

C
30 per cent
shareholder

D
15 per cent
shareholder

CGT consequences

No CGT
discount

CGT
discount

No CGT
discount

CGT
discount

No CGT
discount

No CGT
discount

CGT
discount

Capital gain

$4.00

$2.00

$4.00

$2.00

$4.00

$4.00

$2.67

Tax

$0.74

$0.37

$1.94

$0.97

$1.20

$0.60

$0.40









After-tax position







Consideration received

$9.00

$9.00

$9.00

$9.00

$9.00

$9.00

$9.00

Less tax

($0.74)

($0.37)

($1.94)

($0.97)

($1.20)

($0.60)

($0.40)

After-tax benefit

$8.26

$8.63

$7.06

$8.03

$7.80

$8.40

$8.60

Conclusion

While the above example is only illustrative, it serves to highlight some of the benefits of an off-market buy-back. Ultimately, when weighing up the pros and cons of selling shares under an off-market buy-back as compared with selling shares on-market, it is necessary to consider all the relevant individual circumstances of the shareholder concerned. In evaluating an off-market buy-back, much will depend on the make-up of the purchase price (i.e. the extent to which it comprises a dividend component and a capital component and the extent to which any dividend component is franked).

If the buy-back produces a capital loss for the shareholder, it is important to realise that a capital loss is only of benefit where a taxpayer has (or will have) capital gains against which the capital loss may be offset. Furthermore, the benefit of such a loss may be eroded to the extent that it is applied against any capital gains eligible for the CGT discount.


JANE TRETHEWEY is a partner in the Tax Group of Blake Dawson Waldron, practising in corporate and international tax law.

STEPHEN BARKOCZY is an associate professor, lecturing in taxation law at Monash University, and a consultant with the Tax Group of Blake Dawson Waldron.

tax@liv.asn.au

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