Share buy-backs explained


From time to time a company might announce a share buy-back scheme involving an offer to shareholders to sell some or all of their shares back to the company for a share price lower than the market price. At first sight a shareholder might wonder why on earth should I dispose of my shares at a price lower than I can achieve by simply selling in the market.

Whilst the features of each such scheme may differ from case to case, from the company point of view the effect of the buy-back is to hand ‘excess’ money back to its shareholders in preference to using it for further investments.

The benefit for shareholders is associated with the way in which the buy-back is featured. Looking at the recent BHP buy-back scheme as rather a typical example, the company offered to buy back the shares at a discount to the then share price of up to 14% (which also in the end turned up to be the actual discount). However, a big benefit for shareholders was, in this case, that the tax office had agreed that of the proceeds only 38 cents would be considered the capital return on each share with the rest of the proceeds, actually $27.26, being considered a fully franked dividend. Thus, all shareholders would be able to claim a capital loss on selling back their shares (as nobody would have bought BHP shares under 38 cents a share) and the remaining $27.26 dividend would carry a lot of franking credits. Such a capital loss could be offset against any other capital gain of any kind, either within the same tax year or carried forward to a future tax year.

To fully illustrate the maximum benefit offered let’s consider the case of a holder not liable to pay any tax in this tax year who participated in the buy-back and who accepted the 14% discount offer. This holder would have first received direct

from the company the $27.26 dividend plus the $0.38 capital proceed, i.e. a total of $27.64 per share (as compared with a declared market price which turned out to be $32.13). However, at the end of the tax year when the holder would have applied for the return of franking credits, which on the $27.26 dividend would have been $11.68 the holder would additionally receive this $11.68 from the tax office. Thus, the total return per share for this non-tax payer would have been $38.94, i.e. well ahead the $32.13 market price. For a holder paying some tax the returned franking credits would have been lower but not eliminated until the marginal tax rate would have been above 30% (equivalent to the company tax rate).

So, to summarise, any participant in the buy-back who had bought their BHP shares at a lower price than the finally declared market price would have avoided capital gains tax that otherwise would have applied, as well as reaped the benefit of refunded franking credits, provided their marginal tax rate would have been less than 30%. BHP itself would have been able to buy back its own shares for a price at a 14% discount to the market share price and cancelling them, which it would have been considering as a sensible use of excess capital and as a means of advantaging its shareholders. And, not to forget, the shareholders choosing not to participate would have seen a boost to the value of each of their shares as those shares cancelled by the company would have meant that the total value of the company would have been spread over a reduced number of total shares on issue.

The BHP share buy-back case is rather a typical one, but each new such offer needs to be considered taking into account its specific features. In the case of BHP as it happened the offer was accompanied by another measure, namely the payment of a special dividend based on the shares held after completion of the buy-back, in other words a dividend for which those who participated in the buy-back were not eligible. Again, this emphasises the importance of taking all the features of the buy-back and any associated measures into account before deciding how to react.