Share buybacks

SHARE BUYBACKS

Over recent years, there have been many public criticisms of the tax treatment in Australia of off-market share buybacks. These criticisms variously refer to high cost to government revenue, tax avoidance, artificially fabricated treatment, participants in the buyback receiving franking credits (under Australia's full imputation system of company tax) at the expense of non-participants, and so on. Viewed more appropriately, however, the revenue loss associated with off-market share buybacks removes what would otherwise be double tax on company profits - consistent with removal of double tax in the case of profit distribution followed by sale of shares or liquidation. Moreover, accurate administrative processes for share buybacks would ensure that non-participating shareholders retained their proportionate interests in undistributed franking credits.

By way of background, one way for companies to increase their debt/equity ratios is to borrow to buy back their own shares. The buying back can be done either ‘on-market’ (where sellers do not know whether they are selling back to the company or to another shareholder) or ‘off-market’ (where shareholders specifically opt to sell back to the company).

With both on-market and off-market variants, the shares bought back by the company are cancelled along with associated contributed capital and retained profits. Thus, a ‘slice’ of the company is removed by the buyback. If the same action were applied to all shareholders of the company, the ‘slice’ would translate into full liquidation of the company.

OFF-MARKET BUYBACKS

Australian shareholders participating in an off-market buyback, because they are specifically identified, effectively receive the capital and profits being cancelled - and a refund of associated franking credits. Shareholders who, say, buy shares just before participating in the buyback (‘participating’ shareholders) also receive capital losses. Those losses reflect the difference between the price paid for their shares and the contributed capital in their ‘slice’ of the company sold back to the company and ‘liquidated’. A similar capital loss (and refund of associated imputation credits) would be realised by these shareholders if, instead of undertaking a share buyback, the company distributed all profits and the shareholders either sold to others or, alternatively, the company was liquidated.

Those capital losses are integral to the removal of double taxation, consistent with Australia's full imputation company tax system designed to tax company profits only once. Double tax arises from tax on a company’s retained profits plus capital gains tax (CGT) on the sale of shares, share value having increased by the retention of profits.

The removal of this double tax via an off-market share buyback may be illustrated using a stylised example involving Australian profits and shareholders: it ignores timing considerations, exclusion from assessment of some part of realised capital gains under CGT arrangements (so, in the example, all realised capital gains are assessed) and administratively imposed changes to the buyback price for CGT purposes.

Kate (paying tax at 30%) contributes $100 of capital at the start-up of a company and the company earns and retains $100 profit on that capital (Figure 7). The value of Kate’s shares increases to $200. All the profits are taxable. The company pays $30 company tax.

An off-market share buyback is foreshadowed by the company. Kate sells her shares for $200 to John prior to the buyback. Kate pays $30 CGT on her sale. At this point, double tax ($60) has been paid on the $100 of company profits.

John participates in the buyback, selling all his newly acquired shares. John receives $170 from the company – $100 of contributed capital and $70 of the company’s after-tax profit. Regardless of his tax rate, he also receives $30 in tax savings (matching the tax paid by the company), explaining why he was prepared to pay $200 for his shares prior to the buyback.

If John’s tax rate was 20%, the $30 of tax savings would comprise a $10 refund of imputation credits ($100 profit x difference between 30% company rate and John’s 20% rate) plus $20 tax saving from a $100 capital loss he also receives (assuming he can offset the $100 loss against capital gains he saves $100 x 20% tax).
If John was a beneficiary of a superannuation fund taxed at 15%, the $30 tax savings would comprise a refund of $15 and $15 worth of capital loss (remembering reduced CGT does not apply).
If John's tax rate was 47%, the $30 tax savings (pictured in Figure 8) would comprise $17 tax on the franked dividends he receives plus $47 worth of capital loss.

The $100 capital loss from the buyback reflects the difference between the $200 John paid for his shares and the $100 of contributed capital in his ‘slice’ of the company sold back to the company and ‘liquidated’. Similarly, $100 capital loss (and refund of imputation credits) would be realised by John after Kate sells to him if the company distributes all profits instead of undertaking a share buyback and John either sells to another for $100 or, alternatively, the company is liquidated. It is the buyback alternative, however, that allows the company to re-jig its capital structure, the company deciding what percentage of its shares are to be 'liquidated'.

Under either buyback or distribution and sale/liquidation, the tax saving of $30 removes the double tax on the original $100 profit and leaves $30 net tax paid on that profit – reflecting the 30% CGT paid by the shareholder (Kate) who held the shares when the $100 of profit was earned (under simplifying assumptions, like full rather than half CGT).

This simple example shows how the design of Australia's full imputation system of company taxation and CGT seeks to ensure no double taxation of company profits over time. In practice this outcome is achieved often with very long lead times. Appropriate adjustments to CGT cost cases of shares could, conceptually, remove double tax on an ongoing basis. The administrative effort involved in such adjustments would, more sensibly, be considered as part of an ideal fully integrated company tax system where shareholders are assessed annually on their companies’ profits even when those profits are not distributed.

Example 12 in the set of Kyscope Examples shows all the numbers associated with an off-market share buyback undertaken by a company with a depreciating asset and an appreciating asset (costing $2000 of capital contributed up front) and a bank account for retained profits (all returning 10% pa before tax). The company borrows to help fund the buyback in Year 4 and then liquidates in Year 5. The example shows that under the above tax treatment, including full CGT applying on a realisations basis, one layer of tax ($541) at the assumed 47% tax rate of shareholders applies to the total income of the company's assets ($1150) over the five years of the company's operations. Shareholders participating in the buyback acquire their shares for $484 in Year 2 and the slice of the company that they receive on the buyback comprises $400 return of capital, $123 unfranked dividends and $43 franked dividends (with $19 attached franking credits) - matching the $585 market value of the shares at that time. They attract a $84 capital loss because the $400 contributed capital component of the bought back shares is $84 less than $484 they paid to acquire the shares.

ON-MARKET BUYBACKS

What if Kate's company decides to undertake the buyback of its shares on market rather than off market? Figure 9 illustrates the tax treatment of on-market share buybacks that also achieves a single layer of tax on company profits over time.

Shareholders participating in an on-market buyback do not know whether it was the company that bought their shares as part of the on-market purchases by the company or whether they simply sold to another purchaser in the market. Because they are not specifically identified, all shareholders selling 'on market' receive the same CGT treatment whether or not their shares happen to be bought by the company.

In Figure 9, Kate again sells her shares to John for $200 before the on-market buyback. Kate again pays $30 CGT on her sale. As before, double tax ($60) has then been paid on the $100 of company profits. The company then buys the shares from John for $200 ($30 of that representing the value of franking credits in the slice of the company being bought back). As John sells for the same amount that he paid for the shares, no CGT applies.

The double tax that has occurred to this point is addressed by not denying the imputation credits for which the company has paid John $30. Eventually shareholders not participating in the buy-back will achieve $30 of tax savings from distribution of those credits with future untaxed profits. At the extreme, if those credits are still held in the company when it is liquidated, the credits should increase franked dividends and decrease measured return of capital, thus increasing the capital loss attracted by shareholders at that time – producing an outcome for remaining shareholders equivalent to that for those participating in the off-market buyback, regardless of their tax rate.

That tax saving of $30 removes the double tax on the original $100 profit and leaves $30 net tax paid on that profit – reflecting the 30% CGT paid by the shareholder (Kate) who held the shares when the $100 of profit was earned (assuming full rather than half CGT). (Alternatively, the double tax could be addressed by again not cancelling imputation credits associated with taxed company income in the buyback slice and increasing commensurately the scope for untaxed future capital profits in the company by allowing the company a capital loss equal to the amount of pre-tax taxable income in the slice - a recommendation of the Review of Business Taxation (1999, Overview, Recommendations, Estimated impacts), pg 456.)

Referring again to Example 12 in the set of Kyscope Examples, if the buyback in Year 4 was on-market rather than off-market those shareholders participating in the buyback would have had $101 capital gain ($585 sale price less $484 purchase price) included in their tax assessments. Not cancelling the $19 of franking credits in the slice of the company bought back produces an extra $62 capital loss ($19/0.3 with rounding) in the hands of those shareholders not participating in the buyback and staying with the company until liquidation. The overall result is again a single layer of tax applied to the income of the company's assets at the assumed 47% tax rate of shareholders.

IMPUTATION FRANKING CREDITS

With appropriate design of buybacks for income tax purposes, shareholders participating in a buyback should not attract a disproportionate share of the company’s profits and associated franking credits.

If the slice of the company subject to the buyback reflected a proportionate share of contributed capital, untaxed profits and taxed profits with associated franking credits, remaining shareholders should not be concerned about losing their franking credits. Those not participating in the buyback would retain their proportionate interests in undistributed profits and associated franking credits (regardless of how the company pays for the assets associated with the shares cancelled – from say borrowing to pay for them, like in Example 12 in the set of Kyscope Examples, to actually selling them).

The above standard analysis underpinning design of the tax treatment of buybacks (with particular focus on the interaction of Australia's full imputation and capital gains tax arrangements) assumes accurate measurement of the composition of the buyback slice - an important empirical matter for tax authorities.