If you hold shares in major companies such as Commonwealth Bank (CBA) and Woolworths (WOW), you will have received an offer from the company to participate in share buy backs. The offer document and process look quite complex and confusing but it’s worth understanding how it works and why.
Whether it is worth participating and selling some of your shares back to the company depends very much on the entity that you own them in. Depending on how the buy back is structured, the simplest answer is often that buy backs are great for low tax rate entities. If the shares are owned in a higher taxed entity, then it may be a terrible deal.
I’ll use CBA as an example to explain how it works.
At first the offer looks confusing because CBA are offering to buy back your shares at a discount. Where the buyback offer is that CBA will buy some of your shares at a 14% discount it appears to be a bad deal. At face value it results in you receiving $86 a share when you could sell them on the share market at $100.
Why would you do this?
The key is in the make up of that $86. CBA are proposing $21.66 is capital and $64.34 is a fully franked dividend. If it was an offer of $86 all capital, it doesn’t make sense. It’s the use of the franking credits in the structure of the offer that makes it work.
The fully franked dividend component is for tax purposes a large dividend. Like any fully franked dividend, the tax credit is added back on as a credit for tax previously paid. It is real money. So, the price becomes $21.66 plus $64.34 plus the franking credit of $27.57 for a total of $113.57 per share.
Let’s assume you own Commonwealth Bank shares in your self-managed super fund which is in pension phase where the tax rate on income and capital gains is 0%. Let’s also assume the current price on the stock market for CBA is $100 a share.
So, for a SMSF in pension phase participating in the buy back, the effective sale price of your CBA shares is actually $113.57 which is a significantly higher price than you could achieve by selling the shares on market.
It’s a great deal for SMSF’s in pension phase. However, these numbers change as the tax rate goes up.
For a SMSF in accumulation phase where the tax rate is 15% those franking credits are only partially refunded because the fund pays 15% tax in super accumulation phase and so you only receive a refund for what’s left after you pay tax. There is also an element of CGT to consider although significantly discounted. For a SMSF in super accumulation phase the effect price is around about $101.21 which is slightly better than selling on market.
If the shares are held in a company paying 30% it simply doesn’t make any sense. The franking credit component is fully absorbed. You’d be selling the shares at $86 in the buyback when you could sell them for $100 a share on market.
For high income earners with CBA shares in their own name the figures would be even worse. Not only would the franking credit be absorbed but you may need to pay additional tax on the difference between your tax rate and the franked dividend component.
For the companies themselves it is an excellent deal. In the case of CBA, the way its structured uses their excess franking credits, they get to buy back their own shares for $86 a share.
You to need to crunch the numbers for your specific situation to consider your tax rate, potential CGT and check the details of how the buy back is structured in each case. But generally speaking, the way they typically work makes these style of share buybacks excellent for SMSF pensions, closer to break even for SMSFs in accumulation phase and terrible for anyone with higher tax rate such as companies and high-income earners.
General advice warning. This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you.