Tuesday, March 14, 2006

Return of capital

Will Rogers was around for the Crash of '29 and had made just enough money to know something about it. He said he had had a lot of advice with recommendations of great returns on his capital. After the Crash, he said, "I don't care about a return on my capital, I want a return of my capital". Or something to that effect, anyway.

All of which is to say I was tickled pink to hear that Coles Meyer (CML) has sold off its Meyers Department Stores and made a boodle - a motza - from the sale. Especially since early stories indicated that the company would be returning some of that to shareholders and I held just enough shares to qualify for their shareholder loyalty discount at their retail stores (before they cancelled that little perk).

Now I've gone from pink to purple. They aren't going to return the capital to shareholders; they're going to have another bloody "share buy back".

Share buy-backs are a major corporate finance boondoggle. Alan Kohler, the business commentator for the Sydney Morning Herald, has utter distaste for the scheme.

"The Australian approach to taxing buybacks is unique, and so powerful is the incentive for corporate self-gratification that there must be danger of some companies going blind - by which I mean buying back so many shares as to become unlisted.

On the day BHP Billiton's buyback was announced this week, turnover in its stock tripled - stockbrokers were deliriously busy filling the orders of super funds and charities trying to climb aboard the gravy train. This is despite the fact that investors who are in it for the tax break alone are exposed to BHP Billiton's share price, and therefore the suddenly volatile commodity markets, for five weeks. The way things are looking, it's possible they could lose several times the tax advantage through a correction in the share price.

But the urge to cut tax is, for many, the greatest urge of all; greater even than fear of loss. The only thing we know for sure about the BHP Billiton buyback is that the capital component of the price will be $2.10 per share.

The difference between that and the buyback price will a fully franked "deemed dividend". Not an actual dividend, you understand, but a deemed one (which avoids the Corporation Law prohibition against discriminatory payment of dividends).

The buyback price, as with all of them, will be a discount to the market price of up to 14 per cent (a figure laid down by the Tax Office). So you get a 30 per cent imputation rebate on the 90 per cent of the price that's a dividend and a huge capital loss on the capital part.

The last time BHP shares were below $2.10 was April 8, 1986 and anyone who has been holding them since then is probably not in a hurry to sell now, so the capital loss is a benefit to almost everyone.

The franked dividend of, say, $22 a share is really only of use to super funds paying 15 per cent tax and charities that pay no tax at all, because the excess franking credits can be applied to other income. The 14 per cent discount is due entirely to these tax breaks, which indicates that there is a transfer of $200 million from taxpayers to shareholders inherent in the BHP Billiton buyback.

For the Rio Tinto one, it's $350 million. For companies and their shareholders (the ones on low tax rates) this is what is technically called in the finance industry a no-brainer; taxpayers, meanwhile, just get brained.

It is instructive to chart how this came about. In 1987 the Australian Government led the world in ending the double taxation of dividends through a system of dividend imputation.

Then in 1988 the Corporations Law was changed to allow companies to buy back their own shares as a result of a lobbying campaign from big business after the October 1987 crash, arguing that their shares were undervalued and that buybacks should be allowed so companies could take advantage of the low prices to improve their earnings per share.

There was some completely unworthy scepticism in government circles that the said companies were simply interested in propping up their share prices with shareholders' money, so the initial legislation was so full of conditions and restrictions no one did it.

In 1995, as part of the first round of the Corporate Law simplification program, the conditions and restrictions were largely dropped. At around the same time the tax law was changed to force companies to make part of the consideration for buybacks income - instead of all capital which, so the Tax Office believed, would be open to abuse. On-market buybacks had still to be entirely capital (why they are never done now). The proportion of income to capital in the consideration for an off-market buyback has to be equal to the proportion of retained earnings in shareholders' funds.

So from the mid-'90s it has been open slather for buybacks, and companies are required to make part of it a dividend. In recent years retained earnings have exploded as a proportion of shareholders funds because earnings have outstripped new capital raisings, which has led to situations like BHP Billiton's buyback, where the consideration is more than 90 per cent franked dividend.

The market is now obsessed with buybacks, as a pampered labrador is obsessed with scraps from the dinner table instead of the usual fare of dry dog food.

Obsessive, widespread use of a tax loophole has a habit of ending in legislative amendment, which is partly why the Tax Law is 2 million pages long. I'm guessing it will soon be 2.1 million pages.

IT IS surely just a matter of time before the tax avoidance scheme known as "share buyback" is shut down. Last year more than $500 million was lost to Commonwealth revenue through these plainly artificial schemes and this year we're up to $500 million and it's not even the end of February.

It's a bottom-of-the-harbour frenzy, a June-30-gumtree-scheme stampede.

Australian companies, especially miners, banks and wealth managers, are rolling in so much cash they can find nothing better to do with it than invest in themselves at a 14 per cent discount to the market, financed by taxpayers.

Billions could be dispersed to Australia's hard-pressed banks and other companies in the form of taxpayer-funded buyback discounts.

Currently Westpac shareholders are frolicking in a splendid game of pass-the-parcel to the taxpayer, in which they sell shares in the company back to the company for $4 each and then buy them back again on the market from someone else.

At the time Westpac's share price was a touch over $20, yet shareholders were queueing outside Westpac branches to fling scrip at bewildered bank tellers. The buyback was for $700 million, but $2 billion worth of stock was flung. The buyback was increased to $1 billion but still thousands of disappointed shareholders had to be told they could not sell their entire holdings for the special pre-Christmas price of $4 a share.

The solution to the mystery, of course, is that the company has agreed to pay a special once-off Christmas dividend of $15.13 per share to those generous enough to sell their shares back for $4 each. The dividend is fully franked so super funds and charities that pay no tax or 15 per cent get a refund cheque from the Tax Office. The rest of the queues of desperate sellers are made up of individuals who pay less than 30 per cent tax.

That Westpac was able to "deem" that $15.13 of the payment was a dividend allowed it to buy back the shares at a discount of 14 per cent to the market price, which saved the company $163 million. The shareholders who sold their shares have also saved various additional amounts according to their tax circumstances.

Everyone's a winner - except me. I'm not a Westpac shareholder, merely a poor schmuck of a 48.5 per cent taxpayer distributing hard-earned cash to the undeserving. I could, of course, have quickly formed a charitable foundation and bought Westpac shares to sell back to the company - as many other charities and super funds have been doing - but I couldn't decide which cause to support.

Anyway, it has been enormous fun for those in the game, and now St George Bank has added extra time with its own offer to buy shares back for $6.54 when its share price is more than $29 (the rest being deemed a dividend). St George has invited some new players to the party as well - financial planners who will have to charge many thousands of dollars to help shareholders make sense of the deal, which has the fiendish twist of including the bank's preferred resetting yield marketing equity securities, or PRYMES - which is one of those things where they start with the acronym and figure out words to go with it.

Westpac shares, meanwhile, have risen 10 per cent in a couple of weeks and will go higher after Christmas because many shareholders who have freed up cash by selling Westpac shares back to Westpac have thought about it long and hard and have decided to invest the money by buying … Westpac! And that's the game - you end up with the same holding in Westpac and with cash for Christmas and/or a better tax position.

Why the Tax Commissioner agrees to this blatant scam can only be guessed at. He and his serried ranks of flint-eyed staff mercilessly pursue hapless small businesses with nothing but their nostrils out of the water, and then meekly allow large corporations to "deem" that the consideration for buying back shares is mostly a franked dividend.

Meanwhile the Australian Securities and Investments Commission just as meekly allows the same companies to unequally distribute the same dividends because they are deemed by ASIC not to be dividends.

The Corporations Act clearly demands that dividends are paid out of retained earnings and must be distributed equally to all shareholders. In a buyback they are obviously distributed only to those people who participate. The companies argue that all are equally invited to participate, which is true. But only those on a low tax rate can viably do so because of the 14 per cent discount to the market.

The modern Australian buyback is either a dividend, in which case it is in breach of the Corporations Law, or it is not a dividend, in which case it is a tax rort. Perhaps it is both, and breaches both the tax and corporate law."

Taxpayers wear the cost of buybacks,February 18, 2006
Time to deem these buybacks as rorts, December 21, 2005


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