The refunding of excess franking credits supersizes the benefits of share buybacks and listed entities have exploited this for years.
Franking credits belong to all shareholders and streaming credits to a particular shareholder class is normally prohibited because it’s unequitable. So why do we allow it if it’s inconsistent with the fundamental principles of our imputation system?
The principle aim of our imputation system is to avoid double taxation and Australia is one of the few countries in the world with such a system. It goes one step further by allowing the refunding of franking credits. This has been in place since 2000.
Franking credits can be used to offset shareholder tax liability and if there is no tax to pay the government will provide a cash refund. The Australian Labor Party proposed removing payments for excess franking credits during the 2019 federal election, causing a heated national debate. This led to more Australians learning about the inner workings of our imputation system. It also exposed the real value of franking credits for people like self-funded retirees, super funds, and entities that pay no tax.
The streaming advantages of off-market share buybacks is an anomaly in our tax system as compared to on-market share buybacks, which are treated differently because the proceeds are on capital account, resulting in either a capital gain or a capital loss.
Off-market buyback proceeds for the share that’s bought back consist of a capital amount and a fully franked dividend. This can cause differing tax outcomes depending on the shareholders’ cost base for the shares sold, and their overall marginal tax rate. This is where the benefit of the franking credits become visible.
Shareholders who can monetise franking credits can run over most off-market offers, which often forces a tender process to meet the insatiable appetite from tax-advantaged shareholders — there’s always more bees than honey. CBA’s buyback in 2021 was oversubscribed by $18 billion.
There are several complex anti-avoidance provisions in the rules which prohibit the streaming of franked distributions to certain groups of shareholders. However, buybacks are one of the few exceptions where the streaming of credits is permitted, and listed entities have been exploiting this at the taxpayers’ expense.
To be fair, you can’t hold it against listed entities that use this kind of capital management because the only real downside for the company is more administration costs. It’s also completely legal, and it benefits all the shareholders.
Shareholders who don’t participate in off-market share buybacks usually have to opt in, and generally they’re not disadvantaged either way because the company can usually buy back the shares at a market discount so earnings can be accretive going forward.
In 2018, the off-market buyback price for BHP was $27.64 when shares were trading at $32.14. The excess franking credits benefited tax-advantaged shareholders by making up for the market shortfall, which would have been very different if the shares were sold on the ASX.
For non-resident shareholders, franking credits have no value so missing out isn’t an issue. In the past, there were schemes (now not allowed) where non-residents could loan shares for a fee to Australian entities during the dividend holding period so that the franking credits could be accessed by Australian domicile beneficiaries.
Simply put, refunding excess franking credits supersizes off-market share buyback opportunities. There’s nothing wrong with refunding excess franking credits, but when they’re combined with off-market buyback opportunities it can create a lot of mischief at the public’s expense.
A company that undertakes a buyback is required to debit its franking account for franking credits that would have been lost to dividends paid to non-residents, but this debit doesn’t fully compensate for the streaming effect that occurs between the high and low tax rates of domestic investors.
Changes to off-market share buybacks are essential to close a loophole that unfairly disadvantages ordinary taxpayers. The government is releasing draft legislation on the changes following their announcement in the budget last month.
