In coming days, Australian investors in BHP (BHP-ASX) will be receiving paperwork detailing the company's recently announced, off-market share buy back. With so many 'Mum and Dad' investors holding BHP, and the technical nature of the buy back being a little difficult to understand, I thought it might be helpful to outline the details as simply as possible for anyone struggling to get their head around it and make their decision a little easier.
In short, investors can opt to sell their shares (or a portion of them) back to BHP. The offer will be at a discount to the trading price of shares on the market, which begs the question, why would you sell? Quite simply, it is in the make up of the payment that you find the answer. A very small proportion of the payment will be considered 'capital', and the rest considered a fully franked dividend. If you are a low or no tax paying individual, or the shares are held in a Self Managed Super Fund (SMSF), the tax benefits of accepting the share buy back can be significant. Those of us paying a significant tax rate (30-46.5%) will find the buy back far less attractive.
The first benefit comes in the way of fully franked dividends. It is times like these that you really thank the Australian government for bringing in the imputation credits system to the investment landscape. Once the payment is 'franked up', that is, adjusted for the real return when considering the franking credits applicable, the actual payment received should exceed the on-market share price. This alone makes the share buy back a pretty attractive option for anyone paying minimal or no tax at all. If you still want to hold BHP shares, there is nothing stopping you buying straight back in after accepting the buy back. It's a simple play and could result in some of the easiest returns you ever likely to come by.
The second significant benefit lies in the fact that very little of the payment is considered 'capital'. This in simple terms means you are accepting a tiny amount of money for you 'share', but are taking a large amount as profit in the way of a whopping big dividend. This results in a large capital loss (despite the likely hood that the real return is likely to exceed the market price), and can be used as a capital gain offset should you be selling other shares at a profit. The tax benefit is harder to estimate in this case, but is absolutely a big benefit to those who accept the share buy back.
Consider the following example (this is not the actualy make up of the buy back prices, but simply an indication of how the above principles work). Assume the share price on-market is $45 per share, and the discount offered in the buy back is 14%, resulting in a payment of $38.70 per share in the buy back. Lets say the capital component is only 38c and the fully franked dividend component is $38.32. For a SMSF in pension phase and paying no tax, the following would be the real returns (lets also assume the shares were originally purchased at $30 per share).
The capital component offers the shareholder a capital loss of $29.62 per share. The dividend component offers a return of $38.32 + $16.42 (franking credits) = $54.74 The real return to a non-tax paying individual or SMSF would be $55.12 + a capital loss of $29.62 which can be used in the future to offset a capital gain should it be required.
Considering the above, the shareholder is receiving a premium of over 22% to the on-market price of their BHP shares, along with a handy capital loss which could be used in the future should it be required. Not a bad return in anybody's book. Returns are slightly lower, but still significant for those paying a 15% tax rate (low income earners and SMSF in accumulation phase). Anybody in a low or no taxation position should be considering the share buy back very carefully. For those of us who are not, you can still accept the buy back, but given the maths applied, I can't see much value in doing so.
I hope this will prove helpful to some. I must stress that the above should not be considered advice. Anyone considering participating in the share buy back (or not for that matter) should definitely be seeking advice from a professional advisor on the matter before making any investment decision.
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