5 November 2018
Off-market buy-backs are an attractive capital management option for companies and their shareholders. However, companies paying a dividend in conjunction with an off-market buy-back should take note of the ATO’s updated guidance on the application of the 45 day rule and its impact on entitlement to franking credits.
Companies can buy-back their shares at a discount of up to 14% to the market value of the shares. Shareholders receive part of their disposal proceeds as a franked dividend for tax purposes, and may also realise a capital loss.
One key issue for an off-market buy-back is ensuring that the timetable allows shareholders to acquire shares before the record date for the buy-back and be entitled to franking credits on the dividend component of the buy-back price. This requires the 45 day rule to be satisfied.
Broadly, the 45 day rule requires the shareholder to have held their shares ‘at risk’ for at least 45 days between the dates of acquisition and disposal of their shares. The 45 day rule has a “last in first out” (LIFO) rule, which deems shareholders to have disposed of their most recently acquired shares first for the purposes of working out whether they have satisfied the 45-day rule in respect of a dividend.
For the dividend component of the buy-back price, it has long been accepted by the ATO that the LIFO rule does not apply to shares acquired on or after the ex-entitlement date for participation in an off-market buy-back. That is, additional shares acquired by a shareholder that do not have an entitlement to participate in the buy-back are not subject to the LIFO rule and will not be taken to have been disposed of in the buy-back (see PS LA 2007/9).
However, it has been common for companies to also pay an ordinary dividend in conjunction with an off-market share buy-back. And as the recent BHP buy-back shows, a company may also pay a special dividend in conjunction with the off-market share buy-back. The ATO has recently updated its website guidance on the LIFO rule to also deal with this additional dividend.
The ATO’s guidance states the LIFO rule will apply to potentially deny franking credits attached to a dividend paid to a shareholder who:
- sells their existing shares into an off-market share buy-back (the old shares);
- acquires additional shares in the company on or after the buy-back ex-entitlement date but where the shareholder is entitled to receive a separate franked dividend on those shares (the new shares); and
- is also eligible for the separate dividend on the old shares which are sold into the buy-back.
The ATO’s position is that the LIFO rule will apply for the purposes of the dividend and will deem the new shares to have been sold into the buy-back. This is so notwithstanding that, legally, the shareholder cannot in fact sell the new shares into the buy-back. This means that as these new shares will not have been held for 45 days, franking credits will be denied on all or some of the dividend paid on the new shares.
And although Example 2 of the ATO’s website guidance refers to a company paying a special dividend, it is understood that the ATO’s position equally applies to an ordinary dividend.
Whilst the franking credits on the dividend component of the buy-back price are not affected, it may be difficult to manage this issue for shareholders who both tender “old shares” into the buy-back and acquire “new shares” that are entitled to a separate dividend.
Although not dealt with in the ATO guidance, it should be possible to mitigate this LIFO issue through one of two ways:
- align the record dates for both the off-market buy-back and the dividend; or
- have the record date for the dividend after the off-market buy-back has completed.