Improving the integrity of off-market share buy-backs: Government releases exposure draft legislation

The 2022-23 federal budget announced a new integrity measure aimed at aligning the tax treatment of off-market share buy-backs undertaken by listed companies with the tax treatment of on-market buy-backs. The Government has now released an exposure draft and has initiated a consultation process seeking stakeholders’ views.

The objective of the exposure draft legislation is to ensure that where a listed public company undertakes an off-market buy-back of shares or non-share equity interests, no part of the purchase price in respect of the buy-back will be taken to be a dividend. The draft would also introduce commensurate integrity measures with respect to the tax treatment of selective share cancellations for listed public companies. If the legislation becomes law, the rules will apply retrospectively to buy-backs and selective cancellations that were first announced to the market on or after 25 October.

This article features a high-level summary of Government objectives underpinning the exposure draft, the current share buy-back rules, the new integrity measures.

Share Buy-backs Explained

A share buy-back occurs when a company offers to repurchase a portion of its shares that was previously issued among shareholders. Although on the surface a share buy-back may seem counter-intuitive as the buy-back will ultimately reduce the equity capital of the company, there are many reasons why it may be desirable for a company to repurchase it shares, including reducing the cost of future dividends, consolidation of ownership, preserving stock prices or a belief within the company that the shares are undervalued.

A listed public company may buy-back shares from shareholders by undertaking either an:

• ‘on-market buy-back’, which occurs when a company buys its own shared on an approved stock exchange in the ordinary course of trading;
• ‘off-market buy-backs’, which refers to buy-backs that do not occur on a stock exchange, but rather when the company makes its offer directly to its shareholders.

An off-market buy-back can either be ‘equal’ access, where all ordinary shareholders are provided with the option to participate in the buy-back, or ‘selective’, which is when the company offers to buy-back shares from specific shareholders.

What is the Current Taxation Treatment of Share Buy-backs?

The current share buy-back provisions in the Commonwealth taxation legislation provide different income tax treatment for shareholders who participate in an on-market share buy-backs compared with those undertaken off-market. Specifically, for an off-market share buy-back, there are generally two components of the purchase price:

• the capital component, which, subject to various anti-avoidance provisions, is the portion of the purchase price debited to the share capital account or non-share capital account of the company; and

• the dividend component, which is the portion of the purchase price that exceeds the price debited against the company’s share capital account.

The capital component is deemed to be the consideration for the disposal of the shares for capital gains tax purposes (assuming the shares are on capital account). The dividend component is treated as a dividend paid to the shareholder by the company out of its profits on the day the buy-back occurs. The company may then elect to frank the dividend portion of the purchase price (assuming franking credits are available), and thus a franking debit arises in the company’s franking account and franking credits are available to the shareholder.

Conversely, an on-market share buyback contains no dividend component. The entirety of the purchase price is treated as consideration received in respect of the sale of the shares. Therefore, the shareholder will generally be subject to capital gains tax on the difference between the capital proceeds from the buy-back and the cost base of the shares (assuming the shares are on capital account).

The misalignment of income tax treatment has paved the way for listed companies to exploit the discrepancy, by utilising off-market share buy-backs to effectively dress up capital returns to investors as franked dividends. The strategy involves the company buying back their shares from shareholders off-market and often at a discount to the market value. In lieu of receiving full market value, the shareholders will receive franking credits from the company as compensation for the price shortfall.

Therefore, a company with a significant franking credit balance may undertake an off-market share buy-back to reduce the cost of the share, whilst providing franking credits to its shareholders, who in turn may in some cases be able to utilise their advantageous marginal tax rate to maximise the benefit of the franking credits and limit their capital gains tax.

Amendment 1: Alignment of Share Buy-back Rules

On 17 November 2022, following the initial announcement in the October 2022-23 Federal Budget, the Government, released Treasury Laws Amendment (Off-Market Share Buy-Back) Bill 2022 (Exposure Draft), which proposed amendments to listed public companies undertaking off-market share buybacks.

The Exposure Draft provides integrity measures, which align the tax treatment of off-market share buybacks and on-market share buybacks, by ensuring that no part of the purchase price is taken to be a dividend in the hands of the shareholders. The alignment seeks to ensure that listed public companies can no longer exploit the concessional tax status of their shareholders as part of their capital management activities.

Amendment 2: New Franking Debit Provision

Additionally, the Exposure Draft provides that where an off-market share buy-back occurs, a franking debit arises in the company’s franking account. The amount of the debit is equal to the debit that would have arisen if the company were not a listed public company and no portion of the purchase price was debited to an account other than the company’s share or non-share capital account. Therefore, despite no part of the purchase price being deemed a dividend in the hands of the shareholders, the company’s franking account is reduced.

This amendment ensures that shareholders only continue to benefit from imputation credits proportionate to their shareholding in the company after the buy-back occurs and aligns with the current treatment of on-market buybacks. This will be achieved by ensuring that the company’s franking account balance is proportionally reduced in line with the reduction of the company’s shares on issue.

Amendment 3: The Treatment of Selective Share Cancellations

Extending beyond the scope of the initial announcement in the Federal Budget, the Exposure Draft also contains additional integrity measures relating to selective share cancellations.

As the legislation is currently drafted, a distribution by a company that is in consideration for the cancellation of a membership interest in the company as part of a selective reduction of capital is a dividend to the extent that the distribution is not debited to the share capital account or non-share capital account.

The proposed amendments create a new category of unfrankable distributions specific to a distribution by a listed public company that is in consideration for the cancellation of a membership interest in the company. The amendments are designed to pre-emptively prevent companies using selective reductions of capital as an alternative method of taking advantage of the concessional tax status of shareholders.

What happens now?

If the Exposure Draft becomes law, the amendments will apply retrospectively to all publicly listed companies who have undertaken buy-backs and selective share cancellations announced on or after 25 October 2022, being the announcement date of the Government’s intentions.

More information from Maddocks

For more information, contact Maddocks on (03) 9258 3555 and ask to speak to a member of the Tax & Structuring Practice Group.