Share Buyback Tax

7

What is a share buyback?

A share buyback involves a company purchasing its own shares from shareholders. The company is thereafter required to cancel those purchased shares. A share buyback is not the same as the redemption of shares whereby the company redeems shares from shareholders and returns paid-up capital.

There are five types of buybacks:

When is a share buyback on market versus off market?

There are two forms of buybacks according to taxation law: on market buybacks and off market buybacks.

An on market buyback occurs in respect of shares in a listed company. The buyback must occur in the ordinary course of trading on the stock exchange. That is, where the shareholder does not know who he/she is selling to.

If the buyback is not on market it will be off market.

What motivates a share buyback?

A share buyback is commonly motivated by any one of the following:

  • To return excess cash to shareholders.
  • To preserve or increase the company share price.
  • Where shares are perceived by the company to be undervalued.
  • To increase certain financial ratios.
  • To pass on franking credits to shareholders.
  • To re-organise control of the company

Is it compulsory for shareholders to participate?

Generally, no. The company may not compel shareholders to sell share back to the company. Instead, a buyback will be framed as an offer from the company. Often the buyback price will be above market value for shares to incentivise shareholders to participate.

Anti-avoidance rules

There are particular anti-avoidance rules that apply in respect of company behaviour intended to benefit certain shareholders and exclude others in order to optimise taxation outcomes for shareholders. Relevant anti-avoidance rules to consider include the dividend streaming rules, capital distributions rules and franking credit scheme rules.

What are the tax implications of an off market share buyback?

For the shareholder

The tax outcomes of a share buyback depend on the source of the funds used to buyback the shares. The two categories of sources include:

  • Share capital (i.e. the contribution price paid by a shareholder to obtain their shares)
  • Accumulated profits

When the company pay the shareholder, the amount paid which is sourced from the share capital account (as a debit to the share capital account) is treated as a non-assessable return to shareholders: the capital component. The remainder of the purchase price is treated as a dividend which may be franked: the dividend component.

Note the average capital per share methodology is the preferred method to determine the amount or split which is considered to relate to share capital / capital component versus accumulated profits / dividend component. The capital component is essentially calculated as the issued capital divided by the number of shares on issue.

Remember that although the returned share capital is not ordinary income or assessed as a dividend, it is still a capital receipt that is subject to taxation under the CGT regime. Specifically, the capital component represents consideration for the sale of the shares from the shareholder back to the company under CGT event A1. The consideration received by the shareholder (reduced by the dividend component to prevent double-taxation) is included in capital proceeds when determining the capital gain or capital loss.

The dividend component of a share buyback is assessable income to the shareholder. As mentioned, the dividends are frankable meaning the shareholder may utilise any franking credits attached to the dividends as a tax offset to reduce tax payable and/or increase tax refundable (noting that franking credits are not refundable to company shareholders).

As an example, take James Pty Ltd which buys back its shares for $70 per share. This buyback price is equal to market value of the share. Of the buyback price, $25 was sourced from a debit (reduction) to the share capital account. The remaining $45 was sourced from accumulated profits. The $25 amount is the capital proceeds received by the shareholder. The taxpayer will make a gain if the capital proceeds exceeds the cost base of those shares. Conversely, the taxpayer will make a capital loss if the reduced cost base exceeds capital proceeds. The $45 amount is assessable income to the shareholder. However, the dividend component may be franked and the franking credits utilised by the shareholder as a tax offset. As you can see with this example, the portion of the cost to buyback the shares that relates to returning share capital is not treated as a dividend.

If the purchase price exceeds the market value of the share, the excess will not be frankable. If the purchase price is less than the market value of the share, the market value less any dividend paid is treated as the disposal consideration (i.e. capital proceeds) for CGT purposes.

The concept of market value refers to the value of the shares assuming the buyback was not proposed or implemented. This prevents a skewed market value outcome as the proposition of a share buyback would naturally influence the perceived value of shares.

As an example where the buyback price exceeds market value, take Ellie who buys 100 shares in Ellie Pty Ltd for $12 per share. The market value is $16 per share. Ellie Pty Ltd undertakes to buy back shares for $18 per share. The buyback involves $14 per share against accumulated profits and $4 per share being against the share capital account. Here, the $14 per share is an assessable dividend to Ellie. Remember that the dividend will need to be grossed-up for franking credits. However, only $12 is frankable as the remaining $2 is the amount which the buyback price exceeds the market value of the share. The $4 per share related to the share capital account is not assessable to Ellie. However, CGT event A1 applies in respect of that amount. In this instance, the capital proceeds of $4 per share are exceeded by the reduced cost base (i.e. purchase price) of $12 per share. Therefore, Ellie is entitled to recognise a capital loss of $8 per share.

As an example where the buyback price is less than market value, assume Ellie Pty Ltd agreed to buy back shares for $15 per share (being $1 undervalue). In this instance, Ellie would still be assessed on a $14 dividend (gross-up for franking credits). However, the tax treatment of capital component would change under the market value rule. Specifically, the capital proceeds (under CGT event A1) will be calculated as the market value of the share less the dividend amount. Therefore, Ellie would recognise an $11 capital loss. That is, capital proceeds of $1 per share less $12 which is the reduced cost base per share. If not for the market value rule, the capital proceeds would have been $0 (i.e. $14 buyback price less $14 dividend) and the capital loss would have been $12 per share.

A note for share traders

The above tax treatment assumes that the shares are held by the shareholders on capital account. That is, the shareholder is not considered to be a share trader, being a person in the business of trading in shares.

If you hold shares as trading stock, you include the consideration received in assessable income and you disregard capital gains or losses.

If you hold shares as revenue assets but not as trading stock, you include the amount by which the consideration exceeds the cost of each share in assessable income OR claim an allowable deduction for the amount by which the cost of the shares sold exceeds the sale consideration. If you also made a capital gain, then the capital gain is reduced by the amount included in assessable income. If you made a capital loss, you reduce the reduced cost base of each share by the amount of any allowable deduction.

For the company

The purchase and subsequent cancellation of the share does not result in any taxation outcome to the company. That is, no capital loss will be available for the company upon cancellation of the re-purchased shares.

What are the tax implications of an on market share buyback?

For the taxpayer

Distinct from the taxation of off market share buybacks, the buyback price for the on market share buyback is treated entirely as capital and not as a dividend. Consequently, the buyback prevents the passing on of franking credits to the shareholders. However, despite this being the case a franking debit will still need to be recognised in the franking account of the company on the day of the buyback. The franking debit is equal to the debit that would have arisen if the buyback had been off market and the dividend was franked at the entitys benchmark franking percentage. The benchmark franking percentage will be treated as 100% if the company did not have a benchmark franking percentage for the relevant franking period.

As mentioned, the entire buyback payment is treated as capital and subject to CGT under CGT event A1. A capital gain is determined under CGT event A1 as capital proceeds less the cost base of the respective share. Therefore, following on from the earlier example provided, the capital proceeds are $180. The cost base (being the original shareholder purchase price) is $120. There is a $60 capital gain (per share). If the shares were held in excess of 12-months by a resident individual or trust, the 50% CGT discount would likely be available to reduce the $60 capital gain.

Remember that a capital loss (if there is one) is determined as capital proceeds less the reduced cost base of a share. A few things to remember here:

  • reduced cost base is a narrower concept than cost base and excludes certain amounts that would otherwise be included. For example, non-deductible interest on loans to finance the acquisition of the shares or any non-deductible insurance premiums relating to the shares.
  • a capital loss can only be applied against a capital gain. In this way, it is not the same as a deduction and may not be liberally applied against other assessable income to reduce the taxpayers taxable income.

For the company

The purchase and subsequent cancellation of the share does result in any taxation outcome to the company. That is, no capital loss will be available for the company upon cancellation of the re-purchased shares.

From 25 October 2022, the taxation treatment of off market share buybacks by listed public companies has been aligned with the taxation treatment of on market share buybacks.

This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.