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How the Buyback Will Work - Eureka Report Article

February 9, 2007
How the buyback will work
By Scott Francis

PORTFOLIO POINT: The buyback offer will be below the market rate, but franking credits worth more than that discount will make the offer attractive for many.

BHP is the most commonly chosen stock in both the "experts" and "people's choice" categories in the Eureka Report Great Share Race (click here). So there is no doubt that the announcement this week of the BHP buyback will create great interest.

You might go as far as to say the BHP buyback is a surely sign that BHP management have been reading the Great Share Race choices and have agreed with participants that the miner's shares are such great value it clearly makes sense to buy some of them back.

With a buyback of the scale BHP is planning, everybody benefits because having a large number of company shares bought back at below market value increases the earnings per share of those that remain; in turn, this should put upward pressure on the share price.

On top of that, some BHP investors will receive a greater benefit again because the shares will be bought back primarily using a fully franked dividend.

For others, such as high tax payers, it will make no sense to participate in the buyback directly; they may as well just enjoy the positive effect on the share price.

This article looks at some preliminary calculations to see which investors will benefit the most and how the BHP buyback will work for you.

The figures in this article are a preliminary look at how the buyback might work, and are based on the outline details released earlier this week from BHP. The final details of the buyback will be announced towards the end of February.
  • Shares will only be bought "on market" by BHP if the buyback price is more than a 10% discount to the current share price. The range will be a 10-14% discount.
  • $2.50 of the price will be considered to be a capital payment.
  • The remainder will be a fully franked dividend

History has shown with buybacks structured in this way, that they have gone at the highest level of discount, such as Commonwealth Bank, Telstra and Woolworths. Therefore we will use a 14% discount for our calculation.

As I write this article BHP shares are trading at $28. A 14% discount to this price sees the shares bought back at $24.08. In this case shares will be bought back with $2.50 of capital and a $21.58 fully franked dividend. The franking credits on a $21.58 fully franked dividend are $9.25 ? and it is these credits that provide the value in the buyback for investors in lower tax environments who sell into the buy-back program.

For those investors who face a 0% tax rate, such as superannuation funds paying a pension or individuals with less than $6000 in taxable income, they will pay no tax on the fully franked dividend and will be able to claim back the full value of the franking credits.

Investors who face a 15% tax rate, primarily superannuation funds, will have to pay 15% tax on the gross value of the dividend (gross value is the cash dividend plus the franking credits). However, they also receive a tax offset from the franking credits equal to 30% of the dividend, so the good news is they will receive a net tax refund.

For the higher tax bracket, people in the 31.5%, 41.5% and 46.5% brackets (including the Medicare levy) the tax payable is greater than the franking credits, which makes the buyback less attractive.

nWhat the buyback is worth at different tax rates
Tax bracket 
Assumed Buy Back Price
Fully Franked Dividend
Franking Credits
Tax Payable on Dividend
Tax Refund (Tax Owing)
Buyback Proceeds (Capital plus Dividend plus Tax Refund/Owing)

What about the capital loss?

Selling the shares for a capital payment of $2.50, plus an additional "tax value" amount that will be calculated under tax office guidelines, means that most investors will realise a capital loss from the sale of BHP shares.

This will give them some further value because that loss can be used against realised capital gains. The exact value of this loss will not be known until after the share sale because of the "tax value" calculation. This capital loss is only useful to offset against capital gains, so each investor's capital gains tax value will be different. For investors with capital gains in the current tax year (and that would be the majority of people in a bull market) the capital loss is most valuable. Of course, for investors in the 0% tax bracket, for whom the franking credits look most attractive, the capital loss is irrelevant.

The 45 day rule

Before running out when markets reopen on Monday to load up your superannuation fund with BHP shares, you need to keep in mind the "45 day rule". This states that to claim more than $5000 of franking rebates in a tax year, you need to own the shares for a holding period of 45 days. BHP says that the cut-off for franking entitlements under the 45-day rule is February 8, which has already passed. Giving that franking credits drive the value of the buyback for investors, there is no point in purchasing the shares with an eye to the buyback.

The bottom line

This buyback will be of most interest to investors with a lower tax rate, as they will have little tax payable on the fully franked component of the buyback while being able to claim back the franking credits. The calculations show how little benefit there is for investors in higher tax brackets, although the benefit may be higher if they do have capital gains to offset.

No doubt this will be a topic of discussion around this BHP buyback: is it fair to all? Or would a special dividend or a straightforward capital return have been better for all? Keep in mind that if shares are bought back, then those that remain will get a bigger slice of future profits, increasing earnings per share.