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Why changes to off-market buyback legislation could be positive for low tax rate shareholders

Answering the key questions around the Australian Government's proposed changes to the tax advantage of off-market share buybacks

While franking is a key component of returns for our Income-focused strategies, off-market buybacks are not. We feel that the changes announced should have only a minor impact and may even be a positive.


What is the Government actually trying to change?

The changes announced remove the differences between on- and off-market buybacks in terms of the tax treatment. Off-market buybacks will no longer be able to distribute a franked dividend as part of the compensation to shareholders and the CGT liability will likely be similar between on- and off-market buybacks. Hence the Government forecast to recoup a significant level of forgone tax revenue from the changes.


Why are some investors are so concerned, while we are not?

Some income focused funds aim to generate income through dividend stripping around franked dividend paying events. Off-market buybacks are an event where these funds undertake trading. However, high turnover from one event to the next is just turning capital into income.

We believe that true income can only be derived from owning an income stream on a long-term basis, and that turning capital into income harms the long-term income growth that is needed to fund a ‘sufficient income for life’.

On the other hand, our Martin Currie Australia Income strategies fully value franking credits on a buy and hold basis and take a low turnover approach to owning high quality, dividend paying companies. While we have participated in off-market buybacks at times, we have found that they have not had a significant contribution to our after-tax returns3.


What is the positive for low tax paying investors such as retirees and charities?

An important point to realise is that off-market share buybacks had traditionally been priced at a 10-14% discount to the prevailing share price4. Low tax payers participating in the buyback incur a capital loss (albeit offset by the benefit of the franked dividend) while the cost to high tax-payers was offset by the earnings per share (EPS) value accretion of the reduced capital base.

If companies change their capital return strategy to distribute accumulated franking credits through other ways, such as larger regular or special franked dividends, then investors can receive the full value of the dividend and franking without any associated capital losses. This helps improves after-tax returns for low taxpayers.

While we have no insight into further government policy changes around the imputation system, we do believe that franked dividends are here to stay. So too are companies accumulating profits and distributing those profits to shareholders as franked dividends. We estimate that in total, the top 200 ASX companies have accumulated a circa A$52 billion franking account balance that can be distributed to shareholders5.

This is a positive for shareholders seeking to maximise dividend income, which is what our Income strategies such as the Equity Income and Ethical Income aim to do.

In summary

So, while the changes announced in October to remove the special tax treatment of off-market share buybacks have generated much debate, we don't see any material impact to franking from these changes, and arguably, this could drive a positive change in how companies distribute franking credits to shareholders.

Our Income strategies are focused on high quality securities that pay higher income, provide inflation protection, and have lower volatility than the broader share market. We believe that these companies can sustainably withstand any changes in tax conditions and retain their franked income appeal.