WHAT THE PROPOSED CHANGES TO SHARE BUYBACKS WILL MEAN FOR SMSFS.

KPMG Enterprise partner and head of SMSFs and estate planning Julie Dolan says changes to share buybacks will impact access to franking credits.

One of the proposed measures of the recent federal budget was that all off-market share buybacks by listed companies will be given the same tax treatment as on-market share buybacks. The government stated this was to “improve the integrity of the tax system between the two types of share buybacks”. Targeted towards superannuation funds and other tax concessional investors, this measure will effectively remove access to refundable franking credits on these transactions.

Division 16K, subdivision C of the Income Tax Assessment Act 1936 (ITAA) currently outlines the tax treatment of off-market share buybacks. In summary, the current tax treatment is that the proceeds from the off-market share buyback is split into two components – a capital and a dividend component. The favourable consequences for the shareholder stem from this dissection.

In relation to an on-market share buyback, the shareholder incurs a taxable capital gain or loss based on the buyback price in a similar way as an ordinary disposal of a share and hence is subject to the normal capital gains tax (CGT) provisions. For the listed company undertaking the buyback, a franking debit arises in respect of the purchase price of the buyback based on the company’s benchmark franking percentage for that franking period.

Under an off-market buyback, the proceeds or purchase price is split into a dividend and capital component. In relation to the CGT provisions, this has the immediate effect of reducing the resulting capital proceeds, hence producing a reduced capital gain, converting a capital gain into a capital loss or even further increasing a capital loss position. The dividend component of the proceeds is regarded as a dividend and qualifies as a frankable dividend. As such, the shareholder receives franking credits from this component. The rationale on how the different components are calculated is contained under section 159GZZZP of the ITAA. The calculation is often based on the composition of the retained earnings and paid-up share capital of the company. The ATO’s Practice Statement Law Administration 2007/9 also deals with further intricacies on the buyback, such as discount to prevailing market value and antiavoidance rules.

As a result of this proposed measure by the government, no part of an off-market share buyback will have a franked dividend component and hence low-tax investors will not benefit from any refundable franking credits.

How does this measure affect SMSF shareholders?

SMSF members benefit from concessional tax rates, especially when members of the fund are in pension phase, and as such on receipt of fully franked dividends the fund not only receives significant tax benefits, but also the potential for refundable franking credits. Therefore, SMSF trustees may have a preference to participate in an off-market share buyback even if the sale proceeds were to be at a discount. As previously stated, depending on the composition of the retained earnings position and paid-up capital of the listed company, the franked dividend component of the proceeds can be significant. As such, the resultant tax benefits to the fund can be substantial. Where the buyback price is largely made up of the dividend component, the current rules also allow taxpayers to recognise a capital loss or reduced capital gain due to the lower capital proceeds for CGT purposes.

As mentioned, under the proposed measure, the tax treatment of off-market buybacks by listed companies will align with on-market buybacks. In other words, no part of the consideration for the off-market share buyback will be taken to be a dividend and the company will be required to debit its franking account.

Reducing the impact of franking credits to concessionally taxed shareholders has to date been a very politically sensitive matter and this proposed measure seems contrary to the election promise of the Labor Party that it would not pursue the removal of refundable franking credits derived by superannuation funds.

This measure will apply from announcement on budget night, that is 7:30pm AEDT, 25 October 2022, and is estimated to increase tax receipts by $550 million over the four years from 2022/23.