Analysis of rio tinto’s share buyback

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Following the sale of its coal assets, Rio Tinto has committed an extra US$3.2bn to its ongoing share buy-back programme. Part of this amount, A$2.7bn will be returned to resident Australian shareholders through an off-market buyback tender. The tender opened on 8 October 2018.

Rio’s decision to offer an off-market buyback may be welcomed by SMSFs and low rate taxpayersdue to the high franked dividend component.

Deciding whether to accept an off-market buyback is a pretty straight forward decision. If you are paying tax at a high marginal rate (34.5% or higher), it is unlikely to appeal based on the example calculations I’ve outlined later in this piece. If you are paying tax at 0% (such as an SMSF in pension or an individual with income under the tax free threshold), then as I mentioned this looks like a good deal. If you are somewhere in between, such as an SMSF in accumulation, then it will generally make sense to accept depending on the tender discount and your ability to use any capital gains tax loss.

Of course, if you sell some or all of your Rio shares in the buy-back, you will then need to make a decision about what to do with the cash.

What’s special about an off-market buyback?

There are 2 types of buybacks. An on-market buyback is conducted on behalf of the company by a broker purchasing the shares on the ASX.

The other type is an off-market buyback which is usually conducted through a tender process, and provided it is an equal access scheme, allows a company to distribute surplus franking credits to its shareholders. It is this distribution of franking credits that makes the off-market buyback very special. Part of the sale proceeds is treated as a franked dividend, with the other part treated as a capital component.

Effectively, the shareholder gets a franked dividend with imputation credits, and materially reduced sale price for capital gains tax purposes. This is what makes off market buybacks so advantageous to some shareholders, and because shareholders are keen to accept, it means that the company can purchase the shares at a discount to the market price.

Rio’s off-market buyback

Shareholders will be offered the opportunity to participate and tender all, some or none of their shares, with the tender closing at 7.00pm (AEST) on Friday 9 November.

The tender will be at a discount to the market price, ranging from 8% up to a discount of 14%. Because the buyback is capped (the $2.7bn represents about 10% of the issued capital of the ASX listed Rio Tinto Limited), Rio will accept tenders from those shareholders offering to sell at the lowest price (highest discount), and reject those offering to sell at a higher price (lower discount).

The buyback will comprise two components – a capital component of $9.44 and the balance as a fully franked dividend. If the market price of Rio shares is (for example) $80.00 and the tender discount is 14%, then the buy-back price will be $68.80. This will comprise a capital component of $9.44 and a fully franked dividend of $59.36.

The buy-back price will be the same for all tenders – so if the tender is cleared at a discount of 10%, shareholders who nominate discounts of 11%, 12%, 13%, 14% will be successful and receive the price at a 10% discount. Rather than nominate a % discount, shareholders can also tender ‘final price’ (take whatever the market clears at). As a scale-back is possible, Rio, has also announced some priority rules – to clear successful shareholders who are left with a residual parcel of 30 shares or less, and a guaranteed minimum allocation to successful tenderers of the first 70 shares.

The market price will be determined by calculating the volume weighted average price of trades on the ASX over the 5 trading days immediately before the closing day, ie from 5 November to 9 November. The announcement of the buy-back price and any scale back will be made on Monday 12 November.

Shareholders worried about Rio’s share price during the buy-back period can also set an overall minimum price. If your tender discount is successful (this also includes ‘final price’ offers), you will only be accepted if the buy-back price is equal to or above your minimum price.

Should I accept?

The premise is that you should consider accepting the buyback if your effective sale price (after tax) is higher than you could achieve by selling the same shares on the ASX.

Let’s compare the two alternatives – selling your shares on market at $80.00 or selling your shares in the buyback.

We will do this from the perspective of an SMSF in accumulation (paying tax at 15%), and an SMSF supporting the payment of a pension (paying tax at 0%).
 

We will also make a few other assumptions:

• For the on-market buy-back, the deemed tax value is also $80.00 (this is determined by the ATO and won’t be available until after the buyback is completed). The sale price for CGT purposes is the deemed tax value less the franked dividend – small variances don’t have a huge impact on the numbers;
• Purchase price for your Rio shares - in the first 2 examples, $40.00, and in examples 3 and 4, $85.00;
• A tender discount of 14% (the maximum), and also the minimum of 8%.
   

Four examples are shown:

• Example 1: discount of 14%; original purchase price of $40.00;
• Example 2: discount of 8%; original purchase price of $40.00;
• Example 3: discount of 14%; original purchase price of 85.00;
• Example 4: discount of 8%; original purchase price of $85.00.

In Example 1, the market price is $80.00. Applying a 14% discount, the buy-back price is $68.80, which comprises a capital component of $9.44 and a fully franked dividend of $59.36.

For a fund in accumulation (columns 2 and 3), the after-tax proceeds from selling the share on market would be $76.00. If the shares had been sold via the buy-back, the effective after-tax price is $81.52. There is also a capital loss of $19.36 per share, which is potentially worth another $1.94 (15% tax rate, one-third discount) if it can be applied to offset a capital gain on another asset.

For a fund in pension (columns 4 and 5,) the buy-back return is $94.24 per share, $14.24 higher than if the shares were sold on market.
 

Example 1 – Discount 14%, Original Purchase Price of $40.00, Market Price $80.00

Source: Switzer Super Report

*Value of losses can only be accessed by applying against other capital gains

Example 2 – Discount 8%, Original Purchase Price of $40.00, Market Price $80.00

Source: Switzer Super Report

*Value of losses can only be accessed by applying against other capital gains

Example 3 – Discount 14%, Original Purchase Price of $85.00, Market Price $68.00

Source: Switzer Super Report

*Value of losses can only be accessed by applying against other capital gains
 

Example 4 – Discount 8%, Shares Purchased at $85.00, Market Price $80.00

Source: Switzer Super Report

*Value of losses can only be accessed by applying against other capital gains
 

Conclusion

In pension, the outcome looks very attractive. At a discount of 14%, you are $14.24 better off – and at the minimum discount of 8%, you would be $21.10 per share richer.

In accumulation, it is still going to make sense to accept in most situations, moreso if you can utilise the capital loss.

Rio conducted an off-market buyback at this time last year. It was over-subscribed and subject to scale-back, clearing at the maximum discount of 14%. This buyback is almost 4 times larger and potentially represents up to 10% of Rio’s Australian domiciled shares. It will, however, be very popular as the franked dividend component is high. As all successful tenders receive the same sale proceeds, if you want your tender to be accepted, my suggestion would be to tender at the ‘14%’or ‘final price’ options.

And if you want to review the outcome for a high marginal taxpayer paying tax at 47% (45% plus 2% Medicare Levy), see Example 5 below. Even at the most favourable tender discount of 8%, a shareholder, after taking into account the value of the capital gains tax loss, is $6.90 per share worse off.
 

Example 5 – 47% taxpayer, Discount 8%, Market Price $80.00, Purchased at $40.00 or $85.00

Source: Switzer Super Report

*Value of losses can only be accessed by applying against other capital gains