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Morningstar | Corporate Action: BHP’s Off-Market Buyback Benefits Lowly Taxed Investors

BHP will return USD 10.4 billion of asset sales proceeds with a USD 5.2 billion off-market buyback of the Australian listed BHP Limited shares and a proposed USD 5.2 billion special dividend. The buyback price, once the likely 14% buyback discount is applied, should be at a small premium to our fair value estimate, but not sufficiently to change our AUD 25 per share fair value estimate. The last day to purchase BHP shares and be entitled to the franking credits from the off-market buyback is Nov. 1, 2018.

We urge shareholders considering participation in the off-market buyback to consult their financial adviser or tax accountant.The desire for shareholders to participate in the buyback, and the attractiveness of the franking credit to shareholders on low income tax rates, is the key driver of the intraday share price rise. The benefits of the off market buyback only accrue to those under the Australian tax regime. BHP has decently balanced the various competing shareholder interests by allocating half to a special dividend and half to a buyback. The purchase price is close to our fair value estimate and should be a better use of funds than building or buying new mines.

Based on yesterday’s closing price of AUD 32.21 and assuming a 14% discount, the buyback would be at AUD 27.70 per share. This is a relatively modest 11% premium to our fair value estimate. At this price, approximately 5% of BHP’s total shares on issue would be repurchased and the dilution to our fair value estimate would be about AUD 0.15 per share, which is immaterial. The final buyback price will be determined based on the five-day volume weighted average price up to the closing date of the offer, on Dec. 14, 2018. The special dividend equates to about USD 1.00 per share, or AUD 1.40 per share. BHP shares will trade ex-dividend on Jan. 9, 2019 for shares traded on the Johannesburg exchange, and on Jan. 10 for shares on the Australian, London, and New York exchanges.

Our analysis suggests repurchasing the ASX-listed shares benefits superannuation funds and individuals on a nil or low tax rate. For example, if a shareholder pays no income tax, or a superannuation fund is in pension mode, the proceeds of the dividend, franking and capital return total AUD 39.41 per share. This assumes a 14% tender discount on an assumed AUD 32.21 market price, resulting in a 22.4% premium from participation in the buyback. Using the same assumptions for a super fund in accumulation, taxed at 15%, sees aftertax income of AUD 33.56 per share, almost 6% ahead of the market price. Depending on the cost base, participants may also gain a tax benefit from capital losses.

Participation is optional. BHP Limited shareholders will be asked to tender their shares at discounts of 8% to 14% (in 1% increments) to the market price, or at the final price tender. The buyback will take place at the largest discount which enables USD 5,200 million to be applied to the buyback. Shareholders can set the minimum price below which the shares will not be bought. All shares tendered offered at the final price or at or greater than the discount chosen by BHP will have their shares bought back. If a higher minimum price or lower discount is specified, the shares will not be bought back. Successful tenders may be subject to scale-back. If there is scale back, there will be a priority allocation for the first 165 shares, which will be accepted in the buyback. If the resulting shareholding is small, 65 shares or less, and all shares are tendered, there will be no scale back.

Given the attractiveness of the buyback for those on low or zero tax rates, we expect the discount to the prevailing market price to be the maximum 14%. In addition, the buyback is likely to be significantly oversubscribed, as has generally been the case with prior buybacks from BHP and Rio Tinto. Rio Tinto’s AUD 750 million buyback completed in November 2017 saw tender offers scaled back by 89%, excluding the priority allocation and repurchase of small holdings. For BHP’s 2011 off-market USD 6.3 billion buyback, tendered shares were subject to scale back of 78.3% after the priority allocation and small holding repurchases.

Using our example of a shareholder within the tax-free threshold, or a superannuation fund in pension mode, the proceeds of the dividend, franking and capital return would total AUD 39.14 per share, 22.4% more than the assumed market price of AUD 32.21. This assumes a buyback price of AUD 27.70 after the 14% tender discount composed of a capital return of AUD 0.38, a dividend of AUD 27.32 (buyback price minus capital return) and an attached franking credit of AUD 11.71 [((1/0.7)-1) x 27.32]. In this case, total income would be AUD 39.41 (0.38 + 27.32 + 11.71) versus a possible AUD 32.21 per share for an on-market sale.

Taking the example of a super fund taxed at 15% in the accumulation phase, a buyback price of AUD 32.21 would result in aftertax income of AUD 33.56 per share – AUD 0.38 of capital, AUD 27.32 of dividend and AUD 5.85 of franking credit, after the 15% tax (AUD 11.71 franking credit x (15%/30%) = AUD 5.85). This would exceed the proceeds from an on-market sale by 5.7%, based on aftertax proceeds of AUD 31.73 after tax. This illustrative cost base of AUD 27.44 per share, a simple five-year average of the closing price, and that the shares have been held for at least a year to qualify for the one third discount on capital gains. The math to get to the proceeds for the on-market sale is: (32.21 – (32.21 – 27.44) x (1 – 33%) x 15%) = AUD 31.73 per share. Obviously, the calculation changes depending on the cost base and so to the potential tax impact from selling on-market versus selling into the buyback.

Depending on the cost base of the shares sold, shareholders could generate a further capital loss by participating in the off-market buyback. This may be a useful offset to other capital gains, such as in a superannuation fund, or to be carried forward to offset against future gains. For example, if we assume a tax value of AUD 32.21, a buyback price of AUD 27.70 and an illustrative cost base of AUD 27.44 per share, a superfund would generate a capital loss tax credit of AUD 2.26 per share by participating in the off-market buyback. Adding this potential capital loss tax value to the AUD 33.56 of cash income would result in total aftertax buyback proceeds of AUD 35.81 per share, 12.8% greater than the AUD 31.73 per share aftertax return from selling on-market.

In our example above, the nominal capital loss on disposal is AUD 22.55 per share (cost base – capital return – (tax value – buyback price), or (27.44 – 0.38 – (32.21 – 27.70)). This becomes AUD 15.03 after the 33% super fund capital gains discount – assuming the shares were held for at least a year – and translates to a potential capital loss tax credit of AUD 2.26 per share at the 15% tax rate (22.55 x 2/3 = 15.03. 15.03 x 15% = 2.25).