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Morningstar | Corporate Action: Rio Tinto’s Off-Market Buyback Benefits Low-Taxed Investors; FVE Unchanged

Our analysis suggests no-moat-rated Rio Tinto’s approximate USD 1.9 billion off-market buyback of ASX-listed Rio Tinto Limited shares benefits superannuation funds and individuals on a nil or low tax rate. Rio is using USD 3.2 billion in proceeds from asset sales to fund the USD 1.9 billion off-market buyback, and to increase its current on-market buyback of Rio Tinto PLC shares by a further USD 1.3 billion. For the pre-existing on-market buyback already announced, USD 1.7 billion of London-listed shares remain to be purchased by the end of February 2019. Assuming completion of the additional USD 3.2 billion of buybacks, about 4% of Rio’s issued capital will be cancelled. This assumes effective buyback prices of about AUD 65 per share for the Australia-listed Rio Tinto Limited shares and GBP 37.20 per share for the London-listed Rio Tinto plc shares.

Based on the most recent exchange rates and close prices for Rio Tinto’s shares, and assuming a 14% discount for the off-market portion of the buyback, we estimate the shares will be bought back at an average price of approximately AUD 66 per share. As the new round of repurchases is above our AUD 48 per share fair value estimate, the buybacks are mildly dilutive, but not sufficiently to warrant a change to our fair value estimate. Recent depreciation of the AUD/USD exchange rate is also an offset. Overall, we think Rio Tinto is repurchasing its shares at a time when commodity prices are relatively favourable, and those are reflected in an elevated share price.

The off-market buyback is not open to shareholders outside Australia and New Zealand and primarily benefits investors subject to low tax rates. 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 88.59 per share. This assumes a 14% tender discount on an assumed AUD 75.40 market price, resulting in a 17.5% premium from participation in the buyback. Using the same assumptions for a super fund in accumulation, taxed at 15%, sees aftertax income of AUD 76.72 per share, modestly ahead of the market price. Depending on the cost base, participants may also gain a tax benefit from capital losses.

We urge shareholders considering participation in the off-market buyback to consult their financial adviser or tax accountant. Participation is optional. Rio Tinto Limited shareholders in Australia and New Zealand will be asked to tender their shares at discounts of 8%-14% (in 1% increments) to the market price, or at the final price tender. The buyback will take place at the largest discount that enables the targeted 41.2 million of shares to be repurchased. 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 Rio Tinto, 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, which Rio Tinto expects to be the first 70 shares. If the resulting shareholding is small at 30 shares or fewer, and all shares are tendered, there will be no scale-back.

We expect the discount to the prevailing market price to be the maximum 14% and for the buyback to be significantly oversubscribed. Rio Tinto’s last AUD 750 million buyback, completed in November 2017, saw tender offers scaled back by 89%, excluding the priority allocation and repurchase of small holdings of fewer than 30 shares.

The buyback will be completed in two months. The shares trade ex-entitlement on Sept. 25, and the tender opens Oct. 9 and closes Nov. 9. The price and scale back will be announced on Nov. 12, with payment on Nov. 19.

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 88.59 per share, 17.5% more than the assumed market price of AUD 75.40 per share. This assumes a buyback price of AUD 64.84 (including a market price of AUD 75.40 and a 14% tender discount), Rio Tinto’s expected capital return of AUD 9.44, a dividend of AUD 55.40 (buyback price minus capital return) and an attached franking credit of AUD 23.74 [((1/0.7)-1) x 55.40]. In this case, total income would be AUD 88.59 (9.44 + 55.40 + 23.74) versus a possible AUD 75.40 per share for an on-market sale.

Taking the example of a superfund taxed at 15% in the accumulation phase, a buyback price of AUD 64.84 would result in aftertax income of AUD 76.72 per share: AUD 9.44 of capital, AUD 55.40 of dividend, and AUD 11.87 of franking credit, after the 15% tax (AUD 23.74 franking credit x (15%/30%) = AUD 11.87). This would exceed the proceeds from an on-market sale of AUD 73.94 per share by 3.8%. This example assumes an illustrative cost base of AUD 60.77 per share, a simple average of the closing price of Rio Tinto Limited shares for the past five years, 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: (75.40 – (75.40 – 60.77) x (1 – 33%) x 15%) = AUD 73.94 per share. Obviously, the calculation changes depending on the cost base, and so too does 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 75.40, a buyback price of AUD 64.84, and an illustrative cost base of AUD 60.77 per share, a superfund would generate a capital loss tax credit of AUD 4.08 per share by participating in the off-market buyback. Adding this potential capital loss tax value to the AUD 76.72 of cash income would result in total aftertax buyback proceeds of AUD 80.79 per share, 9.3% greater than the AUD 73.94 per share return from selling on-market.

In our example above, the nominal capital loss on disposal is AUD 40.77 per share (cost base – capital return – (tax value – buyback price), or (60.77 – 9.44 – (75.40 – 64.84)). This becomes AUD 25.21 after the 33% superfund capital gains discount, assuming the shares were held for at least a year, and translates to a potential capital loss tax credit of AUD 4.08 per share at the 15% tax rate (40.77 x 2/3 = 27.18. 27.18 x 15% = 4.08).