|Summary: Woodside Petroleum’s proposal to buyback most of Shell’s holding using dividend franking credits appears to be structured so as to lower the incidence of realised capital gain and therefore tax. The simple cost-effective alternative for WPL would have been to declare a $2.7 billion special dividend to all shareholders.|
|Key take-out: The biggest threat to franking credits and their role in supporting the pension expectations of superannuants is their abuse by the “big end” of town.|
|Key beneficiaries: General investors. Category: Shares.|
A few weeks ago the Australian Treasurer, Joe Hockey, claimed as part of his budget presentation that Australia had a budget crisis.
He did so to justify a number of initiatives which he suggested were needed to reduce the projected growth in Commonwealth Government debt over the next 10 years.
In upcoming months, Australia will host and chair various G20 summits that will climax at the G20 Leaders Summit in Brisbane. A key agenda item for the participants will be the formulation of an agreed position concerning the cross-border taxation of large multinational companies. There is much concern across the G20 that tax is being aggressively minimised by many large multinationals, which are able to transfer profits through international networks to low-tax regimes.
This background suggests to me that the federal government needs to have a serious look at our taxation law and its interpretation as it applies to selective share buybacks. In particular, it should review the proposal of Woodside Petroleum (ASX:WPL) to facilitate both the buyback and the sell-down of the equity position of its major shareholder – Shell. The transaction on its face appears to be structured so as to lower the incidence of realised capital gain and therefore tax. The transaction also involves the diversion of franked dividends to one exiting ordinary shareholder, away from every other ordinary shareholder (also see Woodside shareholders lose to Shell).
In recent years, the undertaking of buybacks through the utilisation of franking credits by public companies appears to have become a legitimate capital management activity. However, this activity does surely involve a significant loss of taxation revenue for the federal government and our society.
We have seen major buybacks that utilised franking credits by BHP Billiton (ASX:BHP), Woolworths (ASX:WOW) and JB Hi-Fi (ASX:JBH). In each case the structure involved a capital payment that was substantially lower than the prevailing market price for the shares. In all cases the advantageous direction or split between dividends and capital was sanctioned by the Australian Tax Office, which ruled that the transactions were legal.
Being legal is one thing, but are these transactions fair? In posing that question I am not investigating the fairness to WPL shareholders of this buyback proposal – there will be a board appointed expert who will focus on that issue. Rather, I am questioning whether these types of transactions are fair to society – that is, a public benefit test. In particular, I do question whether these transactions can be claimed as a general benefit for Australia and its citizens when tax that would normally be paid is not? Further, I question whether these schemes are an appropriate use of franking credits because they do not appear to be a true dividend!
Apart from the loss of revenue, everyone who invests in the stockmarket should be concerned about a massive transaction (some billions of dollars) that utilises franking credits. This is because the government has proposed a significant tax review in 2015, and clearly the franking credit system will be reviewed. I believe the biggest threat to franking credits and their role in supporting the pension expectations of superannuants is their abuse by the “big end” of town.
The Woodside selective buyback
WPL is an important company in Australia. So much so that a previous attempt by Shell to take it over was rejected by the federal government in 2001.
Originally Shell was a 40% owner of WPL, as was BHP, and these parties together form part of the North-West Shelf Venture. In 1994, BHP sold its position out for a consideration of about $3 per WPL share. That gives you an insight into the likely cost of Shell’s shares in WPL.
Shell’s holding in WPL decreased to 24% in November 2010 when it sold 10% in a block trade at $42.23 per share. The current buyback/sell-down proposes to take Shell down to about 4.5%.
The deal has two tranches. Already, Shell has sold 78.3 million shares into the market at $41.35. The selective buyback of another 78.3 million shares will occur for consideration of $US34.24 per share (about $36.49) and $2.7 billion will be paid. The consideration is split as a franked dividend of $US26.29 and a capital payment of $US7.95.
What is WPL worth?
This is an important question in any buyback scenario. When companies choose to use shareholder capital to buy back shares, they need to do so at a significant discount to value to lift the resulting value for remaining shareholders.
The following table (Figure 1) shows that the intrinsic value of WPL approximates the buyback price, and on this basis the buyback is no bargain.
The price of WPL shares has lifted in recent times due to the board’s decision to lift the payout ratio of the company to about 80%. This is commendable, because WPL has strong cash flows that offset the fact that earnings (market consensus) are not expected to rise over the next few years (see Woodside’s weak growth pipeline). When companies cannot deploy capital at a high rate of return, then it should be returned. However, should it be returned to just one shareholder?
In passing, I note that WPL directors claim that a benefit of this deal is that it relieves the share price of a perceived stock overhang. To me that is nonsense, as is exhibited by the fact that many major Australian companies are currently heavily shorted on the ASX. For instance, should Cochlear (ASX:COH) undertake a buyback given that 18% of its shares are short sold? To me that is a real overhang, and WPL could well be in the same position in the future.
I am sceptical of this deal and I am concerned about the likely consequences for all of us if a rational taxation enquiry in 2015 suggests that franking has been abused by too many companies and needs to be drastically restructured.
Thus, the simple cost-effective alternative for WPL would have been to declare a $2.7 billion special dividend to all shareholders. The dividend of $3.40 per share would have created a deep market in which Shell could have sold its shares cum dividend. There may not have been certainty in such a transaction for Shell, but is that really a concern for WPL directors? I do not think so.
John Abernethy is the Chief Investment Officer at Clime Asset Management. Clime offer excellent performing growth and income portfolios through its individually managed accounts service. To find out more, or to request a review of your share portfolio, call Clime on 1300 788 568 or visit www.clime.com.au.