Capital management or tax avoidance?

Telstra’s billion dollar share buy back, which only made financial sense for zero-tax shareholders, has been a roaring success. So much so, a scale-back by almost 70 per cent of tenders was required and the firm paid out at the bottom of the agreed range — just $4.60 a share, compared to a close of $5.40 on Monday.

That was a real win for the company as it bought back a billion worth of shares at a 14 per cent discount. This was achieved by offering almost half the payment, $2.27 a share to be precise, in the form of a fully franked dividend component — a boon for zero-tax paying investors such as retirees, who benefit by receiving the franking credits and a subsequent tax refund.

But that raised the ire of some observers, who argue these dividend components amount to an illegal streaming of dividends, in which some shareholders receive an advantage over their peers. A high income-tax Telstra investor would clearly earn more by simply selling on market.

Some shareholders count the favouring of a group of non-tax paying shareholders as “dividend streaming”, which is illegal. If so, it would be a strange for the ATO to approve, particularly in light of its recent efforts to crack down on tax avoidance.

The franking-credit system is only applied in Australia, New Zealand and Malta, and is taking on an increasing significance as the population ages, and the amount invested in low-tax superannuation funds and self-managed super funds inflates.

As an alternative to the capital return structure employed, Telstra could have simply increased franked dividends to all shareholders, and made an ordinary return of capital.

The Telstra offer is telling of a conservative business climate and a 2.5 per cent cash-rate that has companies scratching to get the best capital structure they can as a marketing tool to attract investors. While shareholders may pay lip service to wanting chief executives to show more initiative, competition is stiff for the investor dollar and the most efficient and safest-run firms are a magnet.

Cynics might argue Telstra responded to shareholder pressure and seized its first opportunity of excess franking credits to appease shareholders, going to a lot of trouble and expense to buy back a meagre 217 million or so of shares, or 1.75 per cent of the issue.

Not all companies are taking advantage of tax allowances. Brickworks and Reece Holdings are examples of firms resisting the temptation to pass sizable franking credits on to shareholders.

But with a growing level of wealthy self-managed super fund retirees moving into the zero tax bracket, unchecked by means tests, more and more money will flow into pension funds and access the “rivers of franking gold” from companies which have paid tax, and then pass that tax onto shareholders.

The ATO will issue a Telstra class ruling by the end of the month, when it is expected to confirm that $2.27 of the buy-back price is treated as a fully franked dividend for Australian taxation purposes, and an extra 44 cents a share (giving a total of $2.77 a share) to be subject to capital gains tax.

But arrangements like Telstra’s lead to selling and buying shares on tax considerations, not market fundamentals, potentially upsetting the capital flows of the country and putting short-term gains above long-term outcomes.

While the government laments an epidemic of tax avoidance by multinationals, Australia’s corporates such as BHP Billiton, Woodside, Woolworths, JB Hi-Fi and now Telstra have all announced share buy-back schemes with benefits to low tax payers, and the company through the buyback price discounts that are effectively paid for by tax avoidance.

Said one investor I spoke to: “How you can have that debate when you have Australian companies engaging with their shareholders in tax minimisation schemes. The hypocrisy is amazing. There’s Joe Hockey going on about international companies not paying tax. It’s happening in his own backyard.”