From a tax point of view, deciding whether to accept an off-market buyback is normally a reasonably straightforward decision. If you are paying tax at a high marginal rate (34.5% or higher), don’t even bother to open the offer document when it hits your mailbox. Dispose of it thoughtfully! However, if you paying tax at 0%, such as a super fund in pension mode, or an individual whose taxable income is below the tax-free threshold, then accepting it will usually make sense. If your tax rate is in between, then depending on the buyback price, it may make sense to accept.

However, the IAG buyback is not as “generous” as some other off-market buybacks, and so potential participants will need to consider carefully their tender price. By “generous”, I mean tax advantageous. Because the capital component has been set at $2.99, the franked dividend component represents approximately 41% of the buyback price (assumes market price $5.50, discount 8%). This compares to Telstra’s current off-market buyback, where the franked dividend component is around 64% (market price $5.20, discount 8%, capital component $1.78).

At $300m, IAG’s off-market buyback is around 2.3% of the total shares on issue, so it is still likely to be well bid. But unlike the Telstra buyback where many low rate or zero rate taxpayers may offer their shares at ‘final price’, for this buyback, you may want to nominate the tender discount to ensure the transaction stacks up.

And of course, deciding to accept a buyback needs to be consistent with your investment intentions. You are disposing of your investment. Some investors sell their shares into the buyback, and because they want to maintain an investment exposure, buy them back on market at the ASX. Some even do this in advance of the completion of the buyback, taking a risk on how many shares they will be accepted for. Or, you can just sell your shares.

What’s special about an off-market buyback?

There are two 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 excess franking credits to its shareholders.

It is this distribution of franking credits that makes the off-market buyback very special. Part of the buyback proceeds is treated as a franked dividend, with the other part treated as a capital component. Effectively, the shareholder gets a franked dividend with franking credits, and reduced sale price for capital gains tax purposes. This is what makes off market buybacks advantageous to some shareholders, and because shareholders are keen to accept, means that the company can purchase the shares at a discount to the market price.

IAG’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 on 7 October. If you elect to participate and own less than 850 shares, you must tender all your shares. If you elect to participate and own 850 shares or more, you must tender at least 850 shares.

The tender will be at a discount to the market price, ranging from 4% up to a discount of 14%. Because the buyback is capped at $300m and is competitive, IAG 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 comprises two components – a capital component of $2.99, and the balance as a fully franked dividend. For example, if the market price of IAG shares is $5.50 and the tender discount is 8%, then the buyback price will be $5.06 and is comprised of a capital component of $2.99 and a fully franked dividend of $2.07.

The buyback 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% and 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, IAG has also announced some priority rules – to clear successful shareholders who are left with a residual parcel of 340 shares or less, and a minimum allocation to successful tenderers of the first 850 shares.

The market price will be determined by calculating the volume weighted average price of IAG share trades on the ASX over the five trading days from 3 October to 7 October. The announcement of the buyback price and any scale back will be made on Monday 10 October.

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

Should I accept?

The premise is that you should accept the buyback if your effective sale price (after tax) is higher than you could achieve by selling the same shares on the ASX. If you feel that you want to maintain your IAG shareholding, you just buy them back on the ASX.

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

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

We will also make a few other assumptions:

• the market price for IAG is $5.50;
• the deemed tax value is also $5.50 (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 IAG shares – in the first two examples, $1.78 (this was the deemed cost price from the NRMA demutualisation on 19 June 2000); and in examples 3 and 4, $6.00. We will also assume that you have owned your IAG shares for at least 12 months; and
• A tender discount of 14% (the maximum), and also the minimum of 4%.

Four examples are shown:

• Example 1: discount of 14%; original purchase price of $1.78;
• Example 2: discount of 4%; original purchase price of $1.78;
• Example 3: discount of 14%; original purchase price of $6.00;
• Example 4: discount of 4%; original purchase price of $6.00

In Example 1, the market price is $5.50. Applying a 14% discount, the buyback price is $4.73, which comprises a capital component of $2.99 and a fully franked dividend of $1.74. For a fund in accumulation, the after tax proceeds from selling on market would be $5.13. In the buyback, the effective after tax price is only $4.89.

For a fund in pension, the buyback return is $5.48, which is marginally lower than the $5.50 achieved if the shares were sold on market.

Example 1 – Discount 14%, Original Purchase Price of $1.78, Market Price $5.50

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

In Example 2 below, the buyback discount in just 4%. Here, the buyback is attractive to both an SMSF in accumulation mode and a fund in pension mode.

Example 2 – Discount 4%, Original Purchase Price of $1.78, Market Price $5.50

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

In Example 3 below, we apply a 14% discount. The cost base is now $6.00. For a fund in accumulation, the after tax proceeds from selling on market would be $5.50. There is also a capital loss of $0.50, which is potentially worth another $0.05 (15% tax rate, one third discount) if it can be applied to offset a capital gain on another asset. In the buyback, the effective after tax price is only $5.11. This now has a capital loss of $2.24, which is potentially worth another $0.22.

For a fund in pension, the buyback return is $5.48, which is marginally lower than the $5.50 achieved if the shares were sold on market.

Example 3 – Discount 14%, Original Purchase Price of $6.00, Market Price $5.50

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

In Example 4 below, the buyback discount in just 4%. Here, the buyback is attractive to both a SMSF in accumulation mode and a fund in pension mode. Because the shares were originally purchased at $6.00 and are now being sold at a capital loss, the fund in accumulation mode may be able to use that capital loss to offset capital gains on other assets.

Example 4 – Discount 4%, Shares Purchased at $6.00, Market Price $5.50

* Value of losses can only be realised against other capital gains

Conclusion

In pension mode, where the SMSF is paying tax at 0% and any capital loss or capital gain is not relevant, it will usually make sense (from a tax point of view) to accept the buyback. At a 4% tender discount (which is very unlikely to be accepted), the fund would be 76c better off – that is, its effective sale price would be $6.26 per share. If it wanted to maintain an exposure in IAG, it could potentially buy those shares back on the ASX for $5.50.

At a discount of 14%, the fund in pension is 2c worse off.

So, what level to tender at? Well, given that there is a little bit of risk in undertaking these transactions (you won’t know until 10 October whether your tender has been accepted or not), and that you won’t receive the franking credit refund until your fund lodges its 2016/17 annual return, you probably want at least 25c to make this transaction worthwhile. While these numbers will change marginally depending on the final market price, a tender discount of 10% will give a fund in pension mode a financial advantage of 29c per share. So, unless you are a really keen seller, I wouldn’t tender at a discount above 10%.

For a fund in accumulation mode, which is paying tax at 15%, it probably needs a tender discount no higher than 7%. It will make more sense to accept the buyback if a capital loss will be generated and the fund is in a position to use that capital loss to offset another capital gain.

Individual taxpayers who earn between $18,200 and $37,000 and pay tax at a marginal rate of 21.0% (including Medicare) could also consider tendering at very low tender discounts. Taxpayers earning more than $37,000 and who are paying tax at a marginal rate of 34.5% or more should not spend any time thing about the offer.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.