Off‐Market Buybacks in Australia: Evidence of Abnormal Trading around Key Dates

• Author: Chloe Choy Yeing Ho,Hue Hwa Au Yong,Christine Brown
• DOI: http://doi.org/10.1111/irfi.12037
• Date: 01 December 2014
• Published date: 01 December 2014

Off-Market Buybacks in Australia:

Evidence of Abnormal Trading

around Key Dates*

HUE HWA AUYONG,CHRISTINE BROWN AND

CHLOE CHOY YEING HO

Department of Banking and Finance, Monash University, Melbourne, VIC, Australia

ABSTRACT

Off-market share buybacks in Australia are often structured with the buyback

price comprising a large dividend component (which may carry imputation

tax credits) and a small capital component. This unique structure has the

consequence that institutions on low tax rates stand to benef‌it most from

selling shares into the buyback. In this article, we explore evidence of abnor-

mal trading activities around key dates in the conduct of off-market buybacks

and investigate the drivers of these activities. We f‌ind evidence of abnormal

trading activities around the initial announcement and the f‌inal announce-

ment dates of the buyback. The signif‌icant differences in abnormal volumes

between the buybacks with and without imputation tax credits highlight the

importance of tax motivations in explaining abnormal trading activities in

the shares of companies conducting off-market buybacks, and are consistent

with observed buying pressure around the announcement of the buyback.

I. INTRODUCTION

The market reaction to the announcement of a share repurchase has been the

focus of many studies since the seminal work of Dann (1981) and Vermaelen

(1981) in the US. Other countries have been slower to enact legislation to allow

share repurchases, but all studies conducted to date show that the market

reaction to a share repurchase announcement tends to be positive. In Australia,

the liberalization of buyback regulations occurred in December 1995, and since

then, share buybacks have become an important capital management tool used

by companies to return cash to investors.1Companies may buy back shares

either on-market or off-market. On-market buybacks (equivalent to open-

market repurchases in the US) are carried out on the Australian Securities

* This research was supported under the Australian Research Council’s Discovery Project

funding scheme (project number DP0878537). We thank Anne Ritter for her excellent research

assistance.

1 Australian companies were f‌irst allowed to undertake share repurchases in 1989. The First

Corporate Law Simplif‌ication Bill was enacted in December 1995, leading to simplif‌ication of

the processes and regulations that govern buybacks.

bs_bs_banner

International Review of Finance, 14:4, 2014: pp. 551–585

DOI: 10.1111/irf‌i.12037

© 2014 International Review of Finance Ltd. 2014

Exchange (ASX) in the ordinary course of trading. The focus of this study is on

equal-access share buybacks (equivalent to tender offers in the US context), a

type of off-market buyback where all shareholders are invited by the company

to tender some or all of their shares into the buyback.2

Prior event studies typically investigate the market reaction to the announce-

ment of a buyback by studying returns in a narrow window around the

announcement date. Other important dates in the buyback process are gener-

ally ignored in these studies (see, Brown 2007). Our study is different. We focus

on two key dates, the initial announcement date and the f‌inal announcement

date, and investigate abnormal trading activities and abnormal returns around

these dates. There are considerable uncertainties surrounding the f‌inal details of

the buyback that are not resolved until the buyback closes. For example, the

f‌inal buyback price (in a Dutch auction tender) and the extent of the under- or

over-subscription are not known until the company announces the outcomes

on the f‌inal announcement date. By investigating abnormal returns and

volumes around the f‌inal announcement date, we can document whether there

are abnormal trading activities around the closing date and investigate possible

causes of abnormal returns and volumes.

Off-market buybacks in Australia offer tax advantages to low marginal tax-

rate investors (which are mainly institutions). These tax advantages can be

captured by buying shares on announcement of the buyback and selling these

same shares back to the company through the buyback offer. This observation

suggests the existence of tax-induced abnormal trading activities around the

initial announcement date. Often, the repurchases are over-subscribed and

institutions that have bought up shares on the initial announcement are unable

to sell all the acquired shares into the buyback. They subsequently sell these

‘excess’ shares when the f‌inal outcome is announced on the completion date.

The initial purchasing creates buying pressure and the selling of ‘excess’ shares

on the completion date creates selling pressure. These activities are associated

with observed abnormal returns and abnormal volumes around both these key

dates. As compared with on-market buybacks, the observed abnormal trading

activity and any changes in market structure (such as changes in bid-ask spread)

can be attributed to investor trading activity rather than f‌irms’ own trading

activities.

To further substantiate our hypothesis of tax-induced trading, we use the net

buying pressure (NBP) variable to directly test our conjecture that investors are

buying shares on announcement in order to participate in the buyback, and

selling unsuccessfully tendered shares after the f‌inal announcement. We also

investigate liquidity around the key dates using the Amihud illiquidity measure

and the effective half-spread measure, which offer convincing evidence of

increases in market liquidity around the initial announcement date and some

evidence for increased liquidity around the f‌inal announcement date. Our setting

2 Within off-market buybacks, there are four categories of buyback: minimum holding, selec-

tive, employee, and equal access.

International Review of Finance

552 © 2014 International Review of Finance Ltd. 2014

provides a unique opportunity to investigate the effects on trading activity and

market structure of tax-induced trading of large institutional shareholders.

This article makes four main contributions to the literature on share repur-

chases. First, it documents tax-induced abnormal trading activity around two

key dates in the off-market buyback process in Australia. Second, our approach

allows for the separation of the information effect and the tax effect on abnor-

mal returns and volumes. The results provide direct evidence that abnormal

trading is higher for buybacks with larger tax benef‌its, thus supporting a tax-

induced trading effect. This adds to our understanding of the importance of tax

effects in company capital raisings. Third, by studying two key dates, we capture

the information effects for the whole buyback period, and provide direct evi-

dence of investor portfolio rebalancing around buybacks when information is

released on the f‌inal announcement date. Fourth, we link the abnormal trading

activities to observed changes in liquidity variables around the key dates,

showing that increases in market liquidity are associated with tax-induced

trading activities.

The remainder of this article is organized as follows: Section 2 provides a

literature review of off-market buybacks. Section 3 provides a description of

hypotheses, data and method. The results and discussions of the analyses are

presented in Section 4. We summarize the article in Section 5.

II. BACKGROUND AND LITERATURE REVIEW

A. Overview of the taxation treatment of

off-market buybacks in Australia

Interaction between Australian taxation law3and company law has led to the

unique taxation treatment of off-market buybacks. When a company buys back

its own shares, the consideration paid to a participant (the buyback price) is

divided into a dividend component and a capital component. The company

determines the capital component after consultation with the Commissioner of

Taxation.4The remainder is the deemed dividend component.5Alternatively,

the entire buyback price can be set as capital component.

3 Taxation treatment provisions are provided in the Income Tax Assessment Act (1936) (ITAA

1936).

4 The Commissioner of Taxation reviews the request from the company for the dividend and

capital split in the light of balance sheet constraints, retained earnings, and the balance of a

company’s franking account. The Tax Commissioner then makes a class ruling on the income

tax consequences of the buyback that are effective for the f‌inancial year in which the buyback

takes place.

5 This is a simplif‌ication of the actual treatment, which changed in 2004. Prior to 2004, for tax

purposes the capital component (sale price) of shares sold in an off-market buyback was

calculated as the difference between the dividend amount and the buyback price From 2004,

this was changed such that the capital component for tax purposes was calculated as the

difference between the pre-announcement market price of the share and the dividend

amount.

Off-Market Buybacks in Australia

553© 2014 International Review of Finance Ltd. 2014