BHP Billiton’s South32 Spinoff: A Potential Tax Implication

If you look up the price of “BHP”, the Australian-based listing of BHP Billiton, you will see a price of $47.03. If you then look up the price of “BBL”, the British-based listing of BHP Billiton that trades on the London Stock Exchange, you will see a price of $44.08 per share. Given that they represent a claim on the exact same mining and resource assets, you may wonder why there is a $3 per share difference for something that tracks the same asset.

The answer has to do with franking tax credits. Australian companies often “frank” their stocks, which means they attach additional money to dividend payments so that shareholders don’t have to pay taxes on their dividend payments. Once a dividend is fully franked (or 100% franked), you can own the Australian stock without having to pay a dividend tax on the dividend payments. However, franking is something that must be done on a per share basis, so BHP Billiton’s Australian shares engage in a policy of franking at the highest possible tax threshold.

The highest marginal rate in Australia is 45%, so the dividend gets franked under the assumption that everyone is paying a 45% rate. This confers an additional benefit if you operate a charitable foundation or are a middle-class investor with a lower tax rate. Your BHP Billiton Australian shares would then come with franking credits in excess of what you owe in taxes on the BHP Billiton shares so you can actually use shares of BHP to lower your tax bill on other taxes that you owe specifically to the Australian government. The reason why I don’t recommend these BHP shares to American ADS investors investing in a retirement account is because the American-Australian tax treaty would call for 15% of your BHP dividends to be sent to the Australian government, and retirement-account investors in the U.S. are unlikely to have taxable Australian assets in that account that would benefit from the franking credit (in greater proportion to the 15% tax taken out).

Meanwhile, someone that owns BBL shares in a U.S. retirement account will owe 0% in taxes on their dividends—it will reinvest just as easily as owning a U.S. based stock. Franking credits aren’t in the picture, but they would deliver no benefit to the overwhelming majority of U.S. investors using IRAs.

The follow-up question is: How will this tax situation play out for investors after the demerger that will be formally proposed at a shareholder meeting next month?

The remaining BHP Billiton will trade in the UK, and franking is not an issue for the remaining parent company. For the South32 shares, page 13 of the BHP Billiton Shareholder Circular gives you an idea of what may come ahead: “South32 intends to distribute a minimum of 40 per cent of Underlying Earnings as dividends to its shareholders following each six month reporting period. Consistent with South32’s priorities for cash flow and commitment to maximizing total shareholder returns, other alternatives including special dividends, share buy-backs and high return investment opportunities will compete for excess capital.

South32 will distribute dividends with the maximum practicable franking credits for the purposes of the Australian dividend imputation system. The extent to which a dividend can be franked will depend on South32’s franking account balance (which immediately following the Demerger will be nil) and its level of distributable profits. South32’s franking account balance will depend on the amount of Australian income tax paid by South32 following the Demerger. The timing of South32’s Australian income tax payments may also impact its capacity to frank any dividend declared for the half year ending 31 December 2015. No assurance can be given in relation to the level of future dividends or the franking of such dividends (if any), as these will depend on future events and circumstances. South32 does not intend to pay a dividend for the period ending 30 June 2015, which will conclude only one month after the implementation of the Demerger.”

I added the bold. It seems to me the conclusion investors ought to reach is this: South32 will try to frank the dividend in accordance with BHP Billiton’s tradition, but there is also the possibility that South32 will not be able to frank the dividend because it will have no franking credits after the merger and the aluminum and manganese mines that will be owned exclusively by South32 are at a lower than usual point in the business cycle. This invites the possibility that someone owning South32 in an American retirement account will have to pay 15% to the Australian government on South32 dividends if there is no franking credit.

The advisability of this demerger is definitely fair to question. It is going to cost BHP Billiton $732 million to split off South32 to shareholders, and the estimated efficiency gains from this split are $100 million per year. Taking seven years to break even from a reorganization is not something clearly in shareholders’ best interests. There is also the possibility, which I peg at 30% or so, that South32 ADS holders will have to pay tax to the Australian government if there is no franking.

That said, there are also things to like—the silver assets that come with South32 may finally get their full due for reinvestment (since they suddenly become the most attractive mines in South32, but they had to take a backseat to the crude oil, iron ore, and diamonds in the BHP Billiton portfolio). The dividend is quite high, and will probably be a bit over 6% when you factor in the eventual South32 dividends collected in addition to the BHP Billiton dividends from the remaining parent company. The valuation is low, and good things happen when high dividends get reinvested at low prices. The issue is not one of production—in fact, BHP Billiton is producing more iron ore than ever (in an attempt to squeeze out the small iron ore producers and buy them at a discount). Rather, it’s about low current commodity prices in the oil, iron ore, aluminum, and manganese segments. Oil and iron ore will recover substantially over a full business cycle, manganese will eventually improve a bit, and the aluminum assets will probably limp along over the long haul. There will be setbacks and volatility, but I imagine that someone holding BHP Billiton and reinvesting each March and September dividend will be quite satisfied with the total income results a decade or so from now.