PUBLIC EQUITY OPTIONS FOR TELSTRA CORPORATION LTD
The submissions received by the Economics Legislation Committee in
respect of this inquiry could be divided into three categories:- those
that supported the partial sale of Telstra by ordinary shares and those
who supported the sale by the issue of redeemable preference shares
or by converting preference shares. Below is a description of each of
these options.
1. Ordinary voting shares
a. Description of ordinary voting shares
Ordinary voting shares are a form of security which represent an ownership
interest in a company. Ordinary shareholders have voting rights at company
meetings and the ability to elect members to the Board of Directors.
Ordinary voting shares rank after debt and preference shares for dividend
payments in a winding up of a company. Ordinary shareholders expect to
receive dividends, which are dependant on the profitability of the issuer.
The return to ordinary shareholders is higher than for other investors
due to the uncertainty of the dividend. [1]
b. Advantages of ordinary voting shares in respect of the Telstra
partial privatisation
Telstra as a company is facing more and more competition, rapid changes
in technology and services, increasingly complex customer requirements,
management information challenges and increasing investment risk, therefore
there is considerable benefit in increasing its exposure to private
sector capital market disciplines.
According to BZW Australia the private sector is well placed to add considerable
value to Telstra through the pressure and responsiveness to improve capital
and operational efficiency. This would best be achieved through the issue
of ordinary voting shares, which will provide the means for feedback,
response and discipline from capital markets. [2]
Capital markets play a significant role in guiding Australia's capital
into productive investments and in monitoring the performance of these
investments to ensure they produce the expected benefits and wealth
creation for the community.
Capital markets encourage investment in areas of the economy which
are more likely to produce the greatest benefit to the community. Indeed,
capital raising options are characterised by the substance of the relationship
between providers of capital and the company which uses the capital
to undertake productive investments.
Ordinary voting shares would provide the most effective relationship
between providers of capital and Telstra as a user of capital. The influence
that voting rights give to shareholders is what makes the relationship
effective.
The Telstra Corporation itself supports the issue of ordinary shares
as there is a well established and understood market for them in Australia
and overseas, ensuring such an issue will achieve the stated objectives
of the government and raise the anticipated capital of $8 billion.
Telstra believes the key benefits delivered by the issue of ordinary
equity shares would be:
private shareholders are better placed to balance a wide range of
risk/reward trade-offs in an industry which is undergoing structural
change, therefore allowing the company to respond more quickly to
new investment opportunities;
exposure to the discipline of continuous performance assessment
by the financial markets will ensure more efficient investment and
resourcing decisions;
commercially based access to resources, including capital, from
which to develop new products and services that address customer needs;
and
a closer alignment between staff, company and shareholders interests.
[3]
c. Disadvantages of ordinary voting shares in respect of the Telstra
partial privatisation
Dwyer Partners, argued if the sale of ordinary equity shares proceeded
the government would forfeit the option to retain full ownership of Telstra's
underlying assets. They were also concerned that the issue of ordinary
shares will need to be heavily discounted relative to the intrinsic value
of the asset to attract shareholders, thereby undervaluing the asset.
Locked-in minority shareholdings tend to trade at a discount since no
control premium is possible. Dwyer Partners stated that the government
should get as much as possible for Telstra in relation to its intrinsic
value. [4]
Senator Harradine was concerned that the one-third sale by ordinary share
would mean that a third of the underlying asset would be disposed of,
whereas the redeemable preference share option would not entail a sale
of a third of the underlying natural monopoly assets. Senator Harradine
also stated that ordinary shares do not provide the shareholders with
the sort of security that redeemable preference and other share options
do. [5]
d. Likely demand for ordinary voting shares
Due to the enormous size of the issue, the shares may have to be heavily
discounted between 10 to 20 per cent below fair value for them to be
attractive to investors. That said, the consensus in the investment
community is that Telstra shares will be viewed as “blue chip”
and be eagerly sought after.
e. Taxation implications for ordinary voting shares
The dividend paid on ordinary equity shares can be franked by the company
that issues them and investors are able to claim a tax credit on the
interest earned.
2. Redeemable preference shares
a. Description of redeemable preference shares
All preference shares are legally equity, and like equity, their dividends
are paid out of after tax profits. However, investors generally regard
preference shares as a form of debt, if there is a contractual obligation
of mandatory redemption by the company and if the dividend is fixed
and cumulative.
A number of different conditions can be attached to preference shares.
They can be cumulative or non-cumulative, redeemable or irredeemable,
participating or non-participating, voting or non-voting or any combination
of these.
Each of these options hold different risk profiles which will affect
the value which the market will place on the instrument and the returns
demanded by their holders.
Redeemable preference shares have a fixed maturity (or redemption)
date, usually but not always with the intention that they will be redeemed
at a pre determined date and at a stipulated price but not necessarily
at their face value. Redemption may be mandatory, at the option of the
investor or the option of the issuer.
b. Advantages of redeemable preference shares in respect of the Telstra
partial privatisation
Some of the advantages of redeemable preference shares put forward
include:
the shares can be structured to offer an assured return to investors
compared to the variable dividend from ordinary voting shares;
the shares are generally less volatile in terms of market price
fluctuations, compared to ordinary voting shares;
the shares generally do not come with voting rights;
the shares once redeemed may provide the ordinary shareholders (the
Commonwealth) with a higher dividend and an increase in the value
of its shares; and
the shares do not result in ownership of the company and its assets
unless they are converted into ordinary shares [6]
The Davis Samuel Corporate Advisory Service submission set out a proposal
that would achieve Senator Harradine's objectives and resolve the government's
concerns with his proposal by having Telstra:
issue redeemable convertible preference shares;
ensure that it can elect to pay back the $8 billion or any part
thereof; and
ensure that it receives the benefit of its performance over a
certain period of time [7]
These objectives could be achieved if the Telstra float offered the
following:
Shareholders to receive fully franked dividends
Investors will subscribe for the preference shares on the basis of
receiving an attractive fully franked dividend whilst holding an entitlement
to ordinary shares in the event of the government electing to convert
the preference shares to ordinary shares.
The preference shares are tradeable securities
The preference shares are listed as tradeable securities on the Australian
Stock Exchange. The market price will reflect the profit performance
of Telstra and in turn, provide the government with an accurate market
assessment as to when to convert the shares, if it decides to do so.
Telstra has the right to convert
Telstra has the right to convert the preference shares to ordinary
shares at any time in the period prior to redemption at a value which
reflects the market value at the time of conversion, but not less than
the issue price.
The preference shares are redeemable
If the preference shares have not been converted to ordinary shares
during the stated period the $8 billion would be returned to investors
by way of redemption. In this regard, 100% ownership of Telstra will
revert to the government.
Benefit to investors
they will receive an attractive fully franked dividend;
they can sell their preference shares at any time on the stock exchange
at the prevailing market rate; and
on a worst case scenario, they will receive a guaranteed return
of their capital if redemption occurs.
c. Disadvantages of redeemable preference shares in respect of the
Telstra partial privatisation
Some of the disadvantages of an issue of redeemable preference shares
include:
redeemable preference shares are not commercially attractive to
investors and therefore may not raise the $8 billion required;
dividend imputation (franking credits) are no longer available on
these shares, unless the Commonwealth Parliament amends the taxation
laws;
a debt obligation is created which may constrain Telstra's business
activities and affect Telstra's ability to enter the capital markets to
access funds for investment purposes [8];
this type of capital raising is sometimes expensive and inefficient;
there is some scepticism in the market place about promoting these
types of shares since the corporate excesses of the 1980's; and
Redeemable preference shares attract a refinancing risk as a result
of the need to repay the holders at the end of the term of the shares.
[9]
The structure of the preference share will determine if it falls into
the category of equity or debt. Dwyer Partners provided a document Taxation
of Financial Arrangements: An issues paper prepared by Treasury
in December 1996 which indicated that certain types of preference shares
are considered as equity. While this appears to contradict Treasury's
submission of 5 February 1997 and Treasury's advice in Mr Costello's
letter of 3 December 1996 to Senator Harradine, the points made above
must be considered in terms of the structure of the preference share.
The crucial point in determining whether dividends on a redeemable preference
share would be frankable and rebateable seems to be whether redemption
is mandatory or optional.
d. Likely demand for redeemable preference shares
According to the Office Asset Sales the use of redeemable preference
shares in the Australian market is now virtually non-existent when the
instrument is structured as a “debt” instrument. [10]
This is because Section 46D of the Income Tax Assessment Act 1936
imposes a double taxation penalty on such instruments. A hybrid of these
forms of shares is not common but if configured in the way proposed by
Davis Samuel Corporate Advisory Service a market may be created for a
wide range of investors.
e. Taxation implications for redeemable preference shares
The Treasury stated that whether a particular share issue by Telstra
would be a debt dividend under section 46D of the Income Tax Assessment
Act 1936 would depend on the precise terms and condition of issue.
[11] Treasury considers straight redeemable
preference shares as debt instruments which should not receive any form
of franking credits or rebates for dividends. Furthermore, Treasury believes
that such dividends should remain non tax-deductible even though taxed
as interest in the hands of the recipient.
Dwyer Partners expressed concern with Treasury's underlying inconsistency
about treatment of debt dividends. [12]
Treasury has stated these are not deductible to the issuer and will be
taxed in full as ordinary income. Any tax system where a form of capital
is dealt with on the basis that the reward for that form of capital is
non-deductible to the company raising it, and yet is assessable to the
person receiving it, is a double taxation outcome. [13]
Two articles published in a recent Stock Exchange Quarterly Journal [14]
expressed the same view and recommended that section 46D of the Income
Tax Assessment Act 1936 be repealed as the tax system should not be
allowed to penalise by double taxation the development of new investor
vehicles and force imputation credits to be wasted.
From Telstra's viewpoint the taxation legislation has effectively resulted
in dividends from most types of redeemable preference shares being deemed
to be "debt dividends" for Australian tax purposes. Essentially
debt dividends are not eligible for franking credits or dividend rebates,
are not tax deductible to the issuer and are subject to withholding tax
for non-residents. Accordingly, unless amendments were made to the tax
legislation, there would be a significant degree of taxation disadvantage
associated with a redeemable preference share issue, unless the redemption
was optional rather than mandatory. [15]
3. Converting preference shares
a. Description of converting preference shares
A converting preference share is a share issued by a company to raise
capital. At a pre-determined date in the future (say 5 years) they are
converted to ordinary shares, often at a discount (say 10%) to the market
price prevailing at the time of conversion. [16]
Prior to conversion a converting preference share pays a fixed return
to the investor in the form of a regular franked dividend stream. From
an investor's point of view they are considered low risk because unlike
ordinary shares, there is minimal risk of capital loss up to the specified
conversion date.
Converting preference shares are considered equity, carry certain voting
rights, are extremely easy to sell, very well understood by the investment
community, can be franked and require no changes to the taxation legislation.
b. Advantages of converting preference shares in respect of the Telstra
partial privatisation
Since 1991 the converting preference share market has emerged as one
of the fastest growing Australian financial markets. A large number
of companies are now issuing converting preference shares to investors
as a mainstream equity instrument as they offer a wide range of benefits
to companies and investors, including:
raising equity from alternative investors;
the amount of capital raised is not dependent upon market sentiment;
the cost of equity to a company issuing converting preference shares
is often lower than the cost of equity in issuing ordinary shares;
they do not share in the gains (and losses) to the same extent as
ordinary shareholders; and
replacing some ordinary shares with converting preference shares can
increase the earnings per share available to the remaining ordinary shares
[17]
In respect of the Telstra partial privatisation, Bankers Trust Australia
submitted that converting preference shares had a role and would benefit
Telstra if the government decided to issue a combination of ordinary and
converting preference shares. [18]
Dr Rumble of the University of NSW also agreed that Telstra and investors
would benefit from an issue of converting preference shares as part of
the sale process. If ordinary shares and $2 billion dollars worth of converting
preference shares were offered for sale, this would raise extra revenue
for the government and offer Telstra a lower cost of capital. [19]
c. Disadvantages of converting preference shares in respect of the
Telstra partial privatisation
Some of the disadvantages given to the issue of converting preference
shares include:
the situation where converting preference shares mature and liquidate
into ordinary shares concurrently with another share issue;
if the value of the company does not increase or grow, the capital instrument
with a fixed dividend may result in an inferior outcome ex post facto;
[20]
possible confusion in the retail market place if both ordinary and
converting preference shares are issued at the same time;
offshore investors are not entitled to the full value of franking
credits attached to the dividends;
if converting preference shares are not included in the relevant
interest calculation for offshore investors, then by reducing the
amount of ordinary shares available from the sale it reduces the access
to Telstra equity by foreign investors;
Telstra considers any hybrid share that is debt in nature is certainly
not to the advantage of the company;
Telstra views converting preference shares as a deferment of an
ordinary share issue and would create extra market pressure on the
company; and
if the share price falls then a large number of shares will be issued
on conversion, simply because of the way the increment is structured.
[21]
d. Likely demand for converting preference shares
According to Bankers Trust Australia the market for converting preference
shares is a growing and highly developed market in Australia. [22]
Many companies such as ANZ, Westpac and St George have issued these shares
to raise Tier One [23] equity which
has a lower cost of capital than issuing ordinary shares. Converting preference
shares broadens their investor base and offer benefits not provided by
ordinary shares.
At present, fixed interest investors are very receptive to large issues
of converting preference shares. The reason for this is the reduced amount
of government bonds on offer. [24]
e. Taxation implications for converting preference shares
Dr Rumble of the University of NSW stated there are no taxation issues
impeding the issue of converting preference shares in this situation.
The Australian Taxation Office customarily issues tax rulings confirming
their tax neutrality, and the Full Federal Court in Radilo Enterprises
Pty Ltd v Commissioner of Taxation has also judicially approved of
them. [25]
Footnotes
[1] Submission No. 5, Office of Asset Sales,
p 68
[2] Submission No. 7, BZW Australia, p 74
[3] Submission No. 1, Telstra, p. 7
[4] Evidence, p. E 52
[5] Senate Hansard, 5 December 1996,
p.6752
[6] Research note, Number 7, Brendan Bailey,
p. 2
[7] Submission No. 8, Davis Samuel, p. 2
[8] Submission No. 1, Telstra, p. 9
[9] Submission No. 1, Telstra, p. 9
[10] Submission No. 5, Office of Asset Sales,
p. 63
[11] Submission No. 3, Treasury, p. 47
[12] Evidence, p. E54
[13] Evidence, p. E54
[14] Double Taxation by the back door by
Terry Dwyer and Fair play needed for a fair proposal by Rod Cox, Australian
Stock Exchange Journal, 1st quarter 1997
[15] Submission No. 1 Telstra, p. 10
[16] Submission No. 2, Bankers Trust Australia,
p. 20
[17] Submission No. 2, Bankers Trust Australia,
p. 21
[18] Submission No. 2, Bankers Trust Australia,
p. 21-22
[19] Evidence, p. E2
[20] Evidence, p. E16
[21] Evidence, p. E16
[22] Submission No. 2, Bankers Trust Australia,
p. 28
[23] Reserve Bank of Australia requires banks
to have a minimum level of equity which is in the form of ordinary shares
or which can only convert into ordinary shares. This is known as Tier
One equity.
[24] Submission No. 2, Bankers Trust Australia,
p. 28-29
[25] Submission No. 4, Dr Tony Rumble, Senior
Lecturer in Law, University of NSW p. 54