What you need to know about Rio Tinto Limited’s (ASX:RIO) $4.4bn capital return

The share price of Rio Tinto Limited (ASX: RIO) is likely to jump higher this morning after the iron ore giant announced details on how it intends to return US$3.2 billion ($4.4 billion) in capital to shareholders.

Management will undertake an off-market share buyback of its ASX-listed stock that will see many shareholders receive more than the value of the buyback amount; and will also buy its London-listed stock on-market.

The news is likely to excite the market even though the capital return itself isn’t a surprise as investors know management was going to hand back the proceeds from the sale of its coal assets.

The rise in commodity prices overnight on the back of a weakening US dollar won’t hurt sentiment too but I digress.

It’s with some nostalgia that Rio Tinto undertakes the off-market buyback of ASX shares as this could likely be the last time it can entice shareholders through this mechanism.

If Labor wins the next federal election (and that looks likely), it will disallow cash refunds of franking credits – which is a big incentive for many to tender their shares into a buyback.

Shareholders can opt to sell their Rio Tinto shares back to the miner at discounts of between 8% and 14% of the yet-to-be-determined market price.

The tax office has ruled that the capital component of the buyback is $9.44 and that a fully franked dividend will be paid to make up the difference to the final tender price.

Rio Tinto intends to buy back up to 41.2 million of its ASX shares, and the number of shareholders participating and the discount they are willing to accept will determine the final tender price and if Rio Tinto needs to scale back the buyback.

From my experience, the buyback will be very popular. Investors should expect a scale-back and the maximum discount (14%) to be applied.

This is because many shareholders will get a double-tax benefit from participating. Firstly, they may be able to claim a capital loss on shares accepted into the buyback (given how low the capital component is set). This can be used to reduce their overall tax liability.

Secondly, they can get a franking credit on the value of the dividend component, which will likely be large as Rio Tinto’s share price last traded at $75.40.

Since shareholders will get the full benefit of the franking under the current rule, the buyback is especially attractive to those that pay little tax – such as SMSFs.

However, investors will need to check with their accountants (or work it out themselves) if participating in the buyback (and at what discount) makes financial sense. The benefit really depends on your tax situation.

Rio Tinto won’t be the only one throwing back capital to shareholders. BHP Billiton Limited (ASX: BHP) is expected to announce its own bigger share buyback very soon and it’s likely that it too will be using an off-market buyback given its franking balance (and the risk of the franking rule change).

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Motley Fool contributor Brendon Lau owns shares of BHP Billiton Limited and Rio Tinto Ltd. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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