For some time now, I have been trying to understand a perplexing phenomenon on the New York Stock Exchange (NYSE), which is, why do BHP Billiton Ltd's (BHP) American Deposit Receipts (ADR), trade at premium to BHP Billiton Plc's (BBL) ADRs. At the time of writing, the price differential sees BHP Ltd trading at a premium of around 18% to BHP Billiton Plc. On face value, this makes BHP Billiton Plc the superior investment for U.S. based investors seeking exposure to BHP Billiton, because they are able to obtain a superior dividend yield for exposure to the same company.
In this article, I am going to investigate in detail why this premium exists, and explain which ADR represents the best opportunity for U.S. based investors seeking exposure to BHP. However, I am not going to undertake an in-depth analysis of BHP, because that has been done many times on Seeking Alpha. For those readers seeking further information on whether BHP is a desirable investment, I would recommend Colin Lea's 'BHP Billiton: A Better Value Proposition Over Vale.'
Background and Company Profile
BHP Billiton is the world's largest mining company and is one of the world's largest producers of major commodities including aluminum, copper, energy coal, iron ore, manganese, metallurgical coal, nickel, silver and uranium along with substantial interests in oil and gas. It operates in 100 locations across the world and was formed out of the merger of Australia's BHP and the U.K.'s Billiton in June 2001.
For the full-year 2011, it reported revenue of $72 billion which was an almost 1% increase on 2010 and net income of $15 billion which was a 35% decrease on 2010. The company over recent months has found itself struggling to grow sales due to increasing volatility in commodity prices. The company's performance is also linked to the performance of the Chinese economy and that country's demand for basic materials as it continues to grow and modernize.
The volatility in commodities and basic materials prices has had a significant impact on the company's profitability and seen the volatility of its share price increase markedly with BHP Billion Ltd ADRs now having a beta of 1.6 and BHP Billiton Plc ADRs having a beta of 1.7. But as I will explain, the performance of each ADR's underlying shares on their respective domestic exchanges drive the price of the ADRs and the volatility now seen in the price of those ADRs.
BHP and Billiton merged in June 2001 becoming a dual-listed company, with BHP Billiton Limited (BHP.AX) having a primary listing on the Australian stock exchange (ASX) and BHP Billiton Plc (BLT.L) having a premium listing on the London Stock Exchange (LSE). The company also has a secondary listing on the Johannesburg Stock Exchange and each company is listed as ADRs on the NYSE. Both companies have identical boards of directors and are run by a single management team, with shareholders in each company having equivalent economic and voting rights.
Despite each share of the two companies having the same economic and voting rights, the ASX-listed BHP Billiton Ltd shares once adjusted for the exchange rate between the Australian dollar (AUD) and the British pound sterling (GBP), are trading at a premium to the LSE-listed BHP shares as the chart below illustrates.
Source data: Yahoo Finance.
At the time of writing, this premium is quite high, with ASX-listed BHP Billiton Ltd trading at a price that is 18% higher than LSE-listed BHP Billiton Plc. Furthermore, as the chart illustrates, BHP Billiton Ltd has traded at a premium to BHP Billiton Plc for almost the last six years.
There has been much conjecture as to why this premium exists particularly as both shares have equal economic value, voting rights and dividend payments. But a key factor supporting the premium is that the shares are not interchangeable and therefore it is impossible to transfer the shares between exchanges. This means that domestic factors including economic risk, liquidity and tax incentives can affect the individual price of each share.
BHP Billiton American Depositary Receipts
When examining BHP's NYSE-listed ADRs, BHP and BBL, this premium is also apparent but slightly lower. Both of BHP's ADRs were listed on the NYSE in June 2003 and BHP represents two ordinary BHP Billiton Ltd shares, while BBL represents two ordinary BHP Billiton Plc shares and the premium can be seen in the chart below mapping the share price of both ADRs.
Source data: Yahoo Finance.
At the time of writing, BHP Billiton Ltd is trading at a premium of almost 18% to BHP Billiton Plc as the chart below illustrates.
Source data: Yahoo Finance.
In the case of ADRs, it is the value of the underlying shares that drive the value of the ADR although there are times when this can become disconnected. This disconnect primarily arises because of three reasons, firstly; investors may be willing to pay a higher price for the ADR because it comes with less risk. This is quite a common phenomenon for emerging markets where settling trades can be quite difficult.
The second reason is that differences in liquidity can drive price discrepancies with the more liquid market driving a higher price for the ADR, forcing the other market to catch-up. While the third and final reason is that in some markets there are restrictions on the number of shares that can be held by foreign investors.
In the case of BHP Billiton Ltd, neither of these three factors exist and therefore there is no disconnect between the price of the NYSE-listed ADR and the underlying share. As the chart below illustrates, once the price of the underlying shares has been adjusted to take into account the exchange rate, there is only a marginal difference in the price of the underlying share and the ADR.
Source data: Yahoo Finance.
This is also the case for BHP Billiton Plc, with the shares once adjusted for the exchange rate trading at close to parity with the NYSE-listed ADR as the chart below illustrates.
This indicates that the reasons for BHP Billiton Ltd trading at a premium to BHP Billiton Plc is not related to the ADRs or any price disconnect between the ADRs and their underlying shares. It appears that this premium is being driven by factors that are affecting the value of the underlying shares as listed on their respective domestic exchanges.
Dividend Payments and Dividend Imputation
One theory for BHP Billiton Ltd's price premium is that the Australian taxation system has created an environment that incentivizes investors to purchase shares in domestically-listed companies that pay what are known as fully-franked dividends. This is because the Australian Taxation System uses a form of dividend imputation to eliminate the double taxation of dividend payments, where tax has been paid on the profits distributed as dividends at the corporate level.
The Australian company tax rate is 30%, and where a company pays tax on the profits distributed as dividends, the dividends are known as 'franked' dividends. In order to prevent double taxation, investors domiciled for tax purposes in Australia receive a 'franking credit' representing the amount of tax paid by the company.
The reason for this is that all dividends received by investors domiciled in Australia for tax purposes are treated as income for tax purposes. The investor then pays tax on that income at their individual marginal rate as set out in the chart below after the value of the dividend has been grossed up to include the value of the franking credit.
Source: Australian Taxation Office.
It is important to note that these rates do not include the Medicare levy of 1.5%, which is an additional tax levied on a tax payers income that is used to fund Australia's public healthcare system. Where the investor is a company or the trustee of a corporate unit trust or a public trading trust, then the company tax rate of 30% applies to any income earned by the company.
The value of the 'franking credits' received is then offset against the investor's total taxable income, thus reducing their income and the amount of tax payable. If the investor's income is too low to utilize the full amount of franking credits available to the investor, then any remaining franking credits are refunded by the Australian Taxation Office (ATO) to the investor.
An example of how this works is where an investor domiciled in Australia for tax purposes holds 625 shares of BHP Billiton Ltd listed on the ASX. I have made the following assumptions in the example below:
- At the time of writing, the BHP share price is AUD$32.
- For the full financial year of 2011/12, BHP paid an annual fully-franked dividend of AUD$1.06 per share.
- The total amount invested is: 625 X $32 = $20,000.
- The fully-franked dividend income is: AUD$1.06 X 625 = $662.50.
- The franking credit formula is: total cash dividend X 30/70, using a corporate tax rate of 30%.
- The investor's marginal tax rate is 45% plus a Medicare levy of 1.5%, giving them a total tax rate of 46.5%.
The chart below after taking all of these assumptions into account shows both the total tax payable and the after tax dividend yield for Australian domiciled investors.
As the table illustrates, the franking credits reduce the investor's overall tax rate from 46.5% to 24%, which is a powerful incentive for Australian investors to purchase shares in domestically-listed companies paying fully-franked dividends.
Where the investor is an Australian company, the outcome from investing in shares that pay fully-franked dividends is even more favorable because the company tax rate is significantly lower. If the same example above is used and the company tax rate of 30% is applied, then as the chart below illustrates, the effective tax rate on fully-franked dividends received by a company is 0%.
This then creates a powerful incentive for both individual investors and companies domiciled in Australia to invest in publicly-listed companies such as BHP Billiton Ltd that pay fully-franked dividends.
This incentive becomes even stronger when it is considered that any excess franking credits, which exceed the value of the investor's taxable income are then refunded to the investor. Furthermore, this creates a disincentive for Australian domiciled investors to invest in foreign stocks because any dividends they receive will be taxed at their full marginal tax rate and they won't receive the benefit of franking credits. Essentially, it means that if an Australian domiciled investor in a U.S. or U.K. company were to receive a dividend payment from that company and their income placed them in the top marginal tax bracket then they would be paying 46.5% in tax on that dividend.
This has made publicly-listed companies paying fully-franked dividends such as; BHP Billiton Ltd, Rio Tinto (NYSE:RIO) as well as the four major banks; Westpac (NYSE:WBK), ANZ (OTCPK:ANZBY), NAB (OTCPK:NABZY) and the Commonwealth Bank (OTCPK:CBAUF) particularly popular with high-net-worth (HNW) and institutional investors in Australia. It has also helped to drive the BHP Billiton limited share price higher as investors seek to access the tax advantages its fully-franked dividends provide.
U.K Tax Treatment of Dividends
These tax advantages are far greater than those available to individuals and companies in the U.K. where dividends are again treated as income, but taxed using a special rate applied to dividends and where the maximum tax credit available is 10%. The tax rates applied to dividends in the U.K. are set out in the table below and they vary depending on the investor's overall taxable income.
Source data: HM Revenue and Customs.
U.K. domiciled investors also receive a tax credit, in order to reduce the likelihood of double taxation. This tax credit is calculated as 10% of the total dividend income. And if an investor pays tax at or less than the basic tax rate of £32,010, then no further tax is payable on the dividend income because of this tax credit.
However, if I take the same example used above to demonstrate the advantages of the dividend imputation system in Australia it becomes clear that U.K. investors pay a higher rate of tax on their dividends. Firstly, it is important to remember that the total dividend paid by BHP Billiton Plc is the same as that paid by BHP Billiton Limited with dividends paid in U.S. dollars, therefore the total dividend received doesn't change.
For ease of comparison, I have retained all figures in Australian dollars and left the total invested unchanged. But because BHP Billiton Plc is trading at a discount to BHP Billiton Ltd, the investor holds 719 shares instead of 625 shares thus increasing their gross dividend. I have also factored in the following assumptions:
- At the time of writing, the BHP Billiton Plc's share price is AUD$27.82 after being adjusted for the exchange rate.
- For the full financial year of 2011/12, BHP paid an annual fully-franked dividend of AUD$1.06 per share.
- The total amount invested is: 719 X $27.82 = $20,000.
- The gross dividend income is: AUD$1.06 X 719 = AUD$762.14.
- The 10% tax credit has been allowed for in the calculation.
- The investor's dividend tax rate is the top rate being 37.5%.
The chart below, after taking all of these assumptions into account, shows both the total tax payable and the after-tax dividend yield for U.K. domiciled investors.
As the example illustrates, even after the dividend tax credit has been taken into account, the rate of tax payable on the dividend is 31%, which is higher than the 24% payable in Australia. It also reduces the effective after tax yield of the dividend to 2.4%, which is lower than the after tax dividend yield for an individual investor in Australia of 2.5%. This further emphasizes the incentive for institutional and HNW investors who are domiciled in Australia to purchase BHP Billiton Ltd in preference to BHP Billiton Plc.
The table further illustrates the tax advantages for individual investors who are domiciled for tax purposes in Australia, by comparing the applicable effective tax rates that investors in both tax jurisdictions have to pay on dividends received.
*NB: The individual income tax rate bands have been broken down to allow a direct comparison of the relevant rates.
As the table illustrates, individual investors in Australia pay a lower tax rate than their counterpart in the U.K. on dividends that are fully franked. Furthermore, where the effective tax rate is a negative percentage, the tax payer has more franking credits than taxable income to offset them against, and as a result will have those excess franking credits refunded to them.
The tax benefits and therefore incentive for institutional investors to purchase BHP Billiton Ltd in preference to BHP Billiton Plc is illustrated by the table below setting out the respective company tax rates.
With the effective tax rate on fully-franked dividends of 0% compared to 10% or 13% for companies domiciled in Australia, it is clear that institutional investors who have an Australian domiciled entity will purchase BHP Billiton Ltd in preference to BHP Billiton Plc. This I believe is a key factor driving the premium of BHP Billiton Ltd shares over BHP Billiton Plc, because many institutional investors have operations and incorporated entities in both tax jurisdictions.
Investors are Attaching a Premium to the Strength of the Australian Economy
Another reason for the disconnect between the share price of BHP Billiton Ltd and BHP Billiton Plc, is the strength and resilience of the Australian economy, particularly in comparison to the U.K. economy. This has acted to attract investors to Australia and seen many investors attach a premium to investing in the country. The strength of the Australian economy in comparison to the U.K. economy over the last two years is illustrated by the chart below, which shows that Australia's quarterly real growth has been consistently higher than that of the U.K.
Source data: Organisation for Economic Co-operation and Development.
The strength of the Australian economy and its resilience to the global crisis that have swept the world since the subprime crisis, is evidenced by Australia being one of the few economies to retain the coveted AAA rating since the GFC. With 'risk free' assets becoming increasingly scarce, Australia's genuine AAA status has made it a natural destination for long-term investors seeking liquidity and capital preservation. Whereas the U.K. economy is perceived to be far more risky and this has seen Moody's strip the country of its triple A rating, while Standard & Poor's reaffirmed their triple A rating but placed the country on negative watch.
Another reason for the preference among investors to invest in Australia in comparison to the U.K. is the ongoing European Financial crisis, which is affecting all of the economies that are members of the European Union. While the U.K. has retained its own currency and not joined the Euro, it is a signatory to the Maastricht Treaty and a member of the E.U. As a result, its economy is still exposed to the effects of the European financial crisis and this has had an impact not only on economic growth but also the value of the U.K. currency, the British pound.
Political risk is another factor that can influence an investor's decision to invest and cause a disconnect between the share price for the shares of dual-listed companies. However, while there is obviously political risk associated with any investment in a foreign jurisdiction, the level of risk for both the U.K. and Australia is perceived as minimal.
This is evidenced by the 2012 Transparency International Corruption Perceptions Index, where the U.K. scored 74 and was rated 17th, while Australia scored 85 and was ranked 5th, with the higher the score and the lower the ranking, the lower the degree of perceived corruption and political risk. Interestingly, both countries were ranked lower than the U.S. which had a score of 73 and was ranked 19th.
This political risk can also manifest itself in changing taxation regimes and regulatory environments and while there have been some changes to the taxation of mining companies in Australia and adjustments to royalty regimes, the risk in both countries remains minimal. Despite Australia receiving a lower rating than the U.K., I don't believe that this is a key drive of the price premium for BHP Billiton Ltd over BHP Billiton Plc. But when this is considered in conjunction with the level of economic risk, it is having some influence on the investment decisions of foreign investors.
The strength and the resilience of the Australian economy combined with the country's AAA rating has seen the country's currency perceived by many investors to be a safe haven currency. As explained earlier, this genuine AAA status has acted to attract long-term investors seeking liquidity and capital preservation and seen the Australian currency perceived to be a safe haven currency. The financial crisis in Cyprus has only further acted to drive this influx of investment in the Australian dollar and the view among investors that it is a safe haven currency. This has acted to continue to drive the value of the Australian dollar and attract increased foreign investment across a range of investments in Australia including Australian listed shares.
The growing strength of the Australian dollar resulting from its safe haven status can be seen in the chart below, particularly in comparison to the ongoing weakness of the pound sterling against the U.S. dollar.
Source data: Reserve Bank of Australia and Bank of England.
As the chart illustrates, over the last ten years, the value of the pound sterling in comparison to the U.S. dollar has remained relatively flat, while the Australian dollar has increased in value by around 57%. This is a significant increase and is indicative of the growing safe haven status of the currency and the Australian economy among investors globally. It also indicates that foreign investors are less likely to see their investment diminish in value because of a significant devaluation of the Australian dollar in comparison to the British pound, and instead may see their returns enhanced as the Australian dollar continues to rise in value.
Another factor that can be responsible for driving a premium or discrepancy in the share price of one dual-listed share over another is differences in market liquidity. Typically the share listed on the more liquid exchange and with greater trading liquidity will trade at a premium to the share listed on the less liquid exchange.
Interestingly, despite the ASX being a far smaller exchange than the LSE with a market cap of $1.5 billion, compared to the LSE's $3,300 billion, BHP Billiton Ltd is far more liquid on the ASX than BHP Billiton Plc is on the LSE with greater trading volumes as the chart below illustrates.
Source data: Yahoo Finance.
This increased liquidity of BHP Billiton Ltd is a contributor to the price premium of the share over BHP Billiton Plc and it is also evidence of institutional investors' preference for investing in BHP Billiton Ltd because of the tax incentives that are available.
Tax Changes Are a Key Potential Driver to Reduce the Premium
The key driver that will cause the premium to narrow or decrease will be changes in the tax laws as applied to dividend income in the U.K. and particularly Australia. This would more than likely happen if the dividend imputation system was changed in Australia to remove or reduce the tax benefits received by investors domiciled in Australia. Thus, reducing or removing the incentive to invest in BHP Billiton Ltd and reducing the demand for the ASX-listed stock.
There have been some calls for the dividend imputation system to be scrapped on the basis that it is costing the Australian government in excess of $20 billion in tax revenue and that this could be used to fund a decrease in the company tax rate from 30% to 19%. This it is argued would make the Australian economy more productive and more appealing for foreign investors.
However, I believe that it is highly unlikely that such a significant change in the Australian Taxation system would occur primarily because the dividend imputation system and franking credits have been in place in Australia since 1987. It has acted as a key catalyst to encourage Australian investors to invest in locally-listed companies and contribute to the growth of economically productive assets. Rather than having investors continuing to invest primarily in what has been the historically preferred investment class in Australia, residential property, which does not contribute to economic productivity.
Furthermore, it has been claimed that the Australian dividend imputation system has been a definitive factor in the ability of Australian listed companies to create consistently higher shareholder returns with less volatility than rival international companies.
What Does this Mean for U.S. Investors?
The first key consideration for U.S. investors is whether dividend payments from an investment in BHP Billiton Ltd of BHP Billiton Plc ADRs are free of foreign withholding tax from the country in which the underlying shares are listed. In the case of Australian-listed companies, dividend payments to foreign investors are subject to foreign withholding tax of 30%. But where those dividends are fully franked, there is no withholding tax payable. For dividends paid by U.K. companies to U.S. investors, there is also no foreign withholding tax payable. Therefore, there is no tax advantage for U.S. investors to choose either BHP Billiton Ltd or BHP Billiton Plc in preference to the other.
However, the growing price premium of BHP Billiton Ltd over BHP Billiton Plc is a key consideration for U.S. investors. This is because by purchasing BHP Billiton Plc they are gaining equal exposure to the performance of BHP Billiton, while receiving a higher dividend yield, which at the time of writing is 3.9% as compared to 3.4%.
For long-term income focused investors this difference in yield can have a significant impact on the amount of income received by way of the dividend payments. In the chart below, I have charted the growth in the value of the dividend between BHP Billiton Ltd and BHP Billiton Plc using the following assumptions:
- An initial investment of $1,000 has been made.
- The share price continues to grow at an average compound annual growth rate of 9%, this is significantly less than BHP's historical CAGR of 19%.
- The dividend continues to grow in value by its historical compound annual growth rate of 12%.
- All dividends are reinvested.
- There are no changes to the tax laws.
As the chart below illustrates, after taking into account the assumptions listed above, BHP Billiton Plc ADRs provide a superior return for U.S. investors, having outperformed BHP Billiton Ltd ADRs by 26% over the 20-year investment period.
Source data: Yahoo Finance, Bloomberg, BHP Billiton Investor Relations.
In addition, as the chart illustrates, the percentage difference in the growth of the investment continues to grow over time, as the power of compounding enhances the investments return. Even if the premium between the two ADRs was to close over time, investors would still be ahead if they invested in BHP Billiton Plc ADRs, because they are starting with a larger initial investment, which would be enhanced by the power of compounding if they reinvested the dividend payment.
If the premium grow over the time of the investment, the advantages that investing in the BHP Billiton Plc ADRs would provide to investors would only be enhanced. This occurs because the dividend yield of BHP Billion Ltd would continue to fall as its price premium grows, thus reducing the number of additional shares purchased as dividend payments are reinvested.
It is clear that there a number of factors driving BHP Billiton Ltd's premium over BHP Billiton Plc. Furthermore, it is clear that this premium is not associated with the NYSE-listed ADRs, but rather specific issues that affect the value of the underlying stocks. I believe that the key factor driving this premium is the tax incentives, which investors domiciled for tax purposes in Australia receive for investing in an Australian-listed company that pays fully-franked dividends like BHP Billiton Ltd. Other factors helping to support the share price and drive the premium is the view among many foreign institutional investors that the Australian currency is now a safe haven currency and that the country has a lower degree of economic and political risk than the U.K. as demonstrated by its AAA rating.
While these are all valid reasons for purchasing BHP Billiton Ltd in preference to BHP Billiton Plc, particularly if the investor is domiciled in Australia and is able to access the tax benefits, it certainly does not make sense for U.S. investors considering the NYSE ADRs. When it is considered that there is no foreign withholding tax payable on the dividend paid by each company and with BHP Billiton Plc's ADRs trading at around an 18% discount at the time of writing, it is clear that this is the superior investment for U.S. domiciled investors. Not only are U.S. investors receiving equal exposure to BHP Billiton Ltd at a considerable discount, they are also receiving a higher dividend yield along with all of the opportunities that an investment in BHP presents, including a solid and consistently growing dividend yield with a 28-year CAGR of around 12%.
Disclosure: I am long BHP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.