New Oriental Education & Technology Group (NYSE: EDU) has filed its delayed annual report on Form 20-F. EDU claims that the SEC has no objection to the consolidation of its VIE. However, the SEC has indicated it will continue to review EDU’s disclosure documents, including the 2012 Form 20-F, which would not have been provided to the SEC until now. In the Form 20-F the company says the SEC investigation is ongoing, so I don’t understand what is going on.
If the SEC has blessed the consolidation of EDU’s VIE, this is big news for VIEs, and I am a bit surprised by the result. The investigation into EDU likely was a consequence of Muddy Water’s allegations against the company; allegations that appear to have been discredited. There is an issue present in EDU that Muddy Waters did not raise, but I thought that the SEC would. EDU has an asset-heavy VIE, that is, most of the business at EDU is in the VIE. Consolidation requires that the parent company have a right to the residual profits of the VIE. EDU claims a right to these residual profits because of a series of service agreements between EDU and the VIE. It is apparent that EDU is not distributing all of the profits through these agreements. The question that the SEC should have addressed is whether all that is necessary to consolidate a VIE is a agreement, or whether those agreements have to give access to the residual profits in practice. This is not just a technical accounting question; it also gets to the substance of the arrangements and what the shareholders actually own. If you do not take the profits out as you are entitled to them, will you ever be able to take them out and do you really own them?
EDU says it obtains a right to receive substantially all of the economic benefits of the VIE in consideration for the services provided by EDU’s wholly owned subsidiaries (WFOEs). The service fees are set at a percentage of revenue. I do not understand how a fee that is a percentage of revenue is considered to be an interest in the residual profits of the company. Residual profits are what remain after the revenue-based fees. Most VIE agreements get around this by allowing the public company to unilaterally set the fees so that they can be made equal to net income. While those kinds of arrangements are more easily argued to result in an interest in residual profits, they are likely to be challenged by tax authorities as violating transfer-pricing rules.
EDU reports that the VIE earned $159 million in 2012. Retained earnings of the VIE increased by $49 million, suggesting that the VIE only made payments to the parent of $110 million. EDU’s VIE has retained earnings of $308 million, which is the accumulated earnings that have not been paid out. The accounting question is whether EDU has an interest in those retained earnings.
From what EDU is saying, the SEC appears to have decided that EDU has a right to the residual earnings of the VIE, despite the disclosure that the VIE is not paying these profits to the public company through the service agreements. Perhaps the fees required under the agreements are equal to or greater than the net income, yet the company has decided against paying them. Payments from a VIE to a WFOE are inherently tax ineffective, and once the profits are in the WFOE it is very difficult to get the cash back to the VIE. Perhaps EDU was able to convince the SEC that it met the letter of the law by having the contractual right to these profits, even if in practice it did not actually collect the payments it was entitled to.
Getting the residual profits through service contracts is the usual method for VIEs, even though it is tax inefficient. There is another, even more tax inefficient way, to get the profits out. That would be through a dividend from the VIE to the VIE’s individual shareholder, who would then turn it over to WFOE. Most VIE agreements provide for that possibility, although I see no disclosure of such provisions by EDU. There are layers of additional taxes in this approach that can drive the effective tax rate up substantially. EDU addresses this issue in its tax footnotes:
Aggregate undistributed earnings of the Company’s PRC subsidiaries and VIE that are available for distribution was US$395,534 and US$483,100 as of May 31, 2011 and May 31, 2012, respectively. Upon distribution of such earnings, the Company will be subject to PRC EIT taxes, the amount of which is impractical to estimate. The Company did not record any tax on any of the aforementioned undistributed earnings because the relevant subsidiaries and VIE does not intend to declare dividends and the Company intends to permanently reinvest it within the PRC.
Of the $483 million of undistributed earnings, $308 million are in the VIE. The remainder is in the WFOEs and would not be subject to enterprise income tax (EIT) on distribution. It would be subject to withholding tax, at 10%, an amount that is not impractical to estimate. (EDU does not appear to use a Hong Kong holding company to reduce the withholding rate to 5%, a technique that probably does not work because of treaty shopping restrictions). The distribution of VIE earnings would be subject to individual income tax when distributed to the individual VIE shareholder, and then to EIT when the individual gives the money to the WFOE, and then to withholding tax when distributed by the WFOE to the Cayman Islands parent. Here is what would happen:
Amount of retained earnings of VIE = $308 million. Individual income tax on dividend to Michael Yu (20% X $308) = $61.6 million. Amount paid to WFOE $308-$61.6 = 246.4 X EIT of 25% =$61.6 million. Total tax liability on VIE retained earnings is $123.2 million. Add to that a 10% withholding tax to get the money out of China to the Cayman Islands.
Does EDU provide for that deferred tax liability? No, the company waves it off by saying they do not intend to distribute dividends and plan to leave the money in the PRC. Accordingly, the taxes that would be payable on distribution are not recorded. The company indicates it never plans to pay the public company any of the retained earnings of the VIE. Not providing tax on income that the company never expects to distribute is allowed under GAAP.
What troubles me about EDU’s accounting is the combination of claiming an interest in the profits of the VIE despite the lack of ownership but also arguing that EDU will never get those profits. When you start layering on aggressive accounting policies, even if individually each is GAAP, the final picture does not fairly present the situation.
If, as EDU appears to say, the SEC has signed off on this, we can stop worrying about accounting challenges to the VIE structure.