In December, I posted about how Autohome had provided a deferred tax liability on the profits accumulated in its VIE, while other companies in similar situations have not done so. I found an additional company, Soufun, that has also provided deferred taxes on VIE retained earnings. Both Soufun and Autohome are audited by Ernst & Young.
I have been told my post set off a flurry of activity in the accounting firms as they tried to find a way to justify not recording deferred taxes. The IPO filing of Ikang Globin Health Care Group, Inc. shows how accountants plan to deal with the issue.
Aggregate undistributed earnings of the Company’s VIEs and its VIEs’ subsidiaries located in the PRC that are available for distribution to the Company were approximately $8,120 as of March 31, 2013. A deferred tax liability should be recorded for taxable temporary differences attributable to the excess of financial reporting amounts over tax basis amount in domestic subsidiaries However, recognition is not required in situations where the tax law provides a means by which the reported amount of that investment can be recovered tax-free and the enterprise expects that it will ultimately use that means. The Company has not recorded any such deferred tax liability attributable to the undistributed earnings of its financial interest in VIEs because it believes such excess earnings can be distributed in a manner that would not be subject to income tax.
What they are saying is that they do not need to provide deferred taxes if they can find a way to get the profits out of the VIE tax-free. That is how the rules work, but getting profits out of a VIE tax-free is not easy.
I understand a proposed idea is that the company will set up a new VIE, and then transfer the operating assets of the old VIE to the new VIE. Then the old VIE would be sold to the WFOE and then liquidated. That would move all the cash to the WFOE.
This transaction requires two huge assumptions. First, the transaction assumes that the assets of the old VIE can be transferred to the new VIE without tax. In the case of Ikang, there are $91 million of assets in the VIE. Transferring assets of that volume without triggering a tax liability for income taxes, VAT, and other levies seems unlikely. Since the business is operated in the VIE, the value of the VIE likely approximates the market capitalization of the company, so it seems likely there would be a big gain since the proposed IPO will likely value the company much higher.
The second big assumption is that the old VIE can then be transferred by the VIE shareholder to the WFOE without triggering a capital gain to the old VIE shareholder. The only way this can be done is if the VIE shares are sold for cost, or less. In Ikang’s case, the retained earnings of the VIE are $8 million, which is the amount of cash that must be extracted. So if the cost basis of the VIE shares are $8 million or more this transfer would not result in any gain. I will bet dollars to donuts that the cost basis is near zero. So the shares have to be valued at less than the cash in the company. The argument for that is that the VIE contracts severely restrict the ability of the shareholder to get the cash. Given the questionable enforceability of these contracts the tax bureau should not have difficulty refuting that argument.
Of course this entire exercise is just mental masturbation for accountants. No company actually plans to take cash out of the VIEs in this way. They just have to say they would be willing to do it if they had to. Nobody plans to take cash out of VIEs, and that is a fundamental flaw in the VIE concept.
I am expecting all of the other companies with VIEs in this situation to follow the Ikan lead so they will not be forced to restate their financial statements. All except for the Ernst & Young clients, of course. While individual fact patterns have some effect on this analysis, the difference in approach between E&Y and the other Big Four firms is not understandable. Somebody has this wrong, and the SEC ought to help the firms sort out who that is.