Deferred taxes and VIEs | China Accounting Blog | Paul Gillis

Deferred taxes and VIEs

Autohome (NYSE:ATHM) had a successful debut on Wednesday with the shares popping 80% above the offering price. That is the seventh IPO in the U.S. this year, ending a drought. Investors seem less spooked by the VIE structure and risk of regulatory problems with the SEC and PCAOB. None of those issues have been fixed, but investors seem convinced that they will not escalate. Despite recent short seller attacks at Fab Universal (successful) and NQ Mobile (largely unsuccessful) investors seem comfortable that they will not be victims of yet another Chinese accounting fraud.

Unless sentiment changes, I am thinking that 2014 could be like 2007 with perhaps as many as 30 U.S. IPOs. That will hardly make a dent in the backlog of private equity money waiting for an exit, but it will be a good start.

Autohome’s filings present a fascinating new issue. Autohome has accrued a deferred tax liability of $75 million for “outside basis difference”. While this issue has been bouncing around for some time, I believe this is the first time that a company has recorded the liability.

The filings are sketchy on details, but what I believe the item relates to is the difference between the book basis of the VIE and its tax basis. That difference is a temporary difference that requires deferred tax accounting. The difference comes about because the retained earnings of the VIE are consolidated for financial reporting purposes, but because they are not paid out to the public company in service charges there is no “tax basis” in them. In this situation the company is required to provide for the taxes that would be payable if the amounts were distributed. This is essentially thesame issue I raised recently when I suggested companies should be accruing the service charges. Providing taxes on the assumption the earnings will be distributed in another form is an alternative to my proposed treatment (and probably with similar affect).

While the company does not disclose the amount of retained earnings in the VIE, they are probably not much different than the equity of the VIE, which is disclosed at $264 million. That means that deferred taxes are being provided at a rate of about 28%. That is higher than China’s statutory tax rate of 25%. I have no idea how they calculated that but the disclosures should have explained it.

It is uncertain at this point whether the SEC forced Autohome to book this liability, or auditors Ernst & Young, or perhaps we just have a savvy and conservative management. What is certain is that this is going to cause a lot of headaches for the other Chinese companies that have not done this.

For example, New Oriental Education and Technology Group Inc.(NYSE:EDU) has not recorded any deferred taxes related to “outside basis difference”. If we apply Autohome’s rate of 28% to New Oriental VIE equity of $418 million would have a deferred tax liability of $117 million. Instead, New Oriental explains that there are several reasons why it has not provided deferred tax. First, it says, it would be difficult to do the calculation. Second, the company intends to reinvest the money indefinitely, and third, there are ways to get the money back tax-free.

For the first argument, it appears that Autohome figured out how to do the calculation, so New Oriental should be able to do so too.

The second argument is only partly true. It refers to an exception in deferred tax accounting for profits that are indefinitely invested in foreign subsidiaries. But this exception only applies in cross border situations, so it would allow New Oriental to not provide the 10% withholding tax required to get the profits from the WFOE to the Cayman Islands holding company, but it does not apply to taxes to get the profits out of the VIE and into the WFOE.

The third argument is the most interesting. While at first blush it looks like Autohome needs to hire New Oriental’s tax advisors, I suspect that arguing that the profits can be taken tax free from the VIE requires an assumption that Chinese tax authorities are daft.

I have heard several arguments that profits could be taken out a VIE by first moving the business into a new VIE, changing the business license of the old VIE to an unrestricted business, and then merging the old VIE into the WFOE. This idea rests on the assumption that the assets can be transferred to the new VIE at cost instead of fair market value. It would not take a particularly talented tax official to realize that the value of these assets is closer to EDU’s market cap of $4 billion and to then assess taxes of $1 billion. In any event, investors deserve to know more about how EDU really expects this strategy to work, especially since Autohome apparently does not think it does.

I have a further problem with New Oriental’s approach. Chinese companies have been telling us for years that they can include VIEs in their financial statements because they can get the profits out through service contracts. Now they say, never mind, that does not work. But we have a new idea. We just won’t explain it to you.

These are all non-cash items. I don’t expect that Autohome ever expect to pay this deferred tax. Nor does New Oriental expect to ever have to use its tax planning strategy. So many analysts might just choose to ignore this kerfuffle. But it is another example of how the VIE structure continues to deepen contradictions.

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