Carson Block of Muddy Waters is shorting 500.com (NASDAQ: WBAI), which did an IPO at the end of 2013. One of the reasons for his short position is the un-usual tax position of the company, which recorded a tax benefit in 2013 equal to 84% of net income.
The tax benefit comes from reversing deferred taxes related to the retained earnings of the companies VIEs. EY is 500.com’s auditor, and I have previously written about how EY clients follow the unusual (although probably correct) ap-proach of providing deferred taxes for the tax cost of transferring profits out of the VIEs.
500.com has revised its VIE agreements and now argues it no longer has to provide those taxes, so they have been released to income.
500.com did this by having its wholly foreign owned enterprise (WFOE) assign certain of these contracts to its Cayman Islands company. It argues that assign-ment makes the Cayman Islands company the principal beneficiary of its VIE. It then takes advantage of an old accounting standard known as APB 23 to argue that the profits are indefinitely invested in the VIE and do not require deferred taxes to be recorded. APB 23 only applies in cross border situations, so it was unavailable when the WFOE was the principal beneficiary of the VIE. but by making the Cayman Islands company the beneficiary, it creates a cross border situation.
In my opinion they are too clever by half. 500.com says that on December 28, 2013, E-Sun Sky Computer, its WFOE, assigned the rights to attend the VIE shareholders meetings and vote to 500.com, a Cayman Islands Company. The accounting rules say that the principal beneficiary of the VIE is the party that: 1) has the power to direct the activities of the VIE that most significantly impact its economic performance and 2) has the obligation to absorb losses OR the right to receive benefits. The VIE agreement that provides the right to receive benefits is the technical service agreement, and that was not assigned to 500.com – it remains in place with the WFOE. 500.com instead put in place a guarantee that it would provide unlimited financial support to the VIEs. While those steps may have made 500.com the principal beneficiary of the VIE, do they change the liability for deferred taxes for retained earnings of the VIE? I don’t think so. The VIE deferred taxes should be based on the method in which those accumulated profits would be extracted from the VIE. Making 500.com responsible for the losses of the VIE may make it the principal beneficiary for determining whether the VIE can be consolidated, but it does not give 500.com the right to the profits of the VIE. Those profits must be extracted through the technical service agree-ments that remain in place with the WFOE. And any taxes that would be paid by the WFOE on receipt of those service fees would not qualify for the APB 23 exception. Alternatively, the profits of the VIE could be distributed as dividends to the Chinese shareholder of the VIE, who would pay a 20% individual income tax. That tax would also not be eligible for APB 23 treatment. And what would happen to the after tax dividend? The agreements provide that any dividends must be transferred by the VIE shareholder to the WFOE, and I don’t see where those agreements were changed. I do not understand the basis under which the company has released the deferred taxes it had previously recorded on the re-tained earnings of its VIEs. I expect that the attention of the market to this issue will draw the attention of the SEC, which will hopefully get to the bottom of it.
Curiously, neither Soufun nor Autohome, two other EY clients that have provided deferred taxes on VIE retained earnings have taken the position of 500.com. It seems so simple to implement that one must wonder why.