Xcelera.com in Collapse, Shares Drop By 90 Percent
by Christopher Byron
Bloomberg News
Nobody likes to drop a bundle on a risky tech stock that collapses soon after purchase. But think how much worse you’d feel if, at year’s end, you were to get blind-sided all over again—this time with a tax bill from the Internal Revenue Service for income you never received, but which the I.R.S. says you have to pay taxes on anyway, simply as a result of having owned the stock.
Well, that’s the fate that now awaits thousands of investors in Wall Street’s zero-to-hero Internet darling of the last year—Xcelera.com Inc.—which soared to nosebleed heights on a deluge of breathless press releases from the company and an equally breathless endorsement from self-styled technology futurist George Gilder.
That, plus some journalistically troubling stock pumping by a reporter on Microsoft Corporation’s MoneyCentral Web site. He bought the stock for his personal account, then began praising it to the skies in print. That helped send Xcelera.com’s American Stock Exchange–listed stock price rocketing from a split-adjusted 14 cents a share in February 1999 to an intraday peak of $112.50 on March 23—a runup of more than 80,000 percent.
As Xcelera.com’s stock price soared, the company began striking deals with others in the Internet space. One of those deals—a $637.5 million transaction involving Exodus Communications Inc., a Web-hosting company based in Santa Clara, Calif.—now has Xcelera’s shareholders facing a huge, year-end tax bill.
Meanwhile, Xcelera’s stock price has predictably enough collapsed—partly, it would seem, because the company’s chairman and chief executive, a Greenwich, Conn., financier named Alexander Vik, began dumping huge amounts of his stock onto the market in February as the share price was peaking.
Now, Xcelera.com is selling for under $14 per share, wiping out almost 90 percent of the company’s market value in little more than four months’ time. Yet anyone who plans to sit with the shares through the end of the year in hopes of a bounce-back in the price could get the shock of his life. That’s because Xcelera.com disclosed that it expects to be classified by the I.R.S. as a so-called Foreign Personal Holding Company.
As a result of the way the tax code works in such matters, end-of-year shareholders will have to pay taxes on their pro rata share of the company’s taxable income, even if none of it is paid out as a dividend.
How much money are we talking about? Xcelera.com itself hasn’t said, but an Aug. 1 report by Lazard Frères & Company puts the potential burden at an estimated $7 a share of imputed dividend income that the company never paid, but that shareholders will have to declare as having been received anyway. Another firm, Anglo-American Investor Services Corporation, citing the Lazard report, puts the number at $6.75, whereas our own estimate pegs the burden at closer to $6.18 a share.
In any case, any investor who bought a round-lot (100 shares) of Xcelera.com when the stock was selling in March for $100 per share would have paid $10,000 only to see, as of this writing, $8,500 of it disappear in Xcelera’s collapse. Of the $1,500 of value that remains, as much as $615 of it may wind up at year’s end being taxed as ordinary income, even though the investor never received a dime of cash and actually suffered an 85 percent loss on the investment.
Why has all this happened? Because Xcelera.com is not a U.S.-based company. Instead, it is incorporated and headquartered in the international tax-haven hideout of the Cayman Islands. What’s more, five or fewer individuals—most prominent among them being Mr. Vik himself—own more than half the company. And finally, thanks to the deal with Exodus Communications, more than 60 percent of Xcelera.com’s income this year has come from passive sources (in this case, the sale to Exodus of a 15 percent stake in an Xcelera subsidiary).
Those facts bring Xcelera.com within the I.R.S.’s definition of a so-called Foreign Personal Holding Company. These are businesses for which the I.R.S. has established special and restrictive rules, to prevent the people who set them up from escaping taxes via the artifice of letting the profits from stock deals, real estate transactions and so forth pile up abroad, in foreign-based companies that are not subject to U.S. tax law.
To stop that from happening, the I.R.S. simply taxes the owners instead. This is done by requiring any U.S. taxpayer who holds stock (no matter how little) in a Foreign Personal Holding Company to declare, as a dividend, his or her pro rata share of the company’s taxable income during the year, whether or not that income is paid out to the shareholders as a dividend or in any other way.
This is something no one seems to have considered when both Exodus and Xcelera.com announced on March 22 that Exodus was making a $637.5 million equity investment in a Woburn, Mass.-based Xcelera subsidiary named Mirror Image Internet Inc.
An Xcelera.com spokesman said the company’s lawyers maintain that the ramifications of the Foreign Personal Holding Company issue were spelled out to the public in a so-called "6K" filing by Xcelera to the Securities & Exchange Commission at the time of the transaction. But the first 6K filing to mention the matter was received by the S.E.C. only on June 2, two and a half months after the deal was announced. Moreover, since 6K filings by foreign companies are not electronically available, investors rarely even know they exist until Disclosure Inc., the leading public-document retrieval firm, physically obtains the filings from the S.E.C. and offers them for sale to the public. Disclosure did not begin offering the 6K in question to the public until July 13, and it said even the S.E.C. did not make the document available publicly until 48 hours earlier, on July 11. This means the investing public knew nothing of the tax cloud over Xcelera’s stock until four months after the fact.
In the deal itself, Xcelera sold roughly 17 percent of its more than 90 percent ownership interest in Mirror Image Internet to Exodus for $75 million in cash and $562.5 million in Exodus stock. Since Xcelera had acquired its Mirror Image stake as of Jan. 31 for less than $17 million, the resale to Exodus of 17 percent of that stake for $637.5 million represented a stock sale in which almost 100 percent of the purchase price was a capital gain.
With somewhere around 106 million total shares in Xcelera.com outstanding (according to the company), the Exodus deal, plus an $18.1 million gain by Xcelera.com from the sale of some Spanish real estate, looks to have resulted in phantom income of as much as $6.18 a share for each U.S. taxpayer holding Xcelera.com stock at the end of the year.
Now one would think that it would be a matter of extreme, overriding and vital importance to each and every actual and potential U.S. shareholder in Xcelera.com to know exactly how much imputed income each share of Xcelera stock will carry at year’s end. That exposure could rise if the company does other Exodus-like deals, or conversely fall if its efforts to establish itself as an Internet company generate large operating losses that reduce taxable income by year’s end.
But investors will almost certainly not learn the truth of the matter until it is too late to do anything about it. That is because, thanks to Xcelera.com’s status as a foreign- incorporated and -domiciled company, it is required to file financial reports to the S.E.C. and the public only once yearly, within six months of the end of its fiscal year.
This means that Xcelera.com is not required, or expected, to file a financial statement covering its year 2000 results until July 31, 2001, or seven months after the end of the current tax year for nearly all individual U.S. taxpayers.
In other words, no individual investor holding Xcelera.com shares at the end of this year will be able to file an April 15, 2001, tax return without automatically having to file an amended return once Xcelera reports its year 2000 financial results the following July. Only then will it be possible to know how much in make-believe dividend income U.S. taxpayers will have had to report. The only way around that problem will be for investors to request an extension of their April 15 filing deadline and wind up having their 2000 tax returns hanging over them until they finally get the necessary information from Xcelera.com.
And who knows what additional burdens Xcelera.com may heap on its shareholders in the meantime? Suppose Exodus buys more of Mirror Image. Or the whole of Xcelera.com is taken over in a merger. What tax burdens will U.S. investors face then?
This is a real problem for the company. Xcelera describes its business strategy as being that of "an Internet holding company." But it makes no sense to pursue that strategy unless Xcelera at some point sells stakes in its portfolio to the public.
Already, one of the companies in which it holds a position—Corechange Inc.—has filed for an initial public offering. But if Corechange proves a hit and Xcelera tries to cash in on it by selling some of its stake in the company, it might well create taxable income under Foreign Personal Holding Company rules and put a whole new burden on its U.S. shareholders.
In other words, the more successful Xcelera proves to be as an incubator of Internet start-ups, the more likely will be the case that all its profits get taxed to its U.S. shareholders even though they may never see a dime of cold, hard cash.
All these problems, and more, are a direct result of investing in a foreign-based company whose latest financials are automatically six months to 18 months out of date by the time the public sees them.
According to the company’s latest financial filing, delivered to the S.E.C. July 31, balance-sheet cash totaled $3.4 million as of Jan. 31. That number has since presumably grown with the inclusion of $75 million from the Exodus deal, but almost four months have passed since Xcelera received the money, so how much of it is left is anyone’s guess. The company’s latest filing says that as of April 30, Xcelera and Mirror Image collectively held $439.7 million of cash and marketable securities. But that sum presumably includes the stock portion of the Exodus deal, which by then had already fallen 50 percent in value, and who knows how much it will be worth in the future!
Nor is Xcelera’s ownership interest in Mirror Image, now put at 78 percent by Xcelera, undisputed. When we first raised a red flag about investing in this company last May, we reported that dissident shareholders in Mirror Image were claiming they’d been improperly maneuvered out of control of their company by Mr. Vik and were preparing legal action to be reinstated. Mr. Vik dismissed this as a meaningless matter, but the company’s filing of July 31 now discloses that an arbitration proceeding has been launched.
Meanwhile, the July 31 filing reveals the existence of what appears to be yet another dispute over the Mirror Image acquisition. In this dispute, Xcelera is apparently negotiating with unnamed third parties and, to make them happy, may have to hand over what looks to be as much as $622 million worth of Xcelera stock. At Xcelera’s current price of $14 per share, that would require the issuance of nearly 45 million new shares in the company, diluting existing shareholders by almost 45 percent. This, too, is something U.S. shareholders are now learning about from the company for the first time.
Who needs surprises like that? There are more than 8,000 publicly traded companies on Wall Street in which investors can put their money. Buying shares in one of a mere handful of them that are domiciled in a foreign tax haven, and only report on their activities after the information being disclosed is months or even a year or more out of date, is simply asking for trouble. |
