Investors in Xcelera.com Get a Tax Surprise: Christopher Byron 8/9/0 0:1 (New York)
Weston, Connecticut, Aug. 9 (Bloomberg) -- Nobody likes to
drop a bundle on a risky tech stock that collapses soon after
buying it. But think how much worse you'd feel if, at year's end,
you were to get blindsided all over again -- this time with a tax
bill from the Internal Revenue Service for income you never
received but which the IRS 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 nose-bleed 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 Corp.'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 14 cents a share in February
1999, to an intraday peak of $112.50 last March 23 -- a run-up of
more than 80,000 percent. (The prices are adjusted for stock
splits.)
As Xcelera.com's stock 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, California -- now has
Xcelera.com's shareholders facing a huge, year-end tax bill.
The CEO Sells
Meanwhile, Xcelera.com's stock price has predictably enough
collapsed -- partly, it would seem -- because the company's
chairman and chief executive, a Greenwich, Connecticut, 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 about $14 a 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 IRS
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.
The Tax Bite
How much money are we talking about? Xcelera.com itself
hasn't said, but an Aug. 1 report by Lazard Freres & Co. 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 Corp., citing the Lazard report, puts
the number at $6.75, whereas our own estimates peg 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 a
share, would have paid $10,000 only to see, as of this writing,
$8,500 of it disappear in Xcelera.com's collapse. Of the $1,500 of
value that remains, almost half of it, or as much as $615, 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 Communications of a 15
percent stake in an Xcelera.com subsidiary).
Special Rules
Those facts bring Xcelera.com within the IRS's definition of
a foreign personal holding company. These are businesses for which
the IRS has established special and restrictive rules to prevent
the people who set such companies 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 IRS 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 Communications and Xcelera.com announced on March 22 that
Exodus Communications was making a $637.5 million equity
investment in an Xcelera.com subsidiary named Mirror Image
Internet Inc., based in Woburn, Massachusetts.
Timing of Disclosure
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.com to the SEC at the time of the transaction. But the
first SEC filing to mention the matter was received by the SEC
only on June 2, two and half months after the deal was announced.
Moreover, since 6K filings by foreign companies are not
available by computer, investors rarely even know they exist until
Disclosure Inc., a public document retrieval firm, physically
obtains the filings from the SEC and offers them for sale to the
public. Disclosure did not begin offering the 6K in question to
the public until July 13, and said the SEC itself did not even
make the document available publicly at all, until 48 hours
earlier, on July 11. This means the investing public knew nothing
of the tax cloud over Xcelera.com's stock until four months after
the fact.
Phantom Income
In the deal itself, Xcelera.com sold roughly 17 percent of
its more than 90 percent ownership interest in Mirror Image to
Exodus Communications for $75 million in cash and $562.5 million
in Exodus Communications stock. Since Xcelera.com had acquired its
Mirror Image stake, as of Jan. 31, for less than $17 million, the
resale to Exodus Communications 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, according to the company, somewhere around 106 million
shares in Xcelera.com outstanding, the Exodus Communications 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.com 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.
Annual Filings
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 SEC 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.com 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.
The Business Strategy
And who knows what additional burdens Xcelera.com may heap on
its shareholders in the meantime? Suppose Exodus Communications
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.com describes
its business strategy as being that of ``an Internet holding
company.'' But it makes no sense to pursue that strategy unless at
some point it 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.com 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.com 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.
Balance Sheet Cash
According to the company's latest financial filing, delivered
to the SEC July 31, balance sheet cash totalled $3.4 million as of
Jan. 31. That number has presumably since grown with the inclusion
of $75 million from the Exodus Communications deal, but almost
four months have passed since Xcelera.com 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.com and Mirror Image
collectively held $439.7 million of cash and marketable
securities. But that sum presumably includes the stock portion of
the Exodus Communications 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.com's ownership interest in Mirror Image, now
put at 78 percent by Xcelera.com, 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 July 31
filing now discloses that an arbitration proceeding has begun.
Another Dispute
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.com 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.com stock. At Xcelera.com's price of about $14 a
share, that would require the issuance of almost 45 million new
shares in the company, diluting existing shareholders by nearly 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 is domiciled in a foreign tax haven, and only reports on its
activities after the information being disclosed is months and
even a year or more out of date, is simply asking for trouble. |
