Potential investors in Twitters’s planned initial public offering may be struggling to estimate how much the company will have to pay in taxes in the future. An article in Politico on Friday highlighted some of the techniques Twitter might use to legally avoid taxes.
Twitter’s biggest potential tax shelter is its history of losing money. Like most growth companies, Twitter has accumulated a lot of operating losses. These losses, in theory, can be carried forward as net operating losses to offset future taxable income. But investors should not count on it.
Buried deep in Twitter’s S-1 (on page F-43) is a description of the company’s tax assets. A tax asset is an accounting item that represents a possible reduction of a company’s tax liability in the future.
For the year ending 2012, these tax assets total $91 million, a potentially significant amount of tax savings if Twitter starts turning a profit. But the financial statements then explain that management established a “valuation allowanceâ€â€"that is, wrote down the value of the tax assetsâ€"by $42 million. That means the company believes that much of the value of these assets will not be fully realized.
This kind of valuation allowance is not unusual among newly public companies. According to research by Eric Allen of the University of Southern California, 82 percent of companies that held I.P.O.’s record an allowance that reduces the value of the associated deferred tax asset to zero.
Why did Twitter’s managers and auditors decide to write down the value of these net operating losses? There are two possibilities, only one of which should bother investors.
One possibility is uncertainty about Twitter’s ability to ever generate enough income to absorb all of these accumulated losses. If you never turn a profit and never have taxable income, then tax losses aren’t valuable at all. Obviously, such a signal that management doesn’t expect the company to have income in the future should be of real concern to investors.
The more likely explanation, however, is rooted in the details of the Internal Revenue Code. Section 382 restricts a company’s ability to use tax losses in the event of certain ownership changes.
These restrictions were intended to prevent trafficking in tax losses: Congress wants mergers and acquisitions to occur for business reasons, not merely because a target has tax losses that a buyer might use to offset other taxable income. If an ownership change takes place, then strict limitations apply to the company’s ability to use previous tax losses to shelter income going forward.
Section 382 is drafted in such a way that it focuses on changes in ownership among shareholders who own at least 5 percent of the company, and it accidentally catches some ownership changes that it probably shouldn’t.
In the case of Twitter, one may expect many of the founders, venture capitalists and later-stage investors to sell their interests over the months and years to come. These ownership changes are likely to restrict Twitter’s ability to use net operating losses under the Internal Revenue Service Code.
This is an unfortunate result for Twitter, as it destroys a valuable tax asset. For investors, however, this technical legal explanation is at least better than the alternative of never seeing Twitter make a profit in the future.
Victor Fleischer is a professor of law at the University of San Diego, where he teaches classes on corporate tax, tax policy, and venture capital and serves as the director of research for the Graduate Tax Program. His research focuses on how tax affects the structuring of venture capital, private equity, and corporate transactions. Twitter: @vicfleischer
