Failure of Yahoo's Alibaba spinoff would have messy consequences

Yahoo informed its shareholders on Tuesday that the Internal Revenue Service had decided not to issue a private letter ruling on its proposal to spin off its $23 billion stake in Alibaba. Such a ruling would have ensured that the spinoff would be tax-free to Yahoo and its shareholders. Yahoo indicated that it was continuing to work on the spinoff. As proposed, the deal would place Yahoo's small-business division into a holding company, Aabaco, along with the Alibaba stake.

One possibility is that the spinoff will proceed as planned, relying on a legal-opinion letter from the law firm Skadden, Arps, Slate, Meagher & Flom to reassure shareholders that it should be tax-free.

But what if it isn't tax-free? If it is a taxable transaction, it will be a blood bath from a tax point of view. At least two bad things will happen. The first is that Yahoo itself will face a tax bill of about $7 billion on the distribution of Aabaco to its shareholders. Under a doctrine known to tax lawyers as the "repeal of General Utilities," section 311(d) of the tax code imposes tax liability on a corporation when it distributes appreciated property to its shareholders.

Yahoo, in other words, will face the same tax bill it would have faced had it sold the underlying Alibaba stock. The difference is that it will not have any cash with which to pay its taxes. I explain this in more detail below.

The second bad consequence of a failed spinoff will be that Yahoo's shareholders will not recognize dividend income equal to the fair market value of the Aabaco shares they received. Making matters worse, the Yahoo shareholders will not receive any cash in the distribution. Some of them might have to sell the newly received Aabaco shares in order to pay the tax bill. Yahoo has expressed confidence in its tax advisers, but at the same time, it is taking steps to protect its own hindquarters in case of a failed spinoff. Aabaco's registration statement, filed in July, explains, "Pursuant to the tax matters agreement, subject to limited exceptions, the fund will be required to indemnify Yahoo, its subsidiaries and specified related persons for taxes and losses resulting from the failure of the spinoff to qualify as a tax-free transaction under Sections 355 and 368(a)(1)(D) of the code."

What this means is that if the spinoff fails, Aabaco will pay back Yahoo for any taxes that Yahoo has to pay as a result of the failed transaction. The indemnification ensures Yahoo a seat in this game of musical tax chairs. Aabaco, not Yahoo, would effectively be on the hook for a $7 billion tax bill.

To cover the tax liability, Aabaco will presumably have to sell about a third of its Alibaba stake, or perhaps borrow the amount using the Alibaba stock as collateral.

What happens next is unclear? Yahoo may decide to play chicken with the I.R.S. and charge ahead. If Yahoo closes the deal fast enough, it puts the I.R.S. in a tough spot. Historically, the I.R.S. has been reluctant to challenge the tax treatment of public deals after they close. No one at the I.R.S. wants to go after thousands of individual Yahoo shareholders for unpaid dividend taxes. If the I.R.S. is going to scotch the deal, it's more likely to do so before the spinoff closes. If the I.R.S. is indeed taking a serious look at the spinoff rules, it should give some preliminary guidance as to what the new rules would look like, and it should do so sooner rather than later.

For example, the I.R.S. could say that there must be a business purpose for any cash or liquid securities contributed to SpinCo (in this case, Aabaco). Because there is no conceivable nontax business purpose for Yahoo's small-business division to hold billions of dollars of Alibaba stock, such a statement would force an end to the deal. I don't think there's a simple way for Yahoo to avoid paying taxes on the appreciation of its stake in Alibaba. It would probably be better off selling the stock, paying the tax, distributing what's left to its shareholders and letting its management get back to concentrating on the core business.

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