The Road Not Taken: Yahoo's Huge Tax Gamble

SMITH BRAIN TRUST — Yahoo announced on Wednesday that it was reversing course on a plan to spin off its stake in the Chinese e-commerce company Alibaba — shares worth more than $30 billion. Yahoo shareholders would like to be able to cash in some of that stake — the fruits of a timely $1 billion dollar investment made a decade ago — but they face substantial taxes if they do so. The company came up with a plan that it thought would offer a way around the tax penalty: Spinning off the Alibaba holdings into a separate company.

Activist investors opposed the plan, saying it was likely to be rejected by the IRS, and Yahoo ultimately gave it up, deciding instead to spin off Yahoo's core Internet businesses. Smith School accounting lecturer Samuel Handwerger explains the accounting logic underpinning why Yahoo wanted to spin off Alibaba, and how it had hoped to escape billions in taxes:

"Yahoo has already sold some of the shares of Alibaba at a nice gain and passed the profits to its shareholders. But there's a tax issue that arises when they do things that way. Yahoo is a C corporation, and so the profits from the sale are doubly taxed.

"Here's how: When Yahoo sells some of the Alibaba stock at a gain, it pays tax at a corporate rate of 35 percent. That rate is not the favored rate on capital gains that individuals pay on sales of stock since C corporations do not have favored capital gains rate of tax. Instead they pay tax at the 35 percent rate, the  regular corporate tax rate.

"After the gains from the stock sale are taxed at 35 percent, Yahoo then sends the cash profit left, after tax, to its shareholders who incur yet another tax at the shareholder level. That tax can be as much as 23.8 percent, the highest rate individuals pay on capital gains. When you put the two levels of tax together, total tax on the gain hits 50 percent. Ouch!

"The idea behind the spin-off was to avoid this double taxation on the fortuitous gain Yahoo has made from its Alibaba investment.

"If Yahoo can spin off this investment into a new corporation — call it 'Newco' — it can then distribute the shares of Newco tax-free to its shareholders. At this point the Yahoo shareholders own shares of two companies — first, the original Yahoo holding all of the assets minus the investment of Alibaba; and second, Newco, the company holding the Alibaba stock. Then the shareholders can go off to the marketplace and sell their Newco shares, thereby recognizing a gain based on the value of the Alibaba holdings, but avoiding the double tax. Complicated? Yes, indeed. But section 355 of the Internal Revenue Code allows for just this type of scenario.

"There's a catch, however. The typical scenario contemplated by section 355 is one of where a corporation has two or more lines of business that it has determined cannot operate together any longer under one roof. The company needs, for business purposes, to split these two lines of businesses into two separate entities. This code section allows you to do that without incurring tax, which could otherwise make the cost of such a split prohibitive.

“So what does this catch have to do with Yahoo? Yahoo’s plan didn’t look like it passed the business purpose test. Yahoo had already formed a new corporation, owned by Yahoo as a subsidiary, called Abaco Holdings. The active business that Yahoo had chosen to place with Abaco is Yahoo Small Business, which sells services that help companies do business on the Web. Yahoo would eventually also place into Abaco Holdings the shares of Alibaba. At that point, the balance sheet of Abaco Holdings would look more like an investment company than an actual business, because the Alibaba investment dwarfed Yahoo Small Business.

"Yahoo outlined its strategy in a written request to the IRS and asked for a private ruling that the transaction would be tax free. The IRS denied rendering an opinion. The IRS didn't say the transaction would be taxable; they simply said they wouldn't rule on it in advance. They then issued a series of announcements in the form of rulings and notices that discussed a transaction like this and proceeded to describe why it would not be tax free. The IRS was not mentioning Yahoo directly, but the subtlety was not lost on Yahoo and, in particular, its shareholders. 

“If the IRS rules that the plan lacks the requisite business purpose requirement of Section 355 the transaction will be taxable to both the corporation and the shareholders. A tax disaster. Ultimately, Yahoo decided that was a risk not worth taking."

SMITH BRAIN TRUST
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